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Chapter 16: Output and the Exchange Rate in the Short Run Multiple Choice Questions 1.

How does an increase in the real exchange rate affect exports and imports? A. Exports increase; imports decrease B. Exports decrease; imports increase. C. Exports increase; imports change ambiguously. . Exports change ambiguously; imports decrease. E. Exports increase; imports are constant. Answer! C ". How does a rise in real income affect aggregate demand? A. # #d $m CA A % but # #d C A B. # #d $m CA A % but # #d C A C. # #d $m CA A % and # #d C A . # #d $m CA A % but # #d C A E. # #d $m CA A % but # #d C A Answer! A &. Assume the economy is initially consuming along the inter'temporal budget constraint at point A% where no sa(ing occurs. How does a fall in the real interest rate% r% affect present consumption? A. )resent consumption decreases. B. )resent consumption increases. C. )resent consumption is unaffected. . )resent consumption*s change is ambiguous. E. +ot enough information is pro(ided. Answer! B ,. -he .'cur(e illustrates which of the following? A. -he effects of depreciation on the home country/s economy B. -he immediate increase in the current account caused by a currency depreciation C. -he gradual ad0ustment of home prices to a currency depreciation . -he short'term effects of depreciation on the current account E. -he 1eynesian (iew of international trade dynamics Answer! by more. by more. . by less. by less.

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-he $4'56 6odel presented in Appendix $ of Chapter 17 implies which of the following? A. 8iscal policy is effecti(e in the short run. B. A permanent increase in the money supply is more effecti(e than a temporary increase. C. -he relationship between the exchange rate and the domestic output is negati(e. . 8iscal policy may be effecti(e only with a temporary increase in go(ernment spending. E. -he exchange rate ad0ustment to a change in the home interest rate is permanent. Answer!

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-he 6arshall'5erner Condition states that A. depreciation always has a fa(orable effect on the current account. B. import dependency reinforces the effects of depreciation on the current account. C. high elasticity of exports is sufficient for the fa(orable effects of depreciation on the current account to be obser(ed. . depreciation has a fa(orable effect on the current account only if the sum of export and import elasticities is greater than one. E. the sum of import and export elasticities must be e9ual to one in order for depreciation to occur. Answer!

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$f the economy starts in long'run e9uilibrium% a permanent fiscal expansion will cause A. an increase in exchange rate% E. B. a decrease in exchange rate% E. C. an increase in output% #. . a decrease in output% #. E. shifting of the AA cur(e up and to the right. Answer! B

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$n the long'run e9uilibrium% after a permanent money'supply increase there follows! A. an increase in exchange rate% E. B. a decrease in exchange rate% E. C. an increase in output% #. . a decrease in output% #. E. Both B and . Answer! A

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<hich of the following are true in terms of the current account balance? A. 6onetary expansion increases the current account balance. B. 6onetary expansion decreases the current account balance. C. 8iscal expansion increases the current account balance. . 8iscal expansion decreases the current account balance. E. Both A and Answer! E

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$n the short run% with prices fixed% how would an increase in go(ernment spending affect the 'AA schedule? A. $t will increase output and appreciate the currency. B. $t will increase output and depreciate the currency. C. $t will decrease output and appreciate the currency. . $t will decrease output and depreciate the currency. E. +one of the abo(e. Answer! A

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How is the AA schedule deri(ed? A. -he AA schedule has a positi(e slope because an increase in output leads to a depreciation of the currency. B. -he AA schedule has a negati(e slope because an increase in output leads to a decrease in the domestic interest rate. C. -he AA schedule has a negati(e slope because an increase in output leads to an increase in the domestic interest rate. . -he AA schedule has a positi(e slope because an increase in the money supply leads to an increase in the domestic interest rate. E. +one of the abo(e. Answer! C

