Jan Matteo Bassi

Section L8 TuTh 3:00-4:20 pm

TA Emily Chen

ECON 2123: Macroeconomics

Problem Set #3
Due Date: November 14, 2024

Instructions:
• Please upload your answers to Canvas by 10:00 pm.
• Late submissions will not be accepted.
• Please put your name, section, and your TA’s name at the upper right corner of the
first page.

1. Interest rates in Hong Kong and the United States

In this question, you will check whether the uncovered interest parity holds in the real world.
We focus on the interest rates in Hong Kong and the US.

(a) (5 points) Briefly explain why the uncovered interest parity implies that the
interest rate in Hong Kong (𝒊𝒕 ) should be equal to that in the US (𝒊∗𝒕 ).

The UIP condition implies that (1+it) = Et * (1+𝑖#∗ ) *(1/Eet+1). We also know that HKD
is pegged to USD, so that Et = Eet+1 = 1/7.8 . This means that Et / Eet+1 = 1 and we can
simplify the UIP condition to 1+it = 1+𝑖#∗ . Subtracting one to each side, we confirm
that it = (𝑖#∗ ).

(b) (5 points) We will compare the federal funds rate in the US and the corresponding
rate in Hong Kong. To download the data, first, go to the data archive run by the
Hong Kong Monetary Authority (https://www.hkma.gov.hk/eng/data-publications-
and-research/data-and-statistics/economic-financial-data-for-hong-
kong/#financialSector). Find “Base Rate,” and click “More Statistics” on the right.
You can download “T070301.xls” file. We will use the “Discount Window Base
Rate,” which is available from June 1992 to July 2024. When cleaning your data,
especially when deleting the empty cells, methods explained in the following link

1
 might be useful: https://www.extendoffice.com/documents/excel/4595-excel-delete-
blank-cells-and-move-left.html.

(c) (5 points) To obtain the US data, go to FRED

(https://fred.stlouisfed.org/series/FEDFUNDS). Set the date from June 1992 to July
2024 and download the data.

(d) (5 points) Draw a figure which shows the federal funds rate in the US and the
discount window base rate in Hong Kong from June 1992 to July 2024. Label axis,
specify units and add legends. Does the interest rate in Hong Kong tightly follow that
in the US? (The uncovered interest parity does not take risk premium into account.
Because the US government bonds are safer than the Hong Kong government bonds,
it is not surprising if you have 𝑖#∗ < 𝑖# ).

The interest rate in Hong Kong does follow the interest rate in the United States, and
as expected is slightly higher due to the risk premium effect. I completed point b) to
download the Hong Kong data and point c) to download the United States data, which I
merged into a single spreadsheet in point d) to get the final graph.

2
2. Growth rates of real exchange rates
(a) (5 points) Let’s denote the growth rate of a variable 𝑋 by 𝑔$ . Show that
𝑔% ≈ 𝑔& + 𝜋 − 𝜋 ∗
for small 𝑔% , 𝑔& , 𝜋, and 𝜋 ∗ , where 𝜋 and 𝜋 ∗ are the inflation rates in a domestic and
foreign country. (HINT: Start from 𝜖 = 𝐸𝑃/𝑃∗ . Remember that the log difference of a
variable 𝑋, Δ ln 𝑋, is similar to 𝑔$ when 𝑔$ ≈ 0.)

𝐸𝑃
𝜖=
𝑃∗
ln(𝜖) = ln(𝐸𝑃) − ln(𝑃∗ )
ln(𝜖) = ln(𝐸) + ln(𝑃) − ln(𝑃∗ )
Δln(𝜖) = Δln(𝐸) + Δln(𝑃) − Δln(𝑃∗ )
g ϵ ≈ gE + gP – gP* = gE +𝜋 − 𝜋 ∗

(b) (5 points) Suppose that the domestic currency depreciated by 3%. During the same
period, the inflation rates in the domestic and foreign country were 2% and 3%,
respectively. What would happen to the real exchange rate during the same period?

