Demystifying Global Macroeconomics

JOHN E. MARTHINSEN

Chapter 19 Shocks to Nations with Flexible Exchange Rates - all with Video Answers

Educators

Chapter Questions

Problem 1

During the 2020 U.S. presidential race, a number of candidates promised to pass a large infrastructure spending bill that would repair and modernize aging roads, bridges, and airports. The proposed expenditures amounted to trillions of U.S. dollars. Assume the following about the U.S. economy:
- The United States has a flexible exchange rate against the euro.
- The United States is in the intermediate range of its aggregate supply.
- The United States has high international capital mobility.
a. Use the Three-Sector Model to analyze the short-run consequences of an increase in government spending on the U.S. economy. In particular, explain how it will affect real GDP, the GDP Price Index, real interest rate, quantity of real credit per period, value of the dollar relative to the euro, and quantity of dollars traded in the foreign exchange market per period. Ignore how the improved infrastructure will affect the U.S. economy in the long run.
b. Use the conclusions you reached in Question 1a to answer how the increase in government spending will affect the unemployment rate, monetary base, M2 money supply, and real exchange rate.
c. As a foreign exporter, would this expansionary fiscal policy improve or hurt your ability to sell products in the United States? What does this mean for the U.S. current account?
d. As a foreign investor, would this expansionary fiscal policy increase or decrease your desire to invest in U.S. financial assets? What does this mean for the U.S. financial account?
e. Has the U.S. central bank changed its foreign exchange reserves? What does this mean for U.S. reserves and related items in the balance of payments?
f. Challenge Question: Explain the effects increased infrastructure spending should have on the U.S. government's structural, cyclical, and total government budget deficits. (Hint: See Structural Versus Cyclical Deficits and Surpluses in Chapter 13,

Beth Stone

Numerade Educator

Problem 2

Suppose international investors believe that investments in Argentina will become riskier relative to alternative investments in the United States, which causes capital flight from the Argentine peso. Use the Three-Sector Model to explain the effects that increased capital flight should have on Argentina's real interest rate, quantity of real credit per period, GDP Price Index, real GDP, nominal dollar-peso exchange rate, and quantity of pesos traded per period. For the purposes of this analysis, assume the peso floats freely. Once you have completed your Three-Sector Model analysis, please address the following points:
a. Explain the (direct and indirect) impacts and effects that capital flight should have on Argentina's M2 money supply.
b. Explain the (direct and indirect) impacts and effects that capital flight should have on Argentina's real exchange rate against the U.S. dollar.
c. Explain the (direct and indirect) impacts and effects that capital flight should have on Argentina's current account, financial account, and reserves and related items.
d. Suppose you are the chief executive officer of a large U.S. company, who is considering erecting a manufacturing facility in Argentina and selling either inside the country or exporting to the United States. Explain the opportunities and possible pitfalls your company faces.

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Problem 3

In the aftermath of Brexit, suppose the European Union imposes trade restrictions on its imports from the United Kingdom. Use the Three-Sector Model to explain the effects that these trade restrictions should have on the U.K.'s real interest rate, quantity of real credit per period, GDP Price Index, real GDP, nominal exchange rate of pound the against the euro, and quantity of pounds traded per period. Assume that the British pound floats against the euro. Once you have completed your Three-SectorModel analysis, please address the following points:
a. Explain the (direct and indirect) impacts and effects that these trade restrictions should have on the U.K.'s M.2 money supply.
b. Explain the (direct and indirect) impacts and effects that these trade restrictions should have on the U.K.'s real exchange rate against the euro.
c. Explain the (direct and indirect) impacts and effects that these trade restrictions should have on the U.K.'s current account, financial account, and reserves and related items.
d. Suppose you are the chief executive officer of a large German company, who is considering erecting a manufacturing facility in the U.K. and selling either inside the country or exporting to the Euro Area. Explain the opportunities and possible pitfalls your company faces.
e. Suppose the Bank of England wishes to maintain its inflation target during the Brexit transition. What sort of monetary policy should it pursue? Specifically, focus your analysis on the U.K.'s real credit market.