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$magine that the economy is at a point on the 'AA schedule that is abo(e both AA and % where both the output and asset mar>ets are out of e9uilibrium. <hich first action is true? A. -he economy will stay at this le(el in the short run. B. -he exchange rate will first drop to a point on the AA schedule. C. -he exchange rate will first mo(e to a point on the schedule. . -he AA' e9uilibrium will shift to the position of the economy. E. +one of the abo(e. Answer! B

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<hich one of the following statements is most accurate? A. $n the long run% foreign output depends only on the a(ailable domestic supplies of factors of production. B. $n the short run% domestic output depends only on the a(ailable domestic supplies of factors of production. C. $n the long run% domestic output depends only on the a(ailable domestic supplies of factors of production. . $n the long run and in the short run% domestic output depends only on the a(ailable domestic supplies of factors of production. E. +one of the abo(e. Answer! C

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<hich one of the following statements is most accurate? A. 8actors of production can only be o(er'employed in the short run. B. 8actors of production can only be under'employed in the short run. C. 8actors of production can be o(er' or under' employed in the long run. . 8actors of production can be o(er' or under' employed in the short run. E. +one of the abo(e. Answer!

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<hich one of the following statements is most accurate? A. $n general% consumption demand rises by less than income. B. $n general% consumption demand rises by less than disposable income. C. $n general% consumption demand rises by more than disposable income. . $n general% consumption demand rises by more than income. E. $n general% consumption demand rises by the same amount as disposable income rises. Answer! B

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-he current account balance is A. the supply of a country*s exports less the country*s own demand for imports. B. the demand for a country*s exports plus the country*s own demand for imports. C. the country*s own demand for imports less the demand for a country*s exports. . the demand for a country*s exports less the country*s own demand for imports. E. +one of the abo(e. Answer!

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-he domestic currency price of a representati(e foreign expenditure bas>et is A. )% the domestic price le(el. B. E% the nominal exchange rate. C. ) times E% the domestic price le(el times the domestic price le(el. . )?% the foreign price le(el. E. )? times E% the foreign price le(el times the nominal exchange rate. Answer! E

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-he domestic currency price of a representati(e domestic expenditure bas>et is A. )% the domestic price le(el. B. E% the nominal exchange rate. C. ) times E% the domestic price le(el times the nominal exchange rate. . )?% the foreign price le(el. E. )? times E% the foreign price le(el times the nominal exchange rate. Answer! A

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-he real exchange rate% q% is defined as A. the price of the foreign bas>et in terms of the domestic one. B. the price of the domestic bas>et in terms of the foreign one. C. the price of the foreign bas>et. . the price of the domestic bas>et. E. +one of the abo(e. Answer! A

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-he real exchange rate% q% is defined as A. E. B. E times ). C. E times )?. . @E times )?AB ). E. )B@E times )?A. Answer!

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$f the representati(e bas>et of European goods and ser(ices costs ,= euros% the representati(e C.4. bas>et costs D3=% and the dollarBeuro exchange rate is D=.;= per euro% then the price of the European bas>et in terms of the C.4. bas>et is A. E@=.; DBeuroA @,= euro per a European bas>etAF B E@3= D B C.4. bas>etAF. B. E@=.; DBeuroA @3= D B C.4. bas>etAF B E@,= euro per a European bas>etAF. C. E@,= euro per a European bas>etAF B E@3= D B C.4. bas>etA @=.; DBeuroAF. . E@3= D B C.4. bas>etAF. E. E@=.; DBeuroA @,= euro per a European bas>etAF B E@3= D C.4. bas>etAF .

