Instructions:
-- Please choose and answer to a total of THREE (3) questions.
-- Please be informed that if you answer all the questions, we will count the three questions with the lowest marks.
-- Copies written in pencil are not eligible for re-grading. You are advised to use an ink pen.
Question 1
a. With a high and growing US trade deficit, many hope that a depreciation of the dollar would help close the deficit. Explain the logic behind this prediction.
b. The US has faced both a trade deficit and a budget deficit, often referred to as "twin deficits". Explain how these two deficits are related. Show how an increase in the budget deficit is likely to be associated with a deepening of the trade deficit.
Question 2
a. The interest rate parity relation can be represented by the following equation:
1 + ! = 1 + !∗ !/!!; where i is the domestic interest rate, i* the foreign interest rate, E and Ee are the actual and expected exchange
rate, respectively. Referring to this equation as needed, explain why investors pay attention to the exchange rate when making investments across countries.
b. Describe the impact of an expansionary fiscal policy in an open economy using the ISLM model and the interest-rate parity relationship.
Explain what happens to output, the interest rate and the exchange rate. Use the appropriate graphs to illustrate your answers.
Question 3
a. Describe the options at the disposal of the government to finance a fiscal deficit. What are the relative advantages and disadvantages of each option?
b. Can the government rely on seignorage to finance an ever-increasing fiscal deficit? Explain why or why not. Use the appropriate graphs to illustrate your answer.
Question 4
a. The early incarnation of the Phillips curve can be represented as: !! = ! + ! - !!!; where is the inflation rate, is the markup factor in the pricing mechanism, z a vector of other factors affecting the price dynamics, and u the unemployment rate. Explain the relevance of this relation for policy purposes.
b. While early historical data confirmed the relationship in part (a), later evidence did not (starting from about 1970). Explain why. How is the relationship between inflation and unemployment conceived by economists today?
Question 5
a. Describe the various instruments of monetary policy and how they are used.
b. Through what channels does monetary policy affect the economy? That is, what are the monetary policy transmission mechanisms? List first them, then clearly describe two of these channels.
Question 6
a. Monetary policy can be conceived as a "game" between the policy maker and the public. Explain.
b. What mechanisms can be used to "keep the policy maker honest" with regard to policy announcements vs. actual policy implementation?