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macroeconomic theory

Macroeconomics A European Text 7th Edition Michael Burda ,Charles Wyplosz - Solutions

Between 2000 and 2007 the price of oil, quoted inUSdollars, increased by 92.4%. Quoted in euros, it ‘only’ increased by 52.8%. Howcan you explain the difference?Explainwhy a‘hard currency’ is frequently considered aweapon against imported inflation.
throughout. Compute period after period theactualand underlyinginflation rate until theeconomy returns to along-run equilibrium. What conclusion do you draw?
Thesupply curveis given by thefollowing relationship: Initially, π = and s = 0. Then the government increases demand and raises output and keeps it at this level until inflation reaches therate of 4%,at which stagethey let the output gap return to zero. Assumethat the underlyinginflation rate˜π
Supposea government underestimates theequilibriumrate of unemployment and attempts to reducethe unemployment rate belowtheequilibriumrate by stimulatingaggregate demand. Showthelikely outcome ofsuch a policy usingtheshort-and long-run Phillipscurves.
UsingExercise 3,consider theeffect ofareformof labourmarket institutions which reducesequilibriumunemployment from7%to 5%. Explain theeffect on inflation in theshort termand in thelongterm.
What could betheeffect ofan increasein valueadded taxation (VAT) on inflation?Ofan increasein corporate profit taxes?Ofan increasein personal incometaxes? State yourassumptionscarefully.
In the 1980s, when inflation in Brazilexceeded 1,000% a year, all prices and wages wereindexed week by week. Why was indexation not only popular but generally perceived as vital?If inflation wereexactly 1,200% over a year, what is theimplied weekly inflation rate(assuming weekly
Usingtheconditions of the previousexercise, showtheimpact ofsupply shocks s = 5%,and s = –2%. Separately showtheeffect of raising to 10,200. Why is it argued that improvingthe performance of thesupply side of theeconomy is good for both inflation and employment?
A Phillips curve is represented by the following relationship: , wheres is a supply shock term, on average equal to zero. Draw the Phillips curve when = 7% and underlying inflation = 3% and 6%. Okun’s Law is. Drawtheaggregatesupply schedulewhen = 10,000.
Using theIS–TR analysis developed in Chapter 11 and 12, consider an exogenous declinein demand, for exampleareduction in publicspending. Show graphically that either exchangerateflexibility or priceflexibility is enough to achievethe neoclassical result that output remains constant at its trend
Figure 13.1 describes howrealGDP and the pricelevel react over timeto a one-off increasein themoney stock. What happens to nominalGDP?
Emergingmarket countries typically haveto offerarisk premiumwhen they borrow. This means that their domesticinterest rates are higher than thoseabroad. What is the impact ofasudden loss of trust?Discuss why thiscould happen. What arethe policy options in each case?
Even within amonetary union, it is still possibleto haveareal depreciation orappreciation, but it involves changes in the pricelevelat home orabroad. Why is this difficult to analyse usingtheIS–TR-IFM framework?
‘Adoptingan exchangerateanchor isamixed blessing.’ Comment.
As their namesuggests, beggar-thy-neighbour policies havea bad reputation. Discuss why this may bethecaseandwhat can be doneto limit the perceived drawbacks.
International financialmarkets mean that the domesticinterest rateis determined abroad. Why does this mean that monetary policy is abandoned, but only in theabsence of capitalcontrols?Why arecapitalcontrols neverthelessconsidered a bad idea?
Imaginethat the Danish central bank prevents its exchangeratefromappreciating by selling 100 million kroner on theexchange market and buying euros. Usethe balance sheets of thecentral bank and ofcommercial banks presented in Chapters 9 and 10 to describecarefully this foreign exchangemarket
Consider asmall open economy in a monetary union (i.e. afixed exchangerateregime). Tracethrough theconsequence of a pricelevel declineat home, holding theforeign pricelevelconstant. Howwould youranswerchangeif foreign prices declined in thesame proportion?12Answer thesame question but
Figure 12.11 shows that in troubled times, safe-haven currencies likethe Swiss franccan risesharply. Concerned international investors seemwilling to accept alower rate of return than in normal times. Evaluatetheimpact of becomingasafe-haven small open economy with (1) flexibleexchangerates,and (2)
What is theeffect of taxcut underafixed exchangerateregime?Underafloatingexchangerateregime?