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Answer! A "". <hen E)?B) rises% A. $6 will rise. B. $6 will fall. C. $6 may rise or fall. . $6 is not affected. E. +one of the abo(e. Answer! C "&. <hen the real exchange rate rises% A. $mports measured in terms of domestic output will rise. B. $mports measured in terms of domestic output will fall. C. $mports measured in terms of domestic output will not be affected. . $mports measured in terms of domestic output will rise or fall. E. +one of the abo(e. Answer! B ",. <hich one of the following statements is the most accurate? A. An increase in disposable income impro(es the current account. B. An increase in disposable income does not affect the current account. C. An increase in disposable income worsens the current account. . An increase in income worsens the current account. E. An increase in income impro(es the current account. Answer! C "3. <hich one of the following statements is the most accurate? A. An increase in the real exchange rate and an increase in disposable income impro(e the current account. B. A decrease in the real exchange rate and a decrease in disposable income impro(e the current account. C. A decrease in the real exchange rate and a decrease in disposable income impro(e the current account. . An increase in the real exchange rate and a decrease in disposable income impro(e the current account. E. +one of the abo(e. Answer!

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<hich one of the following statements is the most accurate? A. A rise in domestic real income raises aggregate demand for home output. B. A rise in domestic real income decreases aggregate demand for home output because of the increased demand for import. C. A rise in domestic real income >eeps aggregate demand for home output at the same le(el. . $t is difficult to tell whether a rise in domestic real income affects positi(ely or negati(ely aggregate demand for home output. E. +one of the abo(e. Answer! A

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$n the short run% a rise in the exchange rate% i.e. currency depreciation% A. raises aggregate demand and raises output. B. raises aggregate demand and lowers output. C. raises aggregate demand and does not affect output. . lowers aggregate demand and raises output. E. lowers aggregate demand and lowers output. Answer! A

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$n the short run% a reduction in the exchange rate% i.e. currency appreciation% A. raises aggregate demand and raises output. B. raises aggregate demand and lowers output. C. raises aggregate demand and does not affect output. . lowers aggregate demand and raises output. E. lowers aggregate demand and lowers output. Answer!

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$n the short'run% any rise in the real exchange rate% E)?B)% will cause A. an upward shift in the aggregate demand function and a reduction in output. B. an upward shift in the aggregate demand function and an expansion of output. C. a downward shift in the aggregate demand function and an expansion of output. . an downward shift in the aggregate demand function and a reduction in output. E. an upward shift in the aggregate demand function% but it lea(es output intact. Answer! B

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$n the short'run% any rise in the nominal exchange rate% E% will cause A. an upward shift in the aggregate demand function and an expansion of output. B. an upward shift in the aggregate demand function and a reduction in output. C. a downward shift in the aggregate demand function and an expansion of output. . a downward shift in the aggregate demand function and a reduction in output. E. an upward shift in the aggregate demand function but lea(es output intact. Answer! A

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$n the short run% any rise in the foreign price le(el% )?% will cause A. an upward shift in the aggregate demand function and an expansion of output. B. an upward shift in the aggregate demand function and a reduction in output. C. a downward shift in the aggregate demand function and an expansion of output. . a downward shift in the aggregate demand function and a reduction in output. E. an upward shift in the aggregate demand function but lea(es output intact. Answer!

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$n the short run% any fall in E)?B)% regardless of its causes% will cause A. an upward shift in the aggregate demand function and an expansion of output. B. an upward shift in the aggregate demand function and a reduction in output. C. a downward shift in the aggregate demand function and an expansion of output. . a downward shift in the aggregate demand function and a reduction in output. E. an upward shift in the aggregate demand function% but it lea(es output intact. Answer!

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$n the short run% a temporary increase in the money supply A. shifts the AA cur(e to the right% increases output% and depreciates the currency. B. shifts the AA cur(e to the left% increases output% and depreciates the currency. C. shifts the AA cur(e to the left% decreases output% and depreciates the currency. . shifts the AA cur(e to the left% increases output% and appreciates the currency. E. shifts the AA cur(e to the right% increases output% and appreciates the currency. Answer! A

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$n the short run% a temporary increase in the money supply A. shifts the cur(e to the right% increases output% and appreciates the currency. B. shifts the AA cur(e to the left% increases output% and depreciates the currency. C. shifts the AA cur(e to the left% decreases output% and depreciates the currency. . shifts the AA cur(e to the left% increases output% and appreciates the currency. E. shifts the AA cur(e to the right% increases output% and depreciates the currency. Answer! E