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Problem 4

Suppose the People's Bank of China tightens controls on domestic residents' financial investment in foreign nations-particularly in the United States. Use the Three-Sector Model to explain the effects that tighter capital controls on financial outflows should have on China's real interest rate, quantity of real credit per period, GDP Price Index, real GDP, nominal exchange rate of the yuan against the dollar, and quantity of yuan traded per period. Assume that the yuan fluctuates freely. Once you have completed your Three-Sector-Model analysis, please address the following points:
a. Explain the (direct and indirect) impacts and effects that tighter capital controls on financial outflows should have on China's M2 money supply.
b. Explain the (direct and indirect) impacts and effects that tighter capital controls on financial outflows should have on China's real exchange rate against the U.S. dollar.
c. Explain the (direct and indirect) impacts and effects that tighter capital controls on financial outflows should have on China's balance of payments (current account, financial account, and reserves and related items).
d. Suppose you are the Chief Executive Officer of a large U.S. company, who is considering erecting a manufacturing facility in China and selling either inside the country or exporting to the United States. Explain the opportunities and possible pitfalls your company faces.

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Problem 5

The Brexit vote separating the United Kingdom from the European Union, had a heavy initial impact on U.K. commercial real estate prices, residential real estate prices, and the market value of the U.K.'s largest commercial property funds (e.g., M\&G Investment, Avia, and Standard Life Investments). Use the Three-Sector Model to analyze the effects that falling real estate and housing market prices (i.e., U.K. residents' wealth) should have on the U.K. economy. In particular, explain how they should affect the U.K.'s real GDP, GDP Price Index, real interest rate, quantity of real credit per period, value of the pound relative to the euro, and quantity of pounds traded in the foreign exchange market per period. When you have completed your three-sector analysis, please answer the following questions.
a. Explain the (direct and indirect) impacts and effects that falling real estate and housing market prices should have on the U.K.'s M2 money supply.
b. Explain the (direct and indirect) impacts and effects that falling real estate and hous. ing market prices should have on the U.K.'s nominal interest rate.
c. Explain the (direct and indirect) impacts and effects that falling real estate and housing market prices should have on the U.K.'s real exchange rate against the euro.
d. Explain the overall effects (i.e., after exchange rate, GDP Price Index, real GDP, and real interest rate changes) that falling real estate and housing market prices should have on the U.K.'s balance of payments (current account, financial account, and reserves and related items).
e. What effect would the withdrawal of investments from commercial property funds have on the U.K.'s monetary base if the proceeds were placed in the U.K. stock market?
f. What effect would the withdrawal of investments from commercial property funds have on the U.K.'s monetary base if the proceeds were placed in into eurodenominated and U.S-dollar denominated funds in the Euro Area and United States?
g. The massive sales of British property funds bring to the fore significant issues dealing with liquidity, market, and credit risks. Explain these risks in the context of Brexit and their impact on commercial property funds.

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01:47

Problem 6

In November 2016, India launched an ambitious demonetization program with a number of goals in mind. One of those goals was to have India's residents embrace cashless exchange in much greater numbers. Use the Three-Sector Model to explain the effects that an increase in electronic payments should have on India's real interest rate, quantity of real credit per period, GDP Price Index, real GDP, nominal exchange rate of the rupee against the dollar, and quantity of rupees traded per period. Assume that the Indian rupee floated freely against the dollar. Once you have completed your Three-Sector-Model analysis, please address the following points.
a. Explain the (direct and indirect) impacts and effects that demonetization and greater cashless exchanges should have on India's M2 money supply.
b. Explain the (direct and indirect) impacts and effects that demonetization and greater cashless exchanges should have on India's real exchange rate against the U.S. dollar.
c. Explain the (direct and indirect) impacts and effects that demonetization and greater cashless exchanges should have on India's current account, financial account, and reserves and related items.
d. Suppose you are the chief executive officer of a large U.S. company, who is considering erecting a manufacturing facility in India and selling either inside the country or exporting to the United States. Explain the opportunities and possible pitfalls your company faces.
e. Suppose that India's central bank has done an analysis similar to your Three-SectorModel investigation above. If the central bank wished to minimize the macroeconomic consequences of this shock, what monetary policy would it pursue? Focus your answer on the real credit market.

