Economics Homework Help

Conceptual Questions

1. Read the article Fix or

oat?”. What are the costs and benets of using a xed vs

oating

exchange rate? Why is a xed exchange rate sometimes hard to maintain (Hint: look up what

happened to Mexico in 1994 and Thailand in 1997)?

2. Read the article The Trilemma of International Trade.” Explain what the Trilemma” means

and how the US, China, and Europe have chosen dierent ways of controlling their monetary and

foreign exchange policies.

3. Read the article An Economics of Magical Thinking” and explain the authors’ views on rationality

and why rational expectations may not be a good assumption for economic models.

4. What are microfoundations? How do microfoundations help answer the Lucas critique? You may

nd it helpful to read the article New Classical Macroeconomics”

5. What are the main features of New Keynesian models”? How do they dier from the Keynesian

model we studied in the rst half of the class? You may nd it helpful to read the article New

Keynesian Economics”

Analytical Questions

1. An open economy is described by the following equations

C = 1000 + 0:6(Y T)

I = 20; 000 200r

G = 5000

T = 5000

MD

P

= 2Y 800r

MS

P

= 60; 000

CA = NX = 2000 0:1Y 1000″

KA = 5500 + z(r r)

r = 10

(a) Derive the IS curve (Y as a function of r and “), LM curve (Y as a function of r) and the

BP curve (r as a function of Y , “, and the capital mobility parameter z)

(b) Assuming free capital mobility (z ! 1) and a

exible exchange rate, solve for the equilibrium

interest rate, income, exchange rate and trade balance.

(c) If government spending increases by 1800, what happens to the interest rate, exchange rate,

income, and trade balance? Draw the change on a graph.

(d) Return to the original level of G. If the money supply increases by 20,000, what happens to

the interest rate, exchange rate, income, and trade balance? Draw the change on a graph.

(e) Repeat b through d assuming a xed exchange rate of ” = 4 (remember that when the

exchange rate is xed the money supply will adjust to keep it xed so you should also solve

for equilibrium M

P )

(f) Repeat b through e assuming imperfect capital mobility with z = 100 (do your best – this is

not covered on the exam, but it is a good challenge to see if you really know what you are

doing.)

2. Demand for a product is given by the function D = 3000 100p. Firms need to decide production

before knowing the market price so supply is given by S = 100pe where pe are rms’ price

expectations.

a. Assume that rms form price expectations using naive expectations pet

= pt 1. If the price

in period 0 is p0 = 10, nd the expected and actual price in period 1 (actual price meaning

price where supply=demand). What is the error in rms’ price expectations (absolute value

of the dierence between actual and expected price)? Repeat for periods 2-5.

b. Now assume the rm uses adaptive expectations of the form pet= 0:8pe t 1 +0:2pt 1. Again

starting with p0 = 10, nd expected price, actual price, and error in periods 1-5 (you can

assume for period 0 expected was equal to actual, pe

0 = p0 = 10). What is happening to the

size of the error over time?

c. Find the rational expectations equilibrium price. Based on your ndings in the previous

question, does it seem like rms are learning the rational expectations price?

d. Now assume that there are two rms in the economy, each with supply function S = 50pe.

Note that with this setup, if both rms have the exact same expected price, we can simply

sum them and get back to the original aggregate supply function, therefore the rational

expectations price is exactly the same as in the previous question. Assume that one rm

always expects the rational expectations price from before pet

= pr. The other rm uses naive

expectations pet

= pt 1, but the rational rm doesn’t know this and assumes they are also

rational. Again, nd the path of prices and expectation errors (remember that now it is the

sum of the two rms supply that have to equal demand). What happens to the expectation

errors over time? Does it appear the economy will converge to the rational expectations

price?

e. Based on your ndings in this question, explain why rational expectations might be a reason-

able assumption even if we know that not everyone in the economy has rational expectations.