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$n the short run% a temporary increase in fiscal policy causes A. a shift of the cur(e to the left% an increase in output% and currency appreciation. B. a shift of the cur(e to the right% a decrease in output% and currency appreciation. C. a shift of the cur(e to the right% an increase in output% and currency depreciation. . a shift of the cur(e to the left% a decrease in output% and currency depreciation. E. a shift of the cur(e to the right% an increase in output% and currency appreciation. Answer! E

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Csing the G AA framewor>% which one of the following statements is the most accurate? A. Hnly monetary policy can bring the economy to full employment. B. Hnly fiscal policy can bring the economy to full employment. C. Hnly both monetary and fiscal policies can bring the economy to full employment. . +either policy is capable of bringing the economy to full employment. E. 6onetary policy by itself or fiscal policy by itself can bring the economy to full employment. Answer! E

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<hich one of the following statements is the most accurate? A. A permanent increase in the money supply cannot ha(e any short'run effects. B. A permanent increase in taxes cannot ha(e any short'run effects. C. A permanent decrease in the money supply cannot ha(e short'run effects. . A permanent decrease in taxes cannot ha(e short'run effects. E. +one of the abo(e. Answer! E

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A permanent increase in the domestic money supply A. must ultimately lead to a proportional decrease in E% and% therefore% the expected future exchange rate must rise proportionally. B. must ultimately lead to a proportional decrease in E% and% therefore% the expected future exchange rate must decrease proportionally. C. must ultimately lead to a proportional rise in E% and% therefore% the expected future exchange rate must rise proportionally. . must ultimately lead to a proportional rise in E% and% therefore% the expected future exchange rate must rise more than proportionally. E. must ultimately lead to a proportional rise in E% and% therefore% the expected future exchange rate must rise less than proportionally. Answer! C

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$n the short run% a permanent increase in the domestic money supply causes A. an upward shift in the cur(e% which is greater than that caused by an e9ual but transitory increase. B. a downward shift in the AA cur(e% which is greater than that caused by an e9ual but transitory increase. C. an upward shift in the AA cur(e% which is smaller than that caused by an e9ual but transitory increase. . a downward shift in the AA cur(e% which is smaller than that caused by an e9ual but transitory increase. E. an upward shift in the AA cur(e% which is greater than that caused by an e9ual but transitory increase. Answer! E

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$n the short run% a permanent increase in the domestic money supply A. has stronger effects on the exchange rate and output than an e9ual temporary increase. B. has stronger effects only on the exchange rate but not on output than an e9ual temporary increase. C. has wea>er effects on the exchange rate and output than an e9ual temporary increase. . has stronger effects on output% but lower effect the exchange rate than an e9ual temporary increase. E. +one of the abo(e. Answer! A

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A permanent fiscal expansion A. shifts the and the AA schedules to the right% increasing output. B. shifts the and the AA schedules to the right% decreasing output. C. shifts the to the right% increasing output. . shifts the to the left% decreasing output. E. shifts the and the AA schedules to the right% lea(ing output the same . Answer! E

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Essay Questions 1. Explain how an increase in go(ernment spending would affect the in the short run. 'AA schedule

Answer! An increase in go(ernment spending will increase aggregate demand% which will shift the to the right. $f AA remains unchanged% the new e9uilibrium will be at a higher # and lower E. 4ince E is the nominal exchange rate% a lower E is an appreciation of the currency. ". Explain how the AA schedule is deri(ed.

Answer! 8or a fixed real money supply% an increase in output leads to an increase in the domestic interest rate. $n the foreign exchange mar>et% an increase in the domestic interest rate leads to a lower nominal exchange rate% thus appreciating the currency. -herefore% the relationship between nominal exchange rate and output is negati(e; this leads to a negati(e slope of the AA schedule% which has the nominal exchange rate and output on its axes. &. $magine that the economy is at a point on the 'AA schedule that is abo(e both AA and and where both the output and asset mar>ets are out of e9uilibrium. Explain what will happen next.