What is theeffect ofan exchangeraterevaluation in afixed (but adjustable)exchangerateregime?
Supposethe UKleft the European Union,and that this movemeant that UKexports to the EUfaced thecommon external tariff.As aresult, UKexports drop sharply. (Its imports would also decline, but assumefor thesake of theexercisethat the decline ofexports is larger.) Explain theeffect of this ex-ogenous
In asituation of economic or political instability, astandard reaction of citizens is to exogenously reducetheir demand for money. What happens then to theinterest rate, income,and themoney supply underafixed exchangerateregime?When thecentral bank obeysaTaylor rule?Explain alsowhat happens to the
Showtheeffects ofan increasein theforeign rate of return under fixed and flexibleexchangerates. What happens to themoney supply in each case?
In 2011–2012, many southern European countries which usetheeuro undertook drasticmeasures to rein in their budget deficits, in particular taxincreasesand spendingcuts.It is often claimed that such austerity measures are counterproductive, especially in a fixed exchange rate regime. Explain why
Show theeffect of a demand shock under afixed exchangerateregime: theeconomy moves frompoint A to point B in Figure 12.4. Explain why point C is not sustainable andwhy theeconomy must moveto point B.
Consider thesamecentral bank in the previous question, but this time underafixed exchangerateregime. What is the outcome? Tracethesteps ofadjustment carefully. What do you concludeabout theeffect ofmonetary policy shocks in afixed exchangerateregime?
Consideracentral bank in an economy that has floating exchangerates and sets interest rates according to the Taylor rule. Show graphically what happens when thecentral bank decides to reducethetarget interest ratefrom to . Stateclearly thesteps involved.
‘Open economies, becausethey havelowmultipliers,arelikely to bemorestablethan largeeconomies.’ Discuss.
The behaviour of inventories is aclosely watched indicator of thestate of theeconomy. Discuss under which conditions it is a valid indicator of things to come. In particular, doesan increasein inventories signalan economicslowdown ora boom?(Hint: inventory changescan beintended or unintended.)
Therearemany ways ofconductingan expansionary fiscal policy: raisingpublicspending,cuttingincometaxes, profit taxes, or VAT. What difference does it makefor different groups in thecountry?In your discussion,as you takea generalequilibriumviewof the question, look at thetwo
Does the Taylor rule summarize everything about monetary policy of a central bank? What do you think determines the slope of the Taylor rule by central banks? Is your answer likely to beconstant over time?
Military spendingis considered to beconsumption in the GDP accounts. Explain why sharp increases inmilitary spendingin the USAand the UKafter theterrorist attacks in 2001 increased GDP in thosecountries in theshort run. Would you expect theeffect to belarger in theUSor theUK,and why?How does
This exerciseconfirms theargument presented in footnote 3. Ignoring foreign absorption, theNXfunction is NX(A, σ). Notethat absorption is A= C + I + G, so with (11.1)we haveY=A+NX(A, σ). Show that this implies NX =NX(Y, σ). Use the simple representation of the NX function NX = a − bA − cσ
Consider an increasein demand for goods in theIS–TR model. Using the apparatus of Figure 11.12, show graphically what happens to output, the interest rate, and money supply when theTRscheduleis horizontal. Howwould you answer the question if theTRscheduleis upward-sloping?Interpret the difference.
Show theeffect on theTR schedule ofan increasein thesensitivity b of the Taylor rule. What is theeffect on theinterest rate?(Hint: start fromasituation where output is at its trend level.)
UsingFigure 11.10, explain why theTR schedule becomes vertical when b = ∞. (It may help to reason in the followingway: consider the effect of a largerb, and then let b becomearbitrarily large.)
Showwhat happens to themoney supply when demand for money increasesexogenously, holdingthe TRcurveconstant. Supposethat, in responseto an exogenous declinein the demand formoney, thecentral bank raises its target interest rate. What happens to themoney supply?Why do you think thecentral bankmight
The policy mix describes a combination of fiscal and monetary policy actions. Show graphically how a combination of fiscal and monetary policies could be used to reduce output without changingthe(effective) interest rate.
Supposethat the Taylor rule of an economy is , wherei is measured in percentage points. Plot theTRcurvein the diagramwith Yon the horizontal axis and i on the vertical axis. What is the effect of an increase in from 5 to 6 on the TR curve? Solve for an analytical expression for output (Y) and
DefinetheTRcurve. Why is it upward-sloping? Explainwhy theeconomy cannot be off theTRcurve, by definition. Show how interest ratesand output respond to situations inwhich theeconomy isaway fromthecrossingof ISand TRcurves.