Erwin Antoni

Numerade Educator

05:22

Problem 7

Use the Three-Sector Model to analyze the effects that tariffs on U.S. imports from China should have on the U.S. economy. In particular, explain how it should affect U.S.'s real GDP, GDP Price Index, real interest rate, quantity of real credit per period, value of the dollar relative to the Chinese yuan, and quantity of dollars traded in the yuan-dollar foreign exchange market per period.
a. Explain the (direct and indirect) impacts and effects that tariffs should have on the U.S. M2 money supply.
b. Explain the (direct and indirect) impacts and effects that tariffs should have on the U.S.'s nominal interest rate.
c. Explain the (direct and indirect) impacts and effects that tariffs should have on the U.S. real exchange rate against the Chinese yuan and its effect on the level of U.S. international competitiveness.
d. Explain the overall effects (i.e., after exchange rate, GDP Price Index, real GDP, and real interest rate changes) that tariffs should have on the U.S.'s balance of payments (current account, financial account, and reserves and related items).
e. Challenge Question. Explain the effects that higher tariffs should have on the U.S. government's structural, cyclical, and total government budget deficits. (Hint: See Structural Versus Cyclical Deficits and Surpluses in Chapter 13, "Fiscal Policy.")

Natalie Britton

Numerade Educator

Problem 8

Shortly after the June 2016 Brexit vote, the Bank of England (BoE) took steps to prevent a recession by pursuing expansionary monetary policies. Its actions focused on (1) purchasing government and also corporate bonds (i.e., from companies that made "a material contribution to the U.K. economy"), thereby extending its existing set of quantitative eas. ing (QE) tools, (2) cutting the interest rates on repurchase agreements ${ }^{19}$ from $0.50 \%$ to
$0.25 \%$, and (3) reducing, from $0.25 \%$ to $0.0 \%$, the countercyclical capital requirement ${ }^{20}$ banks were required to hold against their risk-weighted assets. This "macroprudential" policy tool was imposed by the BoE on domestic banks in March 2016 (on top of the standard capital requirement). For Questions $8 \mathrm{a}, 8 \mathrm{~b}$ and $8 \mathrm{c}$ (below), consider only the effects that BoE's expansionary open market operations should have had on England's economy. Assume the following about the U.K. economy:
- The pound fluctuated freely in foreign exchange markets.
- England's economy was in the intermediate range of its aggregate supply curve.
- Financial capital could flow freely in and out of England and, therefore, there was high international capital mobility.
- The Bank of England was highly credible.
a. Use the Three-Sector Model to analyze the effects of the BoE's expansionary monetary policy on the U.K. economy. In particular, explain how they should have affected the U.K.'s real GDP, GDP Price Index, real interest rate, quantity of real credit per period, value of the pound relative to the euro, and quantity of pounds traded in the foreign exchange market per period.
b. Use the conclusions you reached in Question 8a to answer how the BOE's expansionary monetary policy should have affected the unemployment rate, monetary base, $M 2$ money supply, real exchange rate against the euro, current account, financial account, reserves and related items, and the central bank's foreign exchange reserves.
c. Challenge Question. How would your answers change if the Bank of England wasn't credible, and people didn't trust its commitment to low inflation?
d. Challenge Question. How should the elimination of BoE's countercyclical capital requirement affect bank incentives to lend?