Let us plug in the values in the formula established in point a):

g ϵ ≈ gE + gP – gP* = gE +𝜋 − 𝜋 ∗
g ϵ = -0.03 + 0.02 – 0.03 = -0.04 = - 4%
This means the real exchange rate depreciated by approximately 4%.

3. (10 points) The uncovered interest parity and the expected rate of appreciation of the
domestic currency relative to the foreign currency

Start from the uncovered interest parity. Using the fact that ln(1 + 𝑥) ≈ 𝑥 for small 𝑥’s, show
$ $
&!"# '&! &!"# '&! &! (
that 𝑖# ≈ 𝑖#∗ − &!
when 𝑖# , 𝑖#∗ , and &!
are small (HINT: Note that $
&!"#
= &$ =
!"# /&!

$
( & &!"# '&!
%$ &%!
; therefore, ln 8& $! 9 = − ln :1 + 8 &!
9; ).
(*+ !"#
%!
, !"#

1
1 + 𝑖# = 𝐸# (1 + 𝑖#∗ ) : - ;
𝐸#*(

3
 𝐸# ∗
1 + 𝑖# = : - ; (1 + 𝑖# )
𝐸#*(

𝐸#
ln(1 + 𝑖# ) = ln : - ; + ln(1 + 𝑖#∗ )
𝐸#*(

- '(
𝐸#*( − 𝐸# + 𝐸#
∗
ln(1 + 𝑖# ) = ln(1 + 𝑖# ) + ln : ;
𝐸#
⬚

- '(
𝐸#*( − 𝐸#
∗
ln(1 + 𝑖# ) = ln(1 + 𝑖# ) + ln : + 1;
𝐸#
⬚

- ⬚
𝐸#*( − 𝐸#
∗
ln(1 + 𝑖# ) = ln(1 + 𝑖# ) − ln : + 1;
𝐸#
⬚
-
𝐸#*( − 𝐸#
𝑖# ≈ 𝑖#∗ −
𝐸#

4. A policy mix and the goods market: exchange rate and fiscal policies

For this question, suppose that 𝑖, 𝐺, and 𝑌 ∗ are fixed. Also, for simplicity, assume that 𝑁𝑋 is
zero initially.

(a) (5 points) Draw a diagram representing the initial equilibrium in the goods market.
Denote the initial equilibrium by point A.

4
(b) (5 points) Suppose that the government increases 𝑇. Denote the new equilibrium by
point B. What will be the effect of this change on 𝑌, 𝐶, 𝐼, and 𝑁𝑋?

With an increase in T, the ZZ curve will shift downward.

This means Y will decrease, and consequently, C will decrease.
Assuming i does not change, I will decrease with Y. If, within the ISLM model, the IS
curve shifts downward while the LM curve stays the same, interests rate will
decrease, so we won’t be able to predict the change in I.
Because Y* and the real exchange rate are unchanged, the NX curve doesn’t shift. As
Y decreases, Imports will decrease, so there will be a positive NX (NXb in the figure).

(c) (5 points) How can an exchange rate policy stabilize output when 𝑇 increases as in
(b)? Denote the new equilibrium by point C. Compare 𝑌, 𝐶, 𝐼, and 𝑁𝑋 under points A
and C.

An exchange rate policy that can stabilize output is to depreciate the real exchange
rate. The NX curve will shift upward, and so will the ZZ curve (ZZ = ZZ’’). In the
new equilibrium, the point C corresponds with the original starting point A.
Therefore, Ya = Yc as seen in the graph.
Reminding that C depends on Y and T, we know that Ca > Cc because Ya = Yc
while Ta < Tc .
Assuming that Y and i are the same in A and C, I is also the same in A and C.
The NX for C is positive, while NX for A is zero, so NXc > NXa .

5
5. A policy mix in the IS-LM-IP model

This question studies the effects of a monetary and fiscal policy mix in the IS-LM model in an
open economy. Here, we focus on an economy with flexible exchange rates.

