The 3rd Assignment of Principles of Macroeconomics

Hand-written
solution only,
will be accepted, and is due for
submission on May 19 (Mo.)

This is an individual assignment. You are expected to complete it on

your own without copying from other student(s) and without letting
other student(s) copy from you. Please strictly observe BNBU’s
academic honesty policy. Plagiarized work will receive zero mark.

If cases of copying were found, all students involved will

receive zero marks, regardless of who copied from whom.

ECON2003, 2nd sem 2024-25

 Make sure you have read the instructions/warnings above before you start

Question 1 (27 marks total)

Part A:
a) Explain, for only the case of foreigners buying our exported goods and and paying for the
goods with our currency CNY, that our net capital outflow (NCO) must equal our net
exports (NX). (4 marks)
b) An open economy had a net foreign investment (NFI) balance of $320 (all $ amounts are
in billions) at the beginning of the year. Their consumption (C) depends on residents’
deposable income (i.e. after tax income) by the relation C = 100 + 0.6×(Y – T), and their
investment (I) depends on interest rate (r) by the relation I = 120 – 500 r. The GDP, the
taxes, the government purchases, and the the net exports for the whole year are $800, $80,
$90, and $50 respectively, and the interest rate is 4%. Find the country’s NFI balance at
the end of year. Show calculations. (6 marks)

Part B: About two economies, Econland and Tradeland, following information is available:
• Current price of a standard textbook in Econland: $E 100
• Current price of a standard textbook in Tradeland: $T 120
• Current nominal exchange rate: $E 1 = $T 0.85
• Expected inflation rate in Econland in coming years: 8% per year
• Expected inflation rate in Tradeland in coming years: 2% per year
c) Calculate the current real exchange rate between Econland and Tradeland using the
textbook as a reference good. Show calculation, and explain what your calculated result
exactly means. (4 marks)
d) Does purchasing power parity (PPP) hold true between the two countries so far as the
textbook is concerned? Explain why yes, why no, or why unclear. Does the PPP hold true
between the two countries generally? Explain why yes, why no, or why unclear.
(4 marks)
e) On first seeing the data as given above, your friend John thought he finds an opportunity
to arbitrage. John is someone who never gives up any opportunity to make money, but
after detailed investigation of this opportunity, he decides to give it up. Explain the
specific plan of arbitrage in John’s mind when he thought it is an opportunity to make
money. And explain further what could be the reasons for him to give it up. 4 marks)
f) Given the limited information given above, give your prediction on how the nominal
exchange rate will change, say, in one year. Explain the reasons for your prediction, and
support your prediction with calculations if necessary or helpful. (5 marks)

ECON2003, 2nd sem 2024-25

Question 2 (25 marks total)
The Trump administration of the United States is now implementing many domestic and
international policies, and the two main objectives are to (1) reduce its trade deficits and (2)
bring manufacturing jobs back to the country. Please evaluate the effectiveness of each of its
following policies in achieving the two objectives above. You should use appropriate
diagrams to illustrate your arguments for each of the policies below.
a) Imposing high tariffs on imports of goods into the U.S. (assuming other countries do not
retaliate by imposing high tariffs on U.S. exports). (7 marks)
b) Implementing DOGE (Department of Government Efficiency) led by Elon Musk to
reduce government expenditure. (8 marks)
c) Use economic and other measures (other than interest rate changes) to encourage foreign
firms to invest in the U.S. and, at the same time, to discourage U.S. firms from investing
in foreign countries. (10 marks)

Question 3 (28 marks total)

Technocracy is a country famous for its advanced technologies. Its successful effort in
globalizing its economy has been beneficial, not just for the growth of its own economy but
also for that of other countries’, especially its main trading partner Solis. Technocracy has just
elected a new President, who, determined to enhance the country’s advantages, decides to
carry out a series of policy changes, as detailed below. Suppose it all starts when its economy
is in a long-run equilibrium.
a) Draw the AD-AS diagram of Technocracy in long-run equilibrium. Be sure to show
aggregate demand, short-run aggregate supply, and long-run aggregate supply. (2 marks)
b) To combat corruption and enhance government efficiency, the government decides to
abolish some departments and dismissed 10% of its civil servants with 7-month salary
compensation. However, the quantity of budget deficit remains in the current year.
Confronting the instability in government budget, many institutions and companies relating
to government freeze their hiring activities. The pessimism in labor market has led to a
decline in consumers’ willingness to consume. Explain and illustrate the shift of the
curve(s) with new AS-AD diagram(s). In particular, what are the short-run impact on the
price level, unemployment rate, and the real output inTechnocracy? (5 marks)
c) In addition, the new Technocracy president also starts a tariff war with Solis. Higher tariff
leads to higher price for all imports, including both final goods and intermediate goods, in
Technocracy, with trade deficit unchanged. Explain and illustrate the shifts of the curve(s)
with new AD-AS diagram(s) in the short run. In particular what happens in the short run to
the price level, unemployment rate, and the real output in Technocracy? (6 marks)
d) Suppose the potential output level (YN) of Technocracy is not affected by the above events
(just suppose, whether it is a valid assumption will be discuss later), and suppose their
government will not take other action to intervene the short-run changes discussed above.

ECON2003, 2nd sem 2024-25

 How will their economy adjust in the long-run? Explain and illustrate the shift of the
curve(s) in adjustment process with new AD-AD diagram(s). Particularly, what will
happen to the real output, the unemployment rate, the real wage, and the price level in this
process? (6 marks)
e) Same as in d), except that the central bank pursues a monetary policy that achieves stable
price, i.e., the central bank constantly adjusts the money supply and interest rate so as to
keep the price level at the initial long run equilibrium price level. Would such monetary
policy accelerate, or slow down, the move from the short-run equilibrium to the long-run
equilibrium? Explain and illustrate the process with new AD-AS diagram(s). (5 marks)
f) About the tariff war only, suppose the high tariff will be permanent, how do you think the
economy’s potential output (YN) will be affected (increase, decrease, or unchanged)?
Explain. (You may draw hint from your answer to Q2 or from any chapter of our textbook).
If the long-run equilibrium will be different with and without high tariff, draw a new AD-
AS diagram to show the difference. (4 marks)

Question 4 (not for submission, only for Practice)

Suppose the economy currently is in recession, with output lower than the potential level by
$400 billion, and the government decides to use expansionary fiscal policy to close the
recessionary gap. The people’s marginal propensity to consume (MPC) is estimated to be
0.75.
a) Suppose the fiscal policy to fight recession is specifically to increase government
spending, and suppose there will be no crowding-out effect from such a policy. Should
the increase of government spending be $100 billion, more than $100 billion, or less than
$100 billion? Explain and show calculations.
b) How would you modify your answer above if there is crowding-out effect? Explain.
c) Alternatively, suppose the expansionary fiscal policy adopted is to cut the taxes by $100
billion (with no change to government spending). In the short-run with no change of the
price level, how much is the initial effect of the tax cut on aggregate demand (i.e. before
there is multiplier effect)? And how much is the total effect on the aggregate demand (i.e.
after the multiplier effect)? Show calculations.
d) Suppose the government spending increase (as the only policy measure) required to end
the recession is $120 billion. How much tax cut (as the only policy measure) is needed to
end the recession? Show calculations.
e) In addition to increase in government spending and decrease of taxes, in the tool box of
the government to fight recession is also the expansionary monetary policy. Will the
long-run equilibrium restored by these three policy measures respectively be the same in
terms of total output (Y), consumption (C), investment (I), and government purchases
(G)? Explain.

ECON2003, 2nd sem 2024-25