Answer the question and calculate - Assignment Example

ASSIGNMENT-2: ECON – ASSIGNMENT-2: ECON – Question A. The Quantity Theory of Money simply links the inflation rate tothe growth rate supply of money starting with the velocity concept, which is the rate at which money circulates; it predicts a 1-to-1 relationship between changes in inflation rate and the changes in the growth rate of money. Therefore, the phrase or statement, “Fast Money Raises My Interest”, can be explained in terms of the Fisher Equation and the quantity of money theory to mean that as money changes hands fast, or frequently-when the velocity is high, results in a high demand for money; that is what “raises my interest implies. B. i.

Therefore, ii. C. If the Canada has low inflation, the value of its currency rises against other currency whose inflation is high, such as Mexico in this case. Therefore, the Canadian Dollar will be stronger than the Mexican peso; meaning, a lot more Mexican peso would be required to buy one Canadian dollar. Question-2: Suppose money demand function is, A) If output (Y) grows at 3% rate, at what rate will the demand for real balances grow; assumption, nominal rates remain constant As the rate of the output Y increase at 3%, the demand for real balances, , will grow at a rate of 2% when the nominal rates remain constant B) The velocity of money in this particular economy will be 5, V=5, because Question-3: A) The type of fiscal policy that IMF needs to propose in situation where it is concerned about currency depreciation, and wants a government’s small open economy to realize currency appreciation, is proposing a flexible fiscal policy with fiscal expansion at home.

This can be achieved by raising real interest rates so that domestic currency can appreciate. Given that the nominal price is sluggish, it will translate to appreciation in the rate of domestic real exchange; international competitiveness is also lost. The balance of trade also deteriorates; this limits the expansionary effects of advanced spending by the government. Given that this is a small economy, then the resulting reduced exports will offset the fiscal expansion because, capital is also internationally mobile.

This implies that the fiscal multiplier will become zero. However, if the rate of exchange rate was fixed, then, the monetary policy adopted by the IMF would have to loosen a bit so that real interest rate does not increase, thus currency appreciation. This will in turn amplify fiscal expansion effects. B) The impact of the IMF proposal on the small open economy’s exchange rate illustrated graphically The graph is based on four micro economic variables S, I, r and r* in response to currency depreciation Figure 1: Impact of the IMF proposal – Flexible exchange rate -, on the small open economy’s exchange rate C) If the small open economy started from a balanced trade position, then, the trade balance will deteriorate as a result of lost international competitiveness.

Question-4: Considering an economy described by Where ? the real exchange rate and r is is the real interest rate. A) i) National saving National saving refers to the output amount that is not purchased for current consumption by the government or households. In this case, we are given the government spending, the output, and the function of consumption; this allows as to solve for consumption, and thus national saving. ii) Investment It is true that investment is negatively depends on the interest rate; this equals the international rate r* of 5.

Therefore, iii) Trade balance The difference between investments and savings equals Net exports, therefore; iv) Equilibrium real exchange rate The exchange rate that clears the foreign exchange market can now be calculated given that we already have solved for net exports B) In this case the same analysis as in part A) is repeated, with a new value where G rises by 500 to 1,500, we find: i) National saving ii) Investment iii) Trade balance iv) Equilibrium real exchange rate Increase in spending by the government reduces national saving; investment remains the same since the world or international real interest rate remains unchanged.

This implies that domestic investment is more than domestic saving and thus part of the investment must be financed by borrowing. Inflow in capital is met by a reduction in net exports; this requires the currency to appreciate. C) With the world interest rate r* risen to 10% and G =1,000, the same steps as in A) above are repeated i) National saving ii) Investment, the world exchange rate r* is 10% iii) Trade balance iv) Equilibrium real exchange rate Compared to A) above, the national saving remains the same, however, the world interest rate results in low investment.

The capital outflow is achieved by running surplus of trade, which in essence need depreciation in currency.