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00:59

Problem 9

On December 16, 2015, the U.S. Federal Reserve decided to increase the interest rate paid on banks' required and excess reserves from $0.25 \%$ to $0.50 \%$. Assume the following about the U.S. economy:
- The U.S. dollar fluctuated freely in foreign exchange markets.
- The U.S. economy was in the intermediate range of their aggregate supply curve.
- Financial capital could flow freely in and out of the United States and, therefore, there was high international capital mobility.
a. Explain how the increased interest rate, paid by the Fed, on required and excess bank reserves affected the U.S. monetary base and the M2 money supply.
b. Use the Three-Sector Model to analyze the economic consequences of the Fed's policy to increase the interest rate paid on required and excess bank reserves. In particular, explain how this policy should have affected the U.S. real GDP, GDP Price Index, real interest rate, quantity of real credit per period, value of the U.S. dollar relative to the euro, and quantity of dollars traded in the foreign exchange market per period.
c. Use the conclusions you reached in Question $9 \mathrm{~b}$ to answer how an increase in the interest on required and excess bank reserves should have affected the unemployment rate, monetary base, $M 2$ money supply, real exchange rate, current account, financial account, reserves and related items, and the central bank's foreign exchange reserves.
d. How would all your previous answers change if, instead of lifting the interest rate on bank reserves, the Fed had implemented open market sales?
ems).

Jennifer Stoner

Numerade Educator

Problem 10

Due to domestic instability, suppose Ukraine experiences significant capital flight. Use the Three-Sector Model to explain the effects of capital flight on Ukraine's real interest rate, quantity of real credit per period, GDP Price Index, real GDP, nominal exchange rate against the U.S. dollar, and quantity of Ukrainian hryvnia traded per period. Assume that Ukraine has a flexible exchange rate.
a. Explain the (direct and indirect) impacts and effects that capital flight should have on Ukraine's M2 money supply.
b. Explain the (direct and indirect) impacts and effects that capital flight should have on Ukraine's real exchange rate against the U.S. dollar.
c. Explain the direct impacts and effects (i.e., immediate impacts and effects before any exchange rate, GDP Price Index, real GDP, and real interest rate changes) of capital flight on Ukraine's balance of payments. Assume the net amount of capital flight equals 600 billion Ukrainian hryvnia (i.e., UAH600 billion). Show the effects on Ukraine's current account, financial account, and reserves and related items.
d. Explain the overall effects (i.e., after exchange rate, GDP Price Index, real GDP, and real interest rate changes) that capital flight should have on Ukraine's balance of payments (current account, financial account, and reserves and related items).

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02:33

Problem 11

. Suppose China sells a portion of its enormous dollar-denominated foreign exchange reserves. Use the Three-Sector Model to analyze the effects these sales should have on the Chinese economy. In particular, explain the effects on China's real interest rate, quantity of real credit per period, GDP Price Index, real GDP, nominal exchange rate against the U.S. dollar, and quantity of Chinese yuan traded per period. Assume China's exchange rate fluctuates freely.
a. Explain the (direct and indirect) impacts and effects that China's foreign exchange reserve sales should have on the nation's $M 2$ money supply.
b. Explain the (direct and indirect) impacts and effects that China's foreign exchange reserve sales should have on China's real exchange rate against the U.S. dollar.
c. Explain the direct impacts and effects (i.e., immediate effects before any GDP Price Index, real GDP, and real interest rate changes) that foreign exchange reserve sales should have on China's balance of payments. Assume the amount of intervention equals $\$ 450$ billion (i.e., CNY3,000 billion). Show the changes in China's current account, and financial account, and reserves and related items.
d. Explain the overall effects (i.e., after GDP Price Index, real GDP, and real interest rate changes) that China's foreign exchange reserve sales have on the nation's balance of payments (current account, financial account, and reserves and related it