(a) (5 points) Draw a diagram for the IS-LM-IP model. Denote the initial equilibrium by
point A.

(b) (5 points) Suppose that the government increases 𝑇. Denote the new equilibrium by
point B. What will be the effect of this change on 𝑌, 𝐶, 𝐼, 𝐸, and 𝑁𝑋?

The increase in T shifts the IS curve left.

Y decreases, and as disposable income also decreases, C decreases.
As Y and i both decrease, we do not know the change in I.
From the IP graph on the right, we see E must decrease.
Assuming P and P* are fixed, the real exchange rate must also decrease.
A decrease in real exchange rate would increase exports and a decrease in Y would
decrease imports, so NX would increase.

6
 (c) (5 points) Suppose that the central bank decides to increase the supply of money to
stabilize output in response to an increase in 𝑇 as in (b). Denote the new equilibrium
by point C. Compare 𝑌, 𝐶, 𝐼, 𝐸, and 𝑁𝑋 under points A and C.

The central bank must perform an expansionary monetary policy to stabilize output.
The LM curve will shift downward.
As seen in the graph, YA = YC.
Because TC > TA, CC < CA , similarly to how discussed in an exercise above.
Y is constant, but iC < iA, so IC > IA.
As shown by the IP graph, EC must be lower than EA, so the real exchange rate in C
will also be lower than in A.
As Y is same in both A and C, but the real exchange rate is lower in C, NX will be
higher for C than for A.

6. Policy coordination and the world economy (Blanchard (2020), #8 Chapter 18).

Please see the attached worksheet below for all subpoints of exercise 6.

Consider an open economy in which the real exchange rate is fixed and equal to one.
Consumption, investment, government spending, and taxes are given by

𝐶 = 10 + 0.8(𝑌 − 𝑇), 𝐼 = 10, 𝐺 = 10, and 𝑇 = 10.

Imports and exports are given by

𝐼𝑀 = 0.3𝑌 and 𝑋 = 0.3𝑌 ∗ ,

where 𝑌 ∗ denotes foreign output.

(a) (5 points) Express equilibrium output in the domestic economy in terms of 𝐺 and 𝑌 ∗ .
What is the government spending multiplier in this economy (when 𝑌 ∗ is exogenously
given)? If we were to close the economy-so exports and imports were identically equal
to zero-what would the multiplier be? Why would the multiplier be different in a closed
economy?

(b) (5 points) Assume that the foreign economy is characterized by the same equations as
the domestic economy (with asterisks reversed). Use the two sets of equations to

7
 express the equilibrium output of each country in terms of 𝐺 and 𝐺 ∗ . Compute the value
of 𝑌 and 𝑌 ∗ when 𝐺 = 𝐺 ∗ = 10. [HINT: Use the equations for the foreign economy to
solve for 𝑌 ∗ as a function of 𝐺 ∗ and 𝑌, and substitute this solution for 𝑌 ∗ in part (a).]
What is the government spending multiplier for each country now? Why is it different
from the open economy multiplier in part (a)?

(c) (5 points) Assume that the domestic government has a target level of output of 125.
Assuming that the foreign government does not change 𝐺 ∗ (= 10), what is the increase
in 𝐺 necessary to achieve the target output in the domestic economy? Suppose that 𝐺 =
10 initially. Solve for net exports and the budget deficit in each country.

(d) (10 points) Suppose each government has a target level of output of 125 and that each
government increases government spending by the same amount. What is the common
increase in 𝐺 and 𝐺 ∗ necessary to achieve the target output in both countries? Solve for
net exports and the budget deficit in each country.

(e) (5 points) Why is fiscal coordination, such as the common increase in 𝐺 and 𝐺 ∗ in part
(d), difficult to achieve in practice?

8
.
6
Policy Coordination and the world
economy
E =
1

C =
10 to 8(Y-T)
.

