# macroeconomic-theory

macroeconomic-theory

Macroeconomic Theory

Name

Institution

Course

Q1a

When the interest parity condition holds and the domestic interest rate is greater than the foreign interest rate then the domestic currency is expected to decrease in value alongside the foreign currency thus a high inflation is expected in the country.

Q 1b

If the nominal interest rate is 2% in the United States and 5% in Canada one is expected to hold the United States bonds than the Canadian bonds since the high interest rate in Canada indicates expected inflation rate in the country to be high. Thus the Canadian dollars is expected to decrease in value against the United States dollar by 3% in regard to international Fisher effect.

E(e) = i\$US -i \$C

2% – 5% = -3%

Qc i

The market conditions may be summarized as follows:

I \$= 5%, I UK pounds= 2%, S =\$1.68per US pound, F= \$1.55 per US pounds.

If \$100 million is invested in United States, maturity value in one year will be

\$100 M ( 1+0.05) = \$ 105 million or

\$100M may be converted to the UK pounds and be invested at the UK interest rate, with pounds maturity value sold forwarded.

(\$100 M *1.68)(1+.02)(1/1.55) = \$109.8 M

This clearly indicates that itâ€™s better to invest \$100M in the UK.

Q C ii

Because the rate of inflation is high in the U.S, we can apply the buying power parity to estimate the exchange rate in pounds today.

E (e) = E pounds\$ – E\$

= 2% – 5% = – 3%

E(St) = So(1 + E(e))

= ( \$1.68 per pound) (1+0.03)

= \$1.68504

= \$1.69 per pound.

Q2 a

Effect of reduction in taxes on output, exports, imports and net exports

A reduction in lump sum taxes may improve the economy through increased output, exports and net exports. The IS curve shifts to the right from IS to IS2. The LM curve also shifts to the right from point LM to LM1. This is illustrated in the graph below.

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18186402597150090424015938500472440159385003816351841500IISIS2LM

106489519812000LM1

7048530543500

Y

Q2b

704857105650047244089217500 When there is a reduction in the foreign trade by one unit, but the domestic government increases spending by one unit. The will be a reduction in the domestic output, exports, net exports and imports. This is due to the changes in foreign exchange rates that affect also the domestic market. The effect tend to shift the IS curve to the left Ss1 toS2 and equilibrium point moves from E0 toE1.

7931158001000 LM

21082021971000S1

69342027940000E0

-40005107188000S2E1

111506099695001905002400300030746709969500

1326515-254000-7048522860000

P

2032025590500237109025590500

204978029464000P2

13265152159000

-19050073723500

Full employment curve

As the aggregate demand (AD) curve moves in, expansionary monetary policy may be implemented for AD to shifts back to starting point, output is now restored.

Q2d

The rise in government expenditure results in the curve of IS to shift to the right and an economy moves from point A to B. at this point there is a deficit in balance of payments leading to depreciation in the exchange rate. Net Exports rises as the relative rate of domestic products on global market has reduced.

1868805-203200091440026098500501655016500ISIS1

160782022606000

I

ABBOP5016527368500

50165317500Q3aY

When the domestic interest rates remain constant at 4% while the foreign interest rate increase to 6% the expected exchange rate for the domestic currency will appreciate against the foreign currency because inflation rate in the foreign market is high. The interest parity may be restored when domestic market sells its foreign reserves in order to move to 4% exchange rate or equilibrium.

Q31557655635000008064570548500bAn increase Government spending will shifts the curve of IS to the right IS- IS1. The shift leads to an increase in rate of interest. A rise in government expenditure forces the fiscal policy to provide the market with local exchange to uphold the rate of exchange constant.

49212516065500501656032500IISIS1LM

26727152997200010045701841500133667524955500 LM1

247205522860000

5016524511000IWFE

-34163057340500

Y

Q3 c

An expansionary monetary authority will move the LM curve to LM1 thus making the equilibrium to shift from point E to E1. And because the trade rates are flexible, the deficit in balance of payments will devalue the domestic money. This will results to rise in the net exports moving the IS curv

1296035773430001606551216025004000569342000IS1LMLM1IS

2582545414655001125220193167000272288012319000152717541465500-1016012319000110490149542500

-6032545085000IE1Y

Q3d

In order to maintain the pegged exchange rate when foreign interest falls. The fiscal policy makers must purchase the foreign assets through home currency. And these increase the supply of domestic money that shifts economy to its final equilibrium. There will be enhanced output through buying of domestic assets and low exports.

Q3e

The effect of increased consumer confidence in domestic economy in a fixed exchange rate. There will be increased government spending, increase in aggregate demand resulting to shift of DD1 to DD2 while the original appreciation falls from E1 to E2. The central bank is forced to acquire foreign assets by home currency. This moves the economy to equilibrium E3 at a higher output.

Q4a

A country which is in a fixed exchange rate such as China might be expected to depreciate its currency due to the following factors: the government has to invest a lot of resources in order to get foreign reserves to grow up so as to defend the fixed exchange rate. And also there is monetary ineffective as the only option in the independent fiscal policy is the exchange controls that avert traders from selling or buying domestic currency. But these exchange controls decrease trade and direct investment in foreign and encourages essence of corruption.

Q4b

The actions that policy makers may choose in response to expected currency devaluations. They can opt to reduce exchange rate and sell foreign reserves. The government can also purchase domestic assets. Taxes should be reduced to raise aggregate demand to increase appreciation in the currency.

Q4C

When the economy is operating below the natural level of output. The labor supply falls with unemployment going back to its normal rate. This only results in reduced output and the only option are to increase inflation in order reduces unemployment. Devaluation of currency will rise the inflation further other creating of employment. An increase in aggregate demand only causes to rise.

Q 4d

An economy that is operating above the natural level of output in a fixed exchange rate regime can adjust to this situation through a decrease in the domestic currency to enhance a rise in output as net export increase.