Alejandro Ruiz

Numerade Educator

08:36

Problem 12

In 2019 , drug overdose in the United States accounted for more deaths each year than traffic accidents or suicides. Most of these deaths were due to heroin and the synthetic opioid fentanyL Many good-paying jobs were reportedly going unfilled because employers could not find qualified applicants who could pass the drug tests. Research suggested that the impact of drugs was high enough to affect the U.S. labor force. For example, a 2016 report by Alan Kreuger found that nearly half of the prime age men not in the U.S. labor force took pain medication on a daily basis, and opioid availabil. ity could account for approximately $20 \%$ of the decline in U.S. labor force participation. Suppose the United States finds a way to substantially reduce the drug abuse problem, in general, and the drug overdose problem, in particular. As a result, the U.S. labor force participation rate and employment increase. Use the Three-Sector Model to explain the effects this solution should have on the nation's real interest rate, quantity of real credit per period, GDP Price Index, real GDP, nominal euro-dollar exchange rate, and quantity of dollars traded per period. Assume the United States has a freely fluctuating exchange rate.
a. Explain the (direct and indirect) impacts and effects that these changes in drug policy and implementation should have on the real U.S. M2 money supply.
b. Explain the (direct and indirect) impacts and effects that these changes in drug policy and implementation should have on U.S. nominal interest rates.
c. Explain the (direct and indirect) impacts and effects that this drug policy and implementation should have on the United States' real exchange rate against the euro.
d. Explain the overall effects (i.e., after exchange rate, GDP Price Index, real GDP, and real interest rate changes) changes drug policy and implementation should have on the U.S. balance of payments (current account, financial account, and reserves and related items).
e. Suppose you are the Chief Executive Officer of a large German company, who is considering erecting a manufacturing facility in the United States and selling either inside the United States or exporting to Europe. Explain the opportunities and pos. sible pitfalls.
f. Challenge Question. Given your answers to the questions above, assume the U.S. govemment spends the same amount on drug prevention as before but uses existing funds in more effective ways. Explain the effects a federal solution to the opioid crisis should have on the U.S. government's structural, cyclical, and total govemment budget deficits. (Hint: See Structural Versus Cyclical Deficits and Surpluses in Chapter 13, "Fiscal Policy.")
g. Challenge Question. Suppose the U.S. government spends $\$ 1.5$ trillion to solve the opioid problem, with the same effectiveness as in Question $12 f$ (i.e., it spends extra funds on the drug problem instead of reallocating existing funds). Use the real goods and services market and real credit markets (only) to explain the effects government spending should have on the U.S. economy. Keep in mind the existing U.S. deficit position.

Sana Riaz

Numerade Educator

Problem 13

The Climate Leadership Council, which includes senior Republican statesmen, proposed the elimination of nearly all of the Obama administration's climate policies in exchange for a carbon tax that would start at $\$ 40$ per ton. Forecasters expected raise about $\$ 80$ billion in government tax revenues during the first year. Becaust carbon content of coal, gas, and oil can be determined with relative precision ease, the plan would impose this tax upstream directly on the suppliers, which mi for example, levying the tax on oil suppliers when it was extracted or imported. result, energy costs for all businesses would rise. Proponents claimed that thi: would be a better approach to tackling climate change than government regulat Analyze how this carbon tax plan would affect the U.S. economy. Assume the fo ing about the U.S. Economy:
- The United States has a flexible exchange rate against the euro
- The United States is in the intermediate range of its aggregate supply
- The United States has high international capital mobility
a. What should be the direct impacts and effects (i.e., before considering chang real GDP, GDP Price Index, real interest rate, and exchange rate) of this carbo on the government's budget deficit?
b. What should be the direct impacts (i.e., before considering changes in real GDP Price Index, real interest rate, and exchange rate) of this carbon tax on ness after-tax income?
c. What should be the direct impacts and effects (i.e., before considering chang real GDP, GDP Price Index, real interest rate, and exchange rate) of this carbo on overall investment spending in the United States?
d. What should be the direct impacts and effects (i.e., before considering chang real GDP, GDP Price Index, real interest rate, and exchange rate) of this carbo on production costs?
e. Where should your analysis begin?
- Explain the reasons, if any, to start your analysis in the real credit market.
- Explain the reasons, if any, to start your analysis in the real goods and servi market.
- Explain the reasons, if any, to start your analysis in the foreign exchar market.
f. Use the Three-Sector Model to analyze the consequences of a carbon tax or U.S. economy. In particular, explain how it should affect U.S. real GDP, GDP Index, the real interest rate, quantity of real credit per period, value of the relative to the euro, and quantity of dollars traded in the foreign exchange $m$ per period. Begin your analysis in the real credit market.
g. Use the conclusions in your previous answers to explain how the carbon tax sh affect the U.S. unemployment rate, monetary base, M2 money supply, rea change rate, and nominal interest rate.
h. Challenge Question. Should investment spending by all firms change in the direction as a result of the carbon tax? Taking into account your previous ans discuss how investment spending by companies that produce carbon-inter goods and by companies that produce non-carbon-intensive goods should chat

