Ec 10 Spring 2007 Pset 4

Tarun Singh TF: Zahler Problem Set #4 1) a) This would help the government because as inflation rises higher than expected, the nominal interest rate rises and the real coupon value they pay out for government-issued bonds is less b) This would help the homeowner with a fixed-rate mortgage because the unexpected inflation decreases the real value of the debt that they owe to their creditors. c) This would hurt the union worker in the second year of a labor contract because the real money amount he earns is less than what the contract meted out under an expected 3% inflation. d) Because inflation is higher than expected, nominal interest rate (which is real interest rate + inflation rate) rises higher than expected, and the value of a bond (determined by the sum of all future payments discounted by the nominal interest rate, or yield) decreases. Thus, bonds are worth less and the college is hurt. 2) a) Predicted Exchange Rate = Price Big MacFOREIGN/Price Big DOMESTIC Mac Country

Price of a Big Mac

Indonesia

14,600 rupiah 529 forints 56.30 korunas 3.27 C$

Hungary Czech Republic Canada

Predicted Exchange Rate 4,771 rupiah/$ 173 forints/$ 18.4 korunas/$ 1.07 C$/$

Actual Exchange Rate 9,541 rupiah/$ 204 forints/$ 24.5 korunas/$ 1.24 C$/$

b) The predicted exchange rate is 161.8 forints/C$, but the actual exchange rate is 164.5 forints/C$. c) The theory of purchasing-power gives a good estimate of exchange rates, but has two weaknesses. First, many goods and services, such as lawn mowing, cannot be easily traded between countries. This difficulty or inability to trade goods and services makes arbitrage difficult or impossible. In this case, since Big Macs are perishable goods, they cannot be easily traded. Second, even tradable goods are not always perfect substitutes

when they are produced in different countries. A price differential between similar goods in two different countries may exist, but arbitrage will not take place if consumer preferences for the two goods are different in the different countries. 3) a)S= Y – C – G = I + NCO 5000 – (250 + .75 (5000 – 1000)) – 1000 = 1000 – 50r + 500 – 50r r = 7.5 National Saving = Y – C – G = $750 Investment = 1000 – 50r = 1000 – 50(7.5) = $625 NCO = 500 – 50r = $125 NX = NCO = $125 E = (500-NX)/500 = (500-125)/500 = .75 What is unusual about the supply of loanable funds in this economy is that national saving is not dependent on real interest rates. Notice that C = 250 + .75(Y-T) which means that the amount that individuals consume is not dependent on r, which therefore implies that the amount that individuals save is not dependent on r. b) G rises to 1250: r = 10 National Saving = $500 Investment = $500 NCO = $0 NX = $0 E=1

4) a) The elasticity of US NCO with respect to real interest rate is high; the smallest increase in savings causes a huge decrease in US domestic investment. As real interest rates decrease due to this shift in savings, the real exchange rate increases, thus making it more expensive to invest in US assets. Overall NCO increases because domestic residents will purchase the relatively cheaper foreign assets and foreigners purchase less of the relatively more expensive US assets. The increase in NCO is seen with a movement along the demand curve for the market of loanable funds which is I + NCO, so as NCO increases I must decrease in order to compensate for the increase in NCO. This means that the domestic investment in the US decreases. b) An increase in private saving decreases the real interest rate. This leads to an increase in NCO and a decrease in the real exchange rate. If the elasticity of US exports with respect to the real exchange rate is low, it will take a large decline in the real exchange rate to increase US net exports by enough to compensate for the increase in net capital outflow. This is supported by the graphs by considering two different elasticities of US exports with respect to real exchange rate. The more inelastic results in larger decline in real exchange rate.

5) This global saving glut means that as these foreign countries save more, their real interest rates decrease. This drives up their NCO, meaning foreign investment in U.S. assets increases, and the U.S.’s NCO decreases. Ultimately this means that more and more foreign countries are buying up U.S. assets, and thus the U.S. imports more than it exports, meaning that there is a trade deficit.