DerivetheIScurvefor theeconomy in Exercise 4, with . Plot it in (Y, i)space.
Compare youranswer with that when t = 0. Comment on your result. DefinetheIScurve. Why is it downward-sloping? Show how theIScurve divides theIS–TRdiagraminto two regions, such that points off theIScurvecorrespond tomarket disequilibrium, which can becharacterized asexcess demand orsupply in the
In reality, taxrevenues are not exogenous, but move positively with income(GDP). Supposethat , wheret is an exogenous taxrate. Usethis taxrevenuefunction to derivethe government spendingmultiplier in thefollowingsimplemodel:
UsingBox11.1, show that if the government increases spendingbut some of that increased spendingfalls on imports—and that fraction is thesameas themarginal propensity to import (z), that themultiplier is smaller than 1/(1 − c(1 − z)). When is the demandmultiplier less than 1?Can it be negative?
Desired demand (DD) is represented by thefollowingsimplified function:Domestic and foreign price levels have been assumed constant and equal to one. Let i = 5% throughout. Initially G= T = 3,000. σ is the nominalexchange rate and is assumed fixed at one.(a) Compute the effect on GDP ofan increase
Comparetwo economies, country A and country B. Country A has a higher marginal propensity to consumefromdisposableincomethan country B. Which should havea flatter desired demand schedule? Showgraphically that thesteeper the desired demand schedule, thelarger is theKeynesianmultiplier.
In order to maintain financial stability, onetask of thecentral bank is to interveneas lender of last resort. One of thetrickiest parts is to determineifa bank is insolvent (it is really bankrupt and cannot recover) or just illiquid (it has no fundamental problembut is runningout ofcash).
The Governor of the Bank of England is obliged to write a letter to the Chancellor of the Exchequer (the Finance Minister of the UK) to explain when it misses the inflation target. Read the Governor’s letter fromAugust
Why do central banks need to havetargets?Discussand evaluatethe various possibletargets.
In prisoner-of-warcamps it wascommon to usecigarettesas money. Explainwhy this makes sense. Do you seeany problems with ‘cigarettecash?’Why might theadministrator of such acamp prefer this to, say, usingregular money or printed coupons?
Thecentral bankmandate of the Eurosystemsets pricestability as its overridingpriority. In theUSA, the Federal Reserve Systemis legally committed to pursue both ‘stability of thecurrency’and a‘high level ofemployment’. Compare and discuss thesemandates.
Box10.1 describes the openmarket operations of theECB. Explain carefully why themarginal lendingfacility establishesaceilingon themarket rateandwhy themarginal deposit facility establishesafloor.
Thetarget inflation ratein Sweden is 2%. Lookingat Figure 10.8, what do you expect thecentral bank (theRiksbank) to do over the years 2012–2014?
Consider the Taylor rule(10.2).Assumeas in thetext that a = 1.5 and b = 0.5 and that the neutral interest rateis 4%. What interest rateis implied by therule when inflation is 2% abovetarget whilethe output gap is zero. What if the output gap is 3%?And −2%?
Why is deposit insuranceaway of reducingthechances ofa bank run?What arethelimits of this scheme?
Duringthefinancialcrisis, somecentral banks bought largeamounts of ‘toxicassets’(packages of poor quality loans) frombanks in financial trouble. Use Figure 10.2 or Figure 10.13 to describetheseactions and theireffect on the bank in distress. Nowimaginethat theseassets lose value: howwill that
Sterilization is defined as a procedurein which thecentral bank conducts an open market operation and simultaneously conducts another to prevent thefirst fromaffecting themoney supply. Consider theexample of aforeign exchange market intervention inwhich thecentral bank buys orsells its
Figure 10.5 highlights the difference betweenmoney growth and inflation-targetingstrategies. Consideran increasein the demand formoney. Howwill thecentral bank react under themoney growth strategy by keepingSM unchanged?Under theinflation-targetingstrategy if S i is kept unchanged?
In somecountries thereserves ratio is not set by thecentral bank, rather it is left to the discretion of commercial banks. Does it matter for thecontrol of the money stock? Does thesame problemexist wherethecentral bank controls interest rates instead?