Answer! 4ince the asset mar>et ad0usts (ery 9uic>ly% the exchange rate drops immediately to a point on the AA schedule. -here will be excess demand for the domestic currency because the high expected future appreciation rate of the domestic currency implies that the expected domestic currency return on foreign deposits is below that on domestic deposits. -his excess demand leads to an immediate fall in the exchange rate. ,. Explain how an increase in the real exchange rate affects exports and imports.

Answer! <hen the real exchange rate increases% domestic products are cheaper relati(e to foreign products. ue to this% exports increase as foreigners demand more domestic exports. -he change in imports is ambiguous because fewer units of imports are purchased @the (olume effectA% but each foreign unit is now more expensi(e @the (alue effectA. Iemember! exports and imports are measured in terms of domestic output% i.e. dollar (alue% not (olume of units. Howe(er% we often assume that the (olume effect outweighs the (alue effect% so that imports decrease when the real exchange rate rises. 3. Explain how a rise in real income affects aggregate demand.

Answer! A rise in domestic real income% #% leads to a rise in disposable income% #d. -his raises the spending on imports% $6% thus lowering the current account% CA% and reducing aggregate demand% A . Howe(er% the rise in #d also causes a rise in consumption% C% and raises aggregate demand% A % by more than the corresponding decrease.

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Assume the economy is initially consuming along the intertemporal budget constraint at point A% where no sa(ing occurs. How does a fall in the real interest rate% r% affect present consumption?

Answer! A decrease in the real interest rate% r% causes the budget line to rotate countercloc>wise about point A% decreasing the slope% and causing a rise in present consumption. 2. iscuss the main factors affecting the position of the schedule.

Answer! -he le(el of go(ernment demand% taxes% and in(estment; the domestic and foreign price le(els; (ariations in domestic consumption beha(ior; and the foreign demand for home output. :. iscuss the main factors affecting the position of the AA schedule.

Answer! Changes in the domestic money supply; changes in the domestic price le(el; changes in the expected future exchange rate; changes in the foreign interest rate; and shifts in the aggregate real money demand schedule. ;. A naJ(e implication of the G AA framewor> is that either fiscal or monetary policy can lead to full employment. iscuss why this (iew is naJ(e. 1. ". &. $nflation may arise without any gain in output if the go(ernment misuses its power to print money. $n practice% it is sometimes hard to be sure whether a disturbance to the economy originates in the output or assets mar>ets. 4hifts in fiscal policy often can be made only after lengthy legislati(e deliberations. Ko(ernments are li>ely to respond to disturbances by changing the monetary policy e(en when a shift in fiscal policy would be more appropriate. 8iscal policy impacts the go(ernment budget and may lead to a go(ernment budget deficit that must sooner or later be closed by a fiscal re(ersal. -he state of the electoral cycle may be more important. )olicies operate in reality with lags of (arying length.

Answer!

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Quantitative/ raphing !ro"lems 1. 8ind the real exchange rate for the following case! Assume that the representati(e bas>et of European goods and ser(ices costs ,= euros % the representati(e C.4. bas>et costs D3=% and the dollarBeuro exchange rate is D=.;= per euro. <hat is the price of the European bas>et in terms of the C.4. bas>et?

Answer! E@=.; DBeuroA @,= euro per a European bas>etAF B E@3= D B C.4. bas>etAF. ".
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8ill in the following table!


