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ECON 305 Intermediate Macroeconomics: Assignment 6 Solution

ECON 305 Intermediate Macroeconomics: Assignment 6 Solution

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ECON 305 Intermediate Macroeconomics: Assignment 6 Solution

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QUESTION 1 – Openness in Goods and Financial Markets

a) Explain the three types of trade that countries conduct.

b) Define the nominal exchange rate of a country. Define the real exchange rate of a

country. Why is the real exchange rate the appropriate price for thinking about decisions

by consumers and firms about whether to buy domestic or foreign goods and services?

c) Explain how the nominal exchange rate, and domestic and foreign price inflation affect

the real exchange rate.

d) If the domestic country’s real exchange rate (currency) depreciates, how would you

expect this to affect the domestic country’s trade balance in goods and services? Explain.

e) What do we mean by purchasing power parity (a theory of real and nominal exchange

rates)? If the domestic country’s price level declines, what does purchasing power parity

predict would tend to happen to the nominal exchange rate and foreign price level?

Explain.

f) What is the source of large differences between the GDP and GNP of oil exporting

countries? In answering the question, explain carefully the difference between gross

domestic product and gross national product.

g) Suppose the uncovered interest parity condition holds, and that the domestic interest

rate is lower than the foreign interest rate. What does this imply about the current versus

future expected currency value for the domestic country?

h) Assume that the one-year interest rate in the United States is 4% and that the one-year

interest rate in Canada is 3%. According to uncovered interest rate parity, what does this

imply about the current versus the future expected value of the US dollar? Explain.

i) Explain why a simple comparison of the interest rates on domestic and foreign bonds

might provide misleading information about which bonds yield the highest expected

returns.

QUESTION 2 – An Open Economy Model of the Goods Market

a) Explain the difference between: (a) the demand for domestic goods; and (b) the domestic

demand for goods. In your answer, write down equations which describe (a) and (b).

b) Explain the determinants of (a) exports and (b) imports. Write an algebraic expression for

each.

c) Explain why the demand for domestic goods curve (ZZ) has a different slope than the

domestic demand curve (DD).

d) Using the ZZ/Y and NX graphs, illustrate graphically and explain what effect an increase

in taxes, T, will have on output, exports, imports, and net exports. Clearly label all curves and

clearly label the initial and final equilibria.

e) Using the ZZ/Y and NX graphs, illustrate graphically and explain what effect an increase

i

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