NATIONAL INCOME ACCOUNTING
- Why is national income ¹ gross national product?
- The National Income Accounts break GNP into four component parts. What are they?
- What does the current account measure?
- How can a country pay for additional imports once it has spent its export earnings?
- Why is a country’s current account surplus also referred to as its net foreign investment?
- Derive the formula: Personal Saving = I + trade surplus + government deficit
BALANCE OF PAYMENTS ACCOUNTS
- What do the BOP accounts record?
- Are exports recorded as debits or credits? What about imports?
- What is the difference between the current account and the capital account?
- In what way are asset sales/purchases treated as exports/imports?
- In theory, the capital account and the current account should sum to zero. Why don’t they?
- Why is a negative balance of payments sometimes considered dangerous?
EXCHANGE RATES
- What is an exchange rate?
- What does it mean to say that a currency has appreciated? Depreciated?
- What is the foreign exchange market?
- What is a spot exchange rate? A forward rate? Are they usually equal? Why/not?
- What is the difference between a forward contract and a futures contract?
- What does it mean to be "long" an asset? "Short"?
- What is an option?
- How does a "call" option differ from a "put" option?
- How do market participants decide whether to hold deposits denominated in the domestic currency, foreign currency, or some combination of these?
- How would you calculate the expected dollar rate of return on a yen deposit?
- When is the foreign exchange market in equilibrium?
- Write down a formula that satisfies the interest parity condition for U.S. dollar and Canadian dollar deposits.
- What variable always adjusts to maintain the interest parity condition?
- Using the simple short-run diagram depicting equilibrium in the foreign exchange market, show the effect of an increase in the interest rate paid on domestic currency deposits.
- Using the simple short-run diagram depicting equilibrium in the foreign exchange market, show the effect of an increase in the interest rate paid on foreign currency deposits.
- Using the simple short-run diagram depicting equilibrium in the foreign exchange market, show the effect of a fall in the expected future exchange rate (i.e. the price of the foreign currency in terms of the domestic currency).
INTEREST RATES
- How does the demand for money respond to changes in the rate of interest, the price level, and the level of income?
- Write down formulas for aggregate money demand and aggregate real money demand.
- Show graphically how real money demand L(R,Y) and the rate of interest R are related.
- What happens to the schedule depicting real money demand if the level of income changes?
- How is the aggregate money supply determined?
- When is the money market in equilibrium?
- What variable adjusts to maintain equilibrium in the money market?
- Using the simple short-run diagram depicting equilibrium in the money market, show the effect of a rise in the nominal money supply.
- Using the simple short-run diagram depicting equilibrium in the money market, show the effect of a fall in the level of real income.
THE SHORT-RUN MODEL
- What does it mean to say that an analysis is "short run"?
- Putting the short-run models of equilibrium in the FX and money markets together, show how a fall in the level of the money supply affects the exchange rate.
- Do the same thing for an increase in the money supply.
THE LONG-RUN TIME PATHS
- What does it mean to say that an analysis is "long run"?
- What distinguishes the short run from the long run?
- If the money supply increases by 4%, by how much will prices rise in the long run?
- The authors of your book provide data, which shows a positive correlation between inflation and money supply growth in a number of OECD countries. According to them, it is evidence that money supply growth causes inflation. Can you think of an alternative explanation for this observed relationship?
- Show graphically what the time paths for prices, the interest rate and the exchange rate would look like following an increase in the level of the money supply.
- Show graphically what the time paths for prices, the interest rate and the exchange rate would look like following a decrease in the level of the money supply.
- Show graphically what the time paths for prices, the interest rate and the exchange rate would look like following a decrease in aggregate real money demand.
- Show graphically what the time paths for prices, the interest rate and the exchange rate would look like following an increase in aggregate real money demand.
- Prices are assumed to adjust very slowly in the short-run. Why do they eventually begin to rise?
- Explain the process of exchange rate overshooting.
PRICES
- What is the law of one price? Explain carefully.
- What is the theory of purchasing power parity?
- Write down an expression for absolute PPP. What does it "say"?
- How does absolute PPP predict the exchange rate will respond to an increase in the domestic money supply?
- Write down an expression for relative PPP. What does it "say"?
LONG-RUN EXCHANGE RATE MODEL BASED ON PPP
- What assumptions are made under the monetary approach to exchange rate determination?
- According to the monetary approach, what will happen to the exchange rate following a permanent rise in the domestic money supply? (ceteris paribus)
- According to the monetary approach, what will happen to the exchange rate following an increase in the rate of interest paid on domestic deposits? (ceteris paribus)
- According to the monetary approach, what will happen to the exchange rate following an increase in domestic real GNP? (ceteris paribus)
- How will a permanent increase in the rate of growth of the money supply affect prices?
- Using the interest parity condition and the expression for relative PPP, show how a permanent increase in the domestic money supply affects the domestic interest rate.
- Write down an expression for the Fisher Effect. What does it "say"?
- Explain why rising interest rates are associated with a currency appreciation in the short-run and a currency depreciation in the long run.
- Graph the time paths for money, interest, prices and the exchange rate for a permanent increase in the rate of growth of the money supply.
- Graph the time paths for money, interest, prices and the exchange rate for a permanent decrease in the rate of growth of the money supply.
LONG-RUN EXCHANGE RATES WITHOUT DEPENDENCE ON PPP
- Why do the authors of your book claim that PPP fails to hold in the real world?