P 2 3 4 5 6 7 9 10 P* 20 40 50 60 80 90 110 EP*/P 30 1.5 40 2.666667 3.75 60 5.833333 80 6.857143 7.875 100 8.888889 110 9.9 10.90909

Answer!
E P 1 2 3 4 5 6 7 8 9 10 P* 20 30 40 50 60 70 80 90 100 110 EP*/P 30 1.5 40 2.666667 50 3.75 60 4.8 70 5.833333 80 6.857143 90 7.875 100 8.888889 110 9.9 120 10.90909

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8ill in the following table

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Nominal Exchange rate Dome tic !rice le"el 0.2 0.3 0.4 0.5 0.6 0.7 0.9 0.1

$eal exchange #oreign !rice le"el rate 20 30 0.15 40 0.266666667 40 0.375 50 60 60 70 70 0.685714286 90 0.7875 90 100 0.888888889 110 0.99 110 120

Answer!
Nominal Exchange rate Dome tic !rice le"el #oreign !rice le"el real exchange rate 0.1 20 30 0.2 30 40 0.3 40 50 0.4 50 60 0.5 60 70 0.6 70 80 0.7 80 90 0.8 90 100 0.9 100 110 0.1 110 120

0.15 0.266666667 0.375 0.48 0.583333333 0.685714286 0.7875 0.888888889 0.99 0.109090909

,. Explain the difference between the following two expressions! # L C@#dA M $ M K M CA@E)?B)% #dA and # L C M $ MK M CA Answer! -he first expression represents a beha(ioral e9uation and thus may express e9uilibrium conditions for the output mar>et or the aggregate desired demand for output. -he second e9uation is only an identity that is always true.

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3. Cse a figure to study the following 9uestion! $magine that the economy is at a point on the 'AA schedule that is abo(e both AA and % where both the output and asset mar>ets are out of e9uilibrium. Explain what will happen next. Answer! 4ince the asset mar>et ad0usts (ery 9uic>ly% the exchange rate drops immediately to a point on the AA schedule. -here will be excess demand for the domestic currency because the high expected future appreciation rate of the domestic currency implies that the expected domestic currency return on foreign deposits is below that on domestic deposits. -his excess demand leads to an immediate fall in the exchange rate. -he figure!

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7. Explain the following figure!

Answer! -he figure depicts the effect of a permanent increase in the money supply starting from full employment e9uilibrium. After the initial increase in the money supply and the mo(e of the AA cur(e to the right from AA1 to AA"% a steadily increasing price le(el shifts the AA and the schedules to the left until a new long'run e9uilibrium is reached. +ote that point & is abo(e point 1% because Ee is permanently higher after a permanent increase in the money supply. -he expected exchange rate% Ee % has risen by the same percentage as 6s. +otice that along the ad0ustment path between the initial short'run e9uilibrium @point "A and the long'run e9uilibrium @point &A the domestic currency actually appreciates @from E" to E&A following its initial sharp depreciation @from E1 to E"A.

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2. Csing the G AA framewor>% show the phenomenon of o(ershooting. Cse a figure to explain when it is ta>ing place. Answer! -he figure below shows the phenomenon of o(ershooting. A permanent increase in the money supply starting from full employment e9uilibrium will shift the AA cur(e to the right from AA1 to AA". +ow% a steadily increasing price le(el shifts the AA and the schedules to the left until a new long'run e9uilibrium is reached. +ote that point & is abo(e point 1% because Ee is permanently higher after a permanent increase in the money supply. -he expected exchange rate% Ee % has risen by the same percentage as 6s. +otice that along the ad0ustment path between the initial short'run e9uilibrium @point "A and the long'run e9uilibrium @point &A the domestic currency actually appreciates @from E" to E&A following its initial sharp depreciation @from E1 to E"A. -his exchange rate beha(ior is an example of o(ershooting% in which the exchange rate*s initial response to some change is greater than its long'run response.

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:. Csing a figure% show that under full employment% a temporary fiscal expansion would increase output @o(er'employmentA but cannot increase output in the long run.
1 " Answer! A temporarily fiscal expansion will mo(e the economy from to % and output increases. A permanent fiscal expansion will also shift the AA cur(e to the left and down. -he nominal exchange rate appreciates% i.e. E decreases.

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