Table 9.1 shows that thesize of themonetary aggregates relativetoGDP varies fromcountry to country. Explainwhy and howtheseratios may reflect the degree of financial development of thecountry.
Defineand explain the distinction between objectives, targets, and instruments of monetary policy. Givesomeexamples of conflicts between different instruments, and between different targets. Do you think it is necessarily better to havemany or fewer instrumentsand targets?
Supposethat thelong-run growth rate of GDP is 3%and that thereserves ratio is 10%. What should bethemoney growth target if thecentral bank wants to achievean inflation of 2%in thelongrun? How quickly, then, should it allow banks reserves to grow?
Cybermoney is, simply put, a decentralized systembased on theinternet—of which Bitcoin is the best-known example—in which ownership of each unit of the means of payment is validated by all members of thecybermoney-using community in question. In this way it is very difficult to counterfeit
HongKong, whilea part of the People’s Republic of China, does not usethe Chinese yuan (also called renminbi), but rather theHongKongdollar. Evenmoreremarkable, HongKongdoes not haveits own central bank, but uses banknotesand reserves issued by thethreemajor private banks. This
Namesomeways inwhich thecentral bank can establish trust in thecurrency. Howcan trust be damaged or destroyed?Howcan the government, to theextent it isaseparateentity fromthecentral bank, damage or reinforcetrust?Do you think that political influence on bank regulation isa positive ora
Gresham’s Law states that ‘badmoney drives out the good’. This means that, when twomoniescirculateat thesametime, firmsand households tend to spend the‘inferior’formof money and keep or hoard the‘better’ one. Is this behaviourconsistent with our definition of money or thosefeatures
StateJevons’ definition ofmoney. Compareit with central banks’ definitionsas wellas that provided in this book. Which definition do you think is themost practical?Which is most likely to endurethe newtechnical innovations in payments systems?
Explainwhy trust in the bankingsystemis thesamethingas trust in the payments system. Howmight arun on the bank damagethe viability ofmoney?Howcan a bankingsystemdealwith this threat?
Supposethe non-bank sector in a particularcountry holds 10%of its money holdingsascurrency,and that theconsolidated bankingsystemholds reserves in thesamerelation to its depositsas the hypothetical bank inQuestion 7.(a) Using the tools of Box9.3,compute the money multiplier for this country.(b)
Inmacroeconomics, balancesheetsare usually reported by sectors in consolidated form, that is, nettingout (cancelling)allclaims (assetsand liabilities) on any otherentity in that samesector. Forexample, the ECBreports dataforallcommercial banks, savings banks,and other financial institutions taken
Consider thefollowingcommercial bank (based on real data):cash and bank reserves: €25 bn; investments in securities €250 bn; loans: €550 bn; otherassets: €25 bn; liabilities to central bank €50 bn; total deposits: €500 bn; total (non-central bank) debt: €200 bn; other liabilities:
What isa balancesheet?Why do you think the balancesheet is important in theeconomicsystem?Namesomeways inwhich balancesheetsareimportant formacroeconomics.
Given the demand for money in the previous problem:suppose nowthat theinterest rateis 1%and is maintained constant by thecentral bank. What is theconsequence ofan increasein real GDP of 2%for thereal demand for money?Howmust this real demand for money besatisfied if the nominalmoney supply
Supposethat the demand for money is (M/P)D= 0.1Y/i, wherei is the nominal interest ratein per cent. If real GDP is given by €17 trillion and theinterest rateis 1%, what is the demand for money? What is theconsequence of arise of theinterest rateto 2%?If the nominal money supply isconstant, howcan
In Exercise 2, wesaw that thereal demand for money declined in responseto an increasein interest rates. What happens to thesupply of money?Draw a graph of beforeand after,assumingthat thecentral bank is fixingtheinterest rate 1%and raises it to 4%. Supposeinstead that the nominalsupply ofmoney is
Wesaw that households in the UK hold M1 in relation to nominal GDP of about 0.20 in 2015. Supposethat thefunction k(i) is well-described by theform wherei is the nominal interest ratein per cent, and that theinterest ratefor short-termnon-money bank deposits (the opportunity cost of holdingM1) is
Table 9.1 shows that thesize(relativetoGDP) of themonetary aggregatescan vary significantly fromcountry to country. What might account for these differences?