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Problem 14

Republican members of the U.S. House of Representatives have proposed a borderadjustment tax. Under it, U.S. importers would not be permitted to deduct the cost of imports from their profits, and export revenues would be free from corporate taxes, which is equivalent to a tax on imports and a subsidy for exports. Suppose the U.S. Congress and the President pass the border tax into law.
a. Starting your analysis in the foreign exchange market, use the Three-Sector Model to explain the effects the border-adjustment tax should have on the U.S. real interest rate, quantity of real credit per period, GDP Price Index, real GDP, nominal eurodollar exchange rate, and quantity of dollars traded per period.
b. Explain the (direct and indirect) impacts and effects that the border-adjustment tax should have on the U.S. M2 money supply.
c. Explain the (direct and indirect) impacts and effects that the border-adjustment tax should have on the U.S. nominal interest rate.
d. Explain the (direct and indirect) impacts and effects that the border-adjustment tax should have on the U.S. real exchange rate against the euro.
e. Explain the overall effects (i.e., after exchange rate, GDP Price Index, real GDP, and real interest rate changes) of the border-adjustment tax on the U.S. balance of payments (current account, financial account, and reserves and related items).
f. Challenge Question. Explain the effects a border adjustment tax should have on the U.S. government's structural, cyclical, and total government budget deficits. (Hint: See Structural Versus Cyclical Deficits and Surpluses in Chapter 13, "Fiscal Policy.")

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Problem 15

Due to the loss of international reserves, suppose the Russian central bank finds it increasingly difficult to defend the ruble's value by "directly intervening" in the foreign exchange market. Explain what tools the Russian central bank might use to "indirectly influence" (i.e., raise) the ruble's international value.
a. Of the aforementioned monetary tools the Russian central bank could use to "indirectly influence" the ruble's international value, explain their (direct and indirect) impacts and effects on Russia's M2 money supply. Do they affect the monetary base or $\mathrm{M} 2$ money multiplier?
b. Use the Three-Sector Model to explain the consequences of these indirect monetary actions on Russia's real interest rate, quantity of real credit per period, GDP Price Index, real GDP, nominal exchange rate of the ruble against the U.S. dollar, and quantity of Russian rubles traded per period. Assume that Russia has a flexible exchange rate and high international capital mobility.
c. Explain the (direct and indirect) impacts and effects that these indirect actions should have on Russia's consumption and investment spending.
d. Explain the (direct and indirect) impacts and effects that these indirect actions should have on Russia's real exchange rate against the U.S. dollar.
e. Explain the overall effects (i.e., after changes in the exchange rate, GDP Price Index, real GDP, and interest rate) these actions should have on Russia's balance of payments (current account, financial account, and reserves and related items).

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