- How can the exchange rate model be modified to account for this shortcoming?
- Write down an expression for the real exchange rate.
- If the real dollar-pound exchange rate is rising, is the dollar appreciating or depreciating?
- Explain how a change in world relative demand can affect the real exchange rate.
- Explain how a change in world relative supply can affect the real exchange rate.
- Write down an expression for the long-run determination of the exchange rate that does not rely solely on PPP.
- Do you understand how changes in the money market and the output market will affect the exchange rate?
AGGREGATE DEMAND
- What do we mean when we say "aggregate demand"?
- What is the primary determinant of consumption demand?
- What is the relationship between disposable income and consumption demand?
- What are the main determinants of the current account?
- What is the relationship between disposable income (foreign and domestic) and the current account?
- What is the relationship between the real exchange rate and the current account?
- Explain why a response to the previous question is ambiguous unless we assume that a particular condition holds.
- Explain carefully what this condition is and why it eliminates the ambiguity of changes in the real exchange rate on the current account.
- How is output determined in the short-run?
- What is true in equilibrium?
- Does the model predict that equilibrium will generally coincide with full employment? Why/why not?
THE AA-DD MODEL
- The AA-DD model shows how the nominal exchange rate and the level of output are determined in the short-run. Draw the graph, labeling both curves and axes correctly.
- The DD curve will shift whenever one of its underlying variables is changed. What are the underlying variables?
- The AA curve will shift whenever one of its underlying variables is changed. What are its underlying variables?
- Do you understand which way AA and DD will shift when an underlying variables rises/falls?
- Derive the DD curve. What is true at every point along DD?
- Derive the AA curve. What is true at every point along AA?
- Draw the AA-DD curves together. Locate a point that is not on either curve, and explain how the economy will eventually reach equilibrium. (hint: which market adjusts first/fastest?)
- Use the dual-graph (FX market and money market) to analyze a temporary rise in the domestic money supply. How does this affect the AA-DD graph?
- What if it had been a temporary decrease in the domestic money supply?
- Use Income-Expenditure Model to analyze a temporary increase in government spending (or a temporary tax cut). How does this affect the AA-DD graph?
- What if it had been a temporary decrease in government spending (or a temporary tax increase)?
- Do expansionary (contractionary) fiscal policy and expansionary (contractionary) monetary policy have exactly the same effects? Explain.
- Why might a government prefer one approach to the other?
- What does the J-Curve show? Why was it developed?
BALANCE SHEETS
- What kinds of things would you find on a typical central bank’s balance sheet? (assets and liabilities)
- What happens to the domestic money supply when a central bank buys an asset from the domestic public?
- What happens to the domestic money supply when a central bank buys a foreign asset?
- What happens to the domestic money supply when a central bank sells an asset to the domestic public?
- What happens to the domestic money supply when a central bank sells a foreign asset?
FIXED EXCHANGE RATE REGIMES
- How could a central bank "sterilize" the purchase of foreign assets?
- How could a central bank "sterilize" the sale of foreign assets?
- What is the point of "sterilizing" an operation?
- If the officials who are in charge of pegging a currency at a fixed rate observe upward pressure on the exchange rate, how should they intervene?
- If the officials who are in charge of pegging a currency at a fixed rate observe downward pressure on the exchange rate, how should they intervene?
- Under a rigidly fixed exchange rate system, if the spot rate is $1.50/unit of the foreign currency, what should be the value of the future expected exchange rate be? Why?
- Under a rigidly fixed exchange rate regime, what is the interest parity condition?
- If foreign interest rates increase, what must a country that is pegging its currency to the foreign one do in order to maintain the peg? Explain.
- Why is monetary policy considered to be on "autopilot" under a fixed exchange rate regime? Explain carefully.
- What would happen if a nation tried to stimulate the economy by implementing an "easy money" policy if it operated under a fixed exchange rate system? Use the AA-DD model to explain.
- Use the AA-DD model to show the effects of expansionary fiscal policy in a nation that operated under a fixed exchange rate system.
- Can a country that is operating under a fixed exchange rate system ever change the peg? Explain.
- What does it mean to say that a country has devalued its currency? Revalued?
- Why would a country ever devalue? (give three reasons)
- How could a nation bring about a devaluation? (Use AA-DD to demonstrate)
- What is a balance of payments (BOP) crisis?
- Explain (very carefully) how an expected devaluation can cause a BOP crisis.
- Under a reserve currency system, the reserve country (i.e. the one that issues the reserve currency) is in a preferred position. Why? (hint: discuss asymmetry)
- Under a gold standard system, the price-specie-flow mechanism is supposed to cause the international monetary system to adjust. Explain this process.
POLICY OPTIONS UNDER A BRETTON WOODS SYSTEM
- What was the Bretton Woods System?
- Countries were supposed to desire internal and external balance. What do these terms mean?
- What variables can policymakers target in their pursuit of short-run internal balance?
- Why isn’t monetary policy an option?
- What variables can policymakers target in their pursuit of short-run external balance?
- Why isn’t monetary policy an option?
- Draw the XX-YY model, labeling both curves and axes correctly.
- What is true at every point along XX?
- What is true at every point along YY?
- Do you understand what is "going on" at every conceivable point in the graph (i.e. those "on" and "off" the XX and YY schedules?
- Why does being at a point other than equilibrium imply a policy dilemma?