Tutorial 6, problem set 6
Monetary Macroeconomics (EBB130A05)
Rijksuniversiteit Groningen
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UNIVERSITY OF GRONINGEN
FACULTY OF ECONOMICS & BUSINESS
EBB130A05 - MONETARY MACROECONOMICS
ACADEMIC YEAR 2017-
SEMESTER 1
Problem Set 6
Exercise 1: Asymmetric Shocks under Different Exchange Rate Arrangements
Consider a pair of two countries,AandB,which are very closely economically integrated and which are currently in a medium-run equilibrium. Supposethat due to a change in consumer preferences there is an increase in demand for the main exporting good of country Aand a fall in demand for the main exporting good of countryB.
(a)If both countries maintain a flexible exchange rate, analyzethe consequences of this shock on both economies in the short run as well as in the medium run. Specifically, discuss what will happen to output, the interest rate, the exchange rate and the price level. Show the effects graphically using either anIS−LM−IP or anAD−AS diagram. Also can you think of possible ways in which the monetary authoritiesof both countries could act in order to mitigate the effects of the shocks on the level of output.
(b)What if both countries maintained a fixed exchange rate? How would the same shock affect both economies in the short run and in the medium run? Discuss again what will happen to output, the interest rate, the exchange rate and the price level, and as above, show the effects graphically using either anIS−LM−IP or anAD−AS diagram. In this case what options exist for the monetary authorities ofboth countries if they wanted to mitigate the effects of the shock?
(c) How would the analysis of part (b) be different if the two countries were part of a currency union? To what extent would in this case the common monetary authorities be able to deal with the effects of the shock in the two economies?Also, apart from a monetary policy response, can you envision other types of policies that could alleviate the effects of the shock? [Hint: Assume that the size of the two economies doesnot differ much!]
Exercise 2: Debt and Economic Activity
Consider an economy in which the official budget deficit is 4% ofGDP, the debt-to-GDP ratio is 100%,the nominal interest rate is 10% and the inflation rate is 7%.
(a)Calculate the primary balance and the inflation-adjusted balance as a share of GDP?
(b)Suppose that the same primary balance is maintained in the next period. If the rate of output growth is 2%,compute the new value of the debt ratio.
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Suppose that financial investors perceive the economy’s debt level in (a)as too high. Hence they expect that in the future the government may try to devalue the currently fixed exchange rate in order to stimulate economic activity and tax revenues. Say that their expectation is for a devaluation of 10%,i. they expect the future nominal exchange rate,Ete+1to decreases by 10% from its current fixed value,E. ̄
(c)Assume the world interest rate equals at the moment 10% and is expected to remain unchanged. What do you expect will happen to the domestic nominal and real interest rates if the government defends the fixed exchange rate? How do you expect this to affect the level of economic activity and the government balance? If the government is able to maintain the above computed primary balance while output growth drops tozero, what is the immediate effect on the government balance? What is the expected debt ratio next period? Were investors’ fears justified?
Exercise 3: Debt Dynamics
Consider a Euro-zone country with a primary deficit ratio as ashare of GDP of 1% the rate of GDP growth be 4%,the inflation rate be 0% and the prevailing real interest rate be 3%.
(a)What is the equilibrium debt ratio? Is that ratio stable?
(b)What is the official deficit ratio as a share of GDP in the equilibrium?
Suppose now the European Commission decides to enforce the Maastricht criterion of a maximum debt ratio of 60% of GDP on all Eurozone members.
(c) What would be the primary deficit that would allow the given country to meet this criterion?
Suppose finally that after the implementation of several painful austerity measures the gov- ernment succeeds in reducing its primary deficit to the pointthat will allow it to meet the 60% maximum debt ratio. However, due to current economic crisis the interest rate on government bonds rises to 5%, whereas the growth rate of realGDP decreases to 3%.
(d)What is the new equilibrium debt ratio and what are the chancesof the government to reach that equilibrium?
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Tutorial 6, problem set 6
Vak: Monetary Macroeconomics (EBB130A05)
Universiteit: Rijksuniversiteit Groningen
