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MGEC61 Assignment 2 (Winter 2022) 2

Question 1 (30 points)

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Sweden is a small open economy that adopts a flexible exchange rate, and the market perceives

the American assets as the only safe assets. Suppose the Swedish economy is characterized by the

DD-AA model; and, for simplicity, assume that the Swedish economy is initially operating at its

full capacity.

 

a) Recently, the Swedish government announced it has lifted all COVID restrictions. This announcement has boost confidence in the economy; as a result, spending on dinning out and

equipment purchase increases permanently. In the context of the DD-AA model. What

happens to the Swedish current account and balance of payments in both short run and long

run? Explain with the aid of ONE DD-AA diagram. (20 points)

b) Now, suppose the central bank of Sweden, Sveriges Riksbank, finds the change in the kr/US$ exchange rate in part (a) undesirable and wants to keep it at the initial level. At the same time,

the Sveriges Riksbank wants to keep the amount of money circulated in the economy from

changing. Do you think it achieve these goals? If yes, explain what they should do and discuss

how the chosen policy affects the country’s balance of payment account. If no, explain the

rationale behind. Make sure to support your answer with the diagram from part (a). DO NOT

draw a new one; otherwise, you will not receive credits. (10 points)

 

Note: Exchange rate is quoted as Ekr/US$, where kr = Swedish krona. DO NOT use DC/FC in your

explanation; otherwise, you will receive a grade of ZERO for the whole question.

 

 

Question 2 (20 points)

“The DD-AA model predicts there will be no change in current account when new payment

technology is introduced to the country such that households no longer use cash as the primary

method of making payments permanently.” True/False/Uncertain, explain with the aid of ONE

DD-AA diagram.

 

Note: Compare your answer to the initial equilibrium.

 

 

Question 3 (20 points)

Consider two economies, Home and Foreign. Home pegs its currency, DC, to the currency of

Foreign, FC. The government of Foreign increases import duty on Home’s lumber from 8.99% to

17.9%.

 

a) If the market expects this change in trade policy is long lasting, what happens to domestic output and current account in the short run? In the long run? Explain and support your answer

by ONE DD-AA diagram. (12 points)

b) Would you change your answer in part (a) if the market expects the change is short-lived? Yes/No, why and how? Explain and use the diagram in part (a) to support your answer. No

credit will be given if you draw a new diagram. (8 points)

 

Note: Compare your answer to the initial equilibrium.

 

 

 

MGEC61 Assignment 2 (Winter 2022) 3

Question 4 (30 points)

A small open economy can be described by the following equations:

Full-employment level of output: YFE = 12500

DD equation: Y = 8700 + G – 150P + 200EDC/FC

AA equation: Y = 2000 + 5( 𝑀𝑆

𝑃 ) + 50Ee – 40EDC/FC

 

In the initial long-run equilibrium, the government collects 9% of the nation’s long-run level of

national income as taxes and it runs a budget surplus of 225. Also, the level of (nominal) money

supply is 28700 and the expected DC/FC exchange rate (Ee) is 25.

 

a) Find the long-run equilibrium exchange rate and price level. (6 points)

The economy is initially in its long-run equilibrium as described in part (a). Suppose there is a

change in the preference of holding money such that the new AA equation is:

AA equation: Y = 1940 + 5( 𝑀𝑆

𝑃 ) + 50Ee – 40EDC/FC

In addition, a permanent shock will cause the expected exchange rate to change by 0.6 DC per FC.

 

b) Suppose the economy adopts a flexible exchange rate, answer the following questions:

• If the change is transitory, find the equilibrium levels of output and exchange rate in the short run. (5 points)

• If both change is permanent, find the equilibrium levels of output and exchange rate in the short run. (7 points)

c) Suppose the economy adopts a fixed exchange rate, and the official rate is set at the one calculated in part (a). In addition, the fixed exchange rate is maintained by a change in real

money supply. Answer the following questions:

• If the change is transitory, find the equilibrium levels of output and real money supply in the short run. (4 points)

• If both change is permanent, find the equilibrium levels of output and real money supply in the short run. (4 points)

• Do you get the same answers for both temporary and permanent changes? Yes/No, explain your answer (i.e., why the answers are not the same or not the same). (4 points)

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