Download Economics Midterm Exam: Questions on Consumer Behavior, Interest Rates, and Exchange Rates and more Exams Capital Markets Regulation in PDF only on Docsity! Economics 296/Political Science 237S Midterm Exam Proposed Answers 1 Multiple Choice 1. According to the consumer's intertemporal problem, a permanent decline in income will: (c) Leave saving unaltered and decrease consumption 2. An increase in the rate of interest will: (d) Reduce investment and either increase or reduce saving [(a) reduce investment and increase saving received 2 pts] 3. Which of the following statements would not be correct for a country with a current account de cit: (c) Domestic absorption is smaller than income 4. If the terms of trade of a country A uctuate more than in country B, we would expect that: (b) The current account in A should be more volatile that in B. 5. When is a current account de cit \not sustainable"? (d) All of the above 2 Problem 1 1. Investment increases because economic reforms could be though as a reduc- tion in the tax rate that increase the after-tax rate of return to capital. The e ect of reform on savings is uncertain. On the one hand, the e ect of gov- ernment policy represents an increase in the wealth of the economy: higher investment leads to higher future output; lower government consumption leads to lower present value of taxes. This wealth e ect increases current consump- tion and reduces saving. On the other hand, savings could increase due to the increase in after-tax interest. Look at Figure 1. 1 2. The relative weights of the wealth and substitution e ects on savings are ambiguous but in any event, the increase in saving will in general be smaller than the increase in investment. This leads to a CA de cit. Look at Figure 1. The CA < 0 is given by distance AB. 3. A fall in the world interest rate has an e ect through the following arbitrage equation: MPK = (1 + r) As r decreases, so will MPK: The way to achieve this is to increase the capital stock. This increases desired investment and leads to an even larger de cit. Looking at gure 1 the larger de cit is given by distance CD. 4. Looking at the uncovered interest rate parity condition, adjusted for risk. it = i t + (risk premium)E(et+1jet = 0) we could account for the the uctuations in Mexico's nominal interest rate by changes in either changes in the risk premium or by changes in the expectation of devaluation. 5. From class we know that: u0(t) u0(t+ 1) = (1 + r) H(it) H(it+1) To account for the initial consumption boom and current account de cit we need the evolution of the monetary distortion to be J-shaped. That is, we need it to decrease initially and then to increase. The interest rate thus needs to follow the same path. Initially we will have decreasing intertemporal marginal rates of substitution and then we will have increasing intertemporal marginal rates of substitution. (see gure 2.) 3 Problem 2 R0 = $12 Minister of Finance: pdef = 0:5=mo; e = 1; Md = 2 1. No. As long as there is a scal de cit, the fundamental equation impmlies 2