,
I = 10 T= 10
,
*
IM =
0 . 34 ,
X =
0 .
34
Y multiplier closed
economy comparison
a . ,
,

Y = c + I + 6 + NX

*
Y = 10 + 0 . 8(y -

T) +
10 + 6 +0 .
34 - 0 .
34
*
Y = 10 +0 .
8y -
8 + 10 + 6 + 0 .
34 -
0 .

34
*
0 .
5 y = 12 + 6+ 0 .
34

y =
2(12 + 6 + 0 .

34#)
y = 24 + 26 + 0 . 64#

= 2
government multiple
If NX =
0 :

y = c I+
+
b

Y = 10 + 0 .
8(y -

T) + 10 + 6

Y =
10 + 0 . 84 -

8 + 10 + 6
 0 .
24 = 12 + 6

y =
5(12 +
6)
= 56 + 60

= 5 -
>
multiplier in closed
economy
- The
multiplie is love in the
open economyof
become of the flows out
part spending
the domestic country i e
is
spent on
-

.
.

foreign goode and service

Foreign ; multiplie
b economy has Y
.
same
equations ;
Domestic
Foreign
*
)
*
C =
10 + 0 .

g(y T) -
C = 10 + 0 8(y *
.
-
T
* * *
E=10 6 =
10 t = 10 I =
10 6 = 10 + = 10
, , , ,
*
IM =
0 .

3Y iM =
0 . 34
#

*
X =
0 . 34# X =
0 34
.

NX
Y =
c + I + 6 +
as in exercise a
Y =
24 + 26 + 0 64#
Ey
.

*
= 24 + 26 *70 67 .
 *
y =
24 + 26 +0 .

6(24 + 26 + 0 .

64)
= *
(1 + 0 .

624 + 26 + 1 .
26 + 0 .
36Y
*
(1 -

0 .
36)y =
1 6 .
.
24 + 26 + 1 26
.

Tot (38 )
Y .
4 + 26 + 1 .
26
*

= (38 .
4 + 26 + 1 .

267)
26
(38
.
4 + 26 +

#
60 + 3 . 1256 + 1 . 8756

So Y* =
60 + 3 .
1256
*
+ 1 .
8756
6#
*
If 6 = = 10 y = Y =
110
,

The
government spending multiplie
is

↓25 . .
3

The
spending multiplie is highe because :

↑Y & IM * ** & y ** X & Y and so feth

for the
So there is a

6
"positive
there
loop"
Will
:

be higher
same

Y
.
change in , a incess in
 A6 for deficit
C .

target ,
NX
, budget for both

y =
125

+ = 10

6 = 10

Yo = 110

SY 15

[=
=

3 . 125

·6=
16 =
34

y 24726*+ 0 .
67 With 6
*
= 10

*
y =
119
*
NX =
X + M = 0 .
3(Y -

y) = - 1 8
.

*
NX = X * 1M + = 0 .
3(Y -
y
*
) = 1 .
8

T -
6 =
10 -
(10 + 4 5) .
= -
4 .
8

+* -

6
*
= 10 -
10 = 0
d .
A6 for both comfries'
target ; NX; definit
*
y 24 + 26 + 0 64

S
= .

Y* =
24 + 26
*
+ 0 .
64
*
y = Y = 125
*
125 =
24 + 26 + 75

3
*
67 75) 1356 16
-(125
=
-
24 -
=
=

16 =
3
6 75) 13
+(125
= -

24 - =

NX = X -

(M = 0 .

3(y -

y
*
) = e

*
NX * = X -
(M * = 0 .

3(4H -

7) = 0

T - G =
10 - 13 = -

+* -
6
*
= 10 -
13 = -

fiscal coordination effialt .

Why
e .
is

fiscal coordination
Game
theory explaine why
remains difficult in
practice. Each comby will want
to wait the other country's fiscol
expansion ,
so

as to
improve NX without intering T-G (see pointc).