Booming economiesfrequently shownegativecurrent account balances. International organizationslikethe International Monetary Fundmust often judge whether acurrent deficit is‘good’ or ‘bad’. Explain what thismight mean or imply. Use your answer to interpret thecase of Poland: in the period
The public debt crisisforcessomecountriesto precipitously cut their budget deficits because governmentscannot borrowany more. Most raisetaxes on householdsand firms, which aretaxpayers. Someeconomistsarguethat thisisaself-defeating strategy. What is your view?
Over the past 20 years the price of computersand software—an essential investment good for modern companies—has dropped steadily. At the same time, the rapid rate of technical change has increased the rate of obsolescence of equipment and programs. In addition, the development of new
Shouldwars—temporarily but abnormally high expenditures of the government—depress or raiseconsumption of households?In formulating your answer, think about all the budget constraints discussed in Chapter 6.
Agreat deal of debate hasarisen in Germany on thefinancing of theexpenditure necessary to improvethe much-neglected infrastructurein its neweastern states. Onesidefavoursincreased taxes, which would fall largely on households. The other sidefavoursan increased budget deficit. Which side isright?
In Ireland, Spain, and the UK, housing pricesincreased considerably over the 2000s, until they fellabruptly in 2008. Isthereany reason why this price declineshould affect consumption?
Over the next 10 or 20 years, Greece, Portugal, andmany other European countrieswill haveto raisetaxesto reducetheir public debts. What doesthismean for consumption, nowand in thefuture?
It is sometimesargued that the Eurozone crisis is related to the mismanaged boom in spending and investment that followed the adoption of the euro. Howcan you explain this boom andwhat do you expect the effect to be on the (primary) current account? (Hint: think of the impact on the interest rate,
Should atemporary increasein taxesto financeatemporary increasein publicspending reducethecurrent account deficit? What about a permanent increasein both taxesand publicspending? What istheeffect on thecurrent account in an open economy?
using the production function Y2 =Aln(K1), where K1 isthecapital in placein period 1. Supposethefirm has no outlays besidesK1, the price of output is given at p2, and that (1 − δ) of thecapital can beresold for pK2 per unit. Future outlaysand revenuesare discounted at rater.(a) Write down
Supposeafirm producesY2 output in period
Governmentssometimestry to stimulatetheeconomy by offering firmsatemporary tax credit. Firmsthat purchasecapital goods beforea deadlinereceiveatax reduction on income madein the next year. Explain why thismeasureshould increaseexpenditures on investment. Would you expect a permanent or atemporary
Acompany isconsidering expanding itscomputer equipment today by €50,000. Supposetheinterest rate used in discounting future profit is 10%, and supposethat theequipment isscrapped after one period.(a) If the newinvestment generates €60,000 of profit, should thecompany undertaketheinvestment?
Thereisevidencethat spending on durable goods dropsfaster than spending on non-durables during arecession. Can you givesomeeconomicreasonswhy?(Hint: think of durable goodsexpenditureasaformof saving.)
Suppose you expect to livefor six decades. Your incomeis €15,000 in thefirst, €100,000 in thesecond, €150,000 in thethird, €250,000 in thefourth, €200,000 in thefifth, and €100,000 in thelast. What is your permanent incomeif theinterest rateis 3%? 5%?If you consume your permanent
Definethe permanent income hypothesis. Howdoesit relateto themore general theory of consumption under intertemporal utility maximization?
only)? Howwould consumers react to an expected futuretax cut?
Show, graphically, the effects on current and future consumption of an income windfall gain expected in the future. Nowapply this reasoning to the national level. Howshould a consumer react to a tax cut that isannounced to be temporary (in period
Ahousehold hasincome of £10,000 today and £50,000 tomorrow.(a) If thereal interest rateis 5%, what is its wealth (i) in terms of today’sconsumption, (ii) in terms of tomorrow’sconsumption?Computethe household’s permanent income(seeEquation (8.2)).(b) If today’s income unexpectedly
Banksarethemost important formof intermediary discussed in Section 7.3.1. In Europe 80%of intermediation occurs through banks (as opposed to 20%in theUnited States). Why do you supposethat Europe has somany banksas opposed to theUnited States?
Financial derivatives haveattracted alot of attention recently, especially sincethefiscaland financialcrisis. Many advocatetheabolition of such instruments. Statearguments forand against such a position.
People have bad opinions of financialmarkets, seen asasource of illegitimateenrichment foralready wealthy people. Discuss this viewcritically.

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