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foundations of microeconomics

Questions and Answers of Foundations Of Microeconomics

Notes: All variables except the interest rate are in logarithms and starred variables refer to the foreign country. Endogenous variables are the outputs (y, y*), the real exchange rate (q), the rate
:MEN is upward sloi . _ stimulates domestic outpo Money market equili:uope of GME7,,, is reverseki country's perspective).—(1 + y)coiciRdr* + coG ([1 Y=(1 + y)(1 —( 1 — y) [( 1 — wx)(1 —
11.2.1 Nominal wage rigidity in both countries If there exists nominal wage rigidity in both countries, the relevant model is obtained from Table 11.4 by setting X = X.* = 0. The resulting model can
Since it is more convenient to work with the logarithmic version of the model(and in order to cut down on notation), equations (11.47)—(11.48) are rewritten in logarithmic form as equations (T3.1)
Domestic output depends on both domestic and foreign government spending in this symmetric model of the world economy. It is, however, not a priori clear which effect dominates, the "own" effect (via
where we have used the fact that dr = dr* due to perfect capital mobility. By comparing(T2.1) and (11.45), it is clear that the IS curve is augmented in a number of ways. First, the interest rate
6 Note that the real exch.L. Ø .explains the positive sign of the t(11.29) shows that the two coin(is no longer exogenous in a two-282 Chapter 11: The Open Economy e is downward sloping and) that
But the domestic economy's exports are (in a two-country world) just the foreign country's demand for imports which, in view of the symmetry assumption, take a form similar to (11.42):EX f + If* +
EP* y= (1 - cy)S20 [A(r , Y) 4- G] . (11.42)
Assume that the world consists of two countries (or regions) that are identical in structure and look like the small open economy discussed in section 1.4. One immediate consequence of this
11.2 Transmission of Shocks in a Two-country World In section 1.4 we introduced a simple Mundell-Fleming type model with a rudimentary aggregate supply side. Some microeconomic foundations provided
The Foundation of Modern Macroeconomics If there is real wage rigidity (A = 1), the AS(LM) curve is downward sloping and independent of the price level (see (T2.3) in Table 11.2) so that the money
where we have used the i paring (T2.1) and (11.45►.ways. First, the interest before. The reason is that countries, and since son:Second, foreign governmt.directly (via the term invk Of course, the
where we have once again used dr = dr* . The real exchange rate affects foreign spending negatively because it is measured from the point of view of the domestic country (i.e. Q EP* /P). By using
where we have used the fact that dr = dr* due to perfect capital mobility. By comparing(T2.1) and (11.45), it is clear that the IS curve is augmented in a number of ways. First, the interest rate
world) just the foreign imetry assumption, take a(11.43)Chapter 11: The Open Economy where stars denote foreign variables, e.g. C; is the demand for domestically produced consumption goods by foreign
Anal wage rigidity (A = 0), on are unchanged, and the real ative effect of the additional hat happens to real wages (as must be free to fall (along positive output effects. This:e rigidity.DU ntry
where we have once _ spending negatively 13e,, tic country (i.e. Q El'6 Note that the real excha-- -explains the positive sign of •(11.29) shows that the two col is no longer exogenous in a •Y*
Assume that the world consists of two countries (or regions) that are identical in structure and look like the small open economy discussed in section 1.4. One immediate consequence of this
11.2 Transmission of Shocks in a Two-country World In section 1.4 we introduced a simple Mundell-Fleming type model with a rudimentary aggregate supply side. Some microeconomic foundations provided
The Foundation of Modern Macroeconomics If there is real wage rigidity (),. = 1), the AS(LM) curve is downward sloping and independent of the price level (see (T2.3) in Table 11.2) so that the money
on function which can-1 aggregate output.the LM curve (11.37), the venience, the equations P curve into the IS and LM domestic price level, and the nominal exchange is exogenous due to the riables
11: The Open Economy may suffer from money al wage target, and if A = 1 suggest on the basis of my in which there is little it to the situation in the ich more common.,rmine employment (by
Figure 11.8. Aggregate demand shocks under wage rigidity longer holds for the augmented Mundell-Fleming model developed in this section(as dY I dG > 0), unless there exists nominal wage rigidity (A =
Notes: Endogenous variables are dY/Y, dQ/Q, P dP/P, exogenous variables are dr*, dM/M, dG/G, Wo = dWolWo, EXo . dEXolEXo. Absorption share of consumption is wc, absorption share of investment is co/,
Graphically these effects can be illustrated as follows. Consider the case of a positive demand shock (say O > 0). In the standard Mundell-Fleming model with fixed prices and flexible exchange rates,
The full model consists of the IS curve (11.35)—(11.36), the LM curve (11.37), the BP curve (11.38), and the AS curve (11.39)—(11.41). For convenience, the equations are gathered in Table 11.2,
The Foundation of Modern Macroeconomics Workers care about their wage in terms of the CPI but may suffer from money illusion (if 0 < A < 1). In case A. = 0, workers have a nominal wage target, and if
5 We use the term semi-elasticity to indicate that Ell? relates the percentage rate of change of investment to the absolute change in the interest rate. In the case of interest rates, the use of
The supply side of the model also contains some new elements. Domestic firms are perfectly competitive (and do not attempt to exploit the export demand function(11.29)) and maximize short-run profit
Since we assume perfect capital mobility, the world interest rate determines the domestic rate (r = r*), so that:dr = dr* . (11.38)
where 0 < ccy YCy/C MPC/APC < 1 and En? > 0 are, respectively, the income elasticity of the aggregate consumption function and (the absolute value of)the interest semi-elasticity of the investment
I nports and exports are of(11.33)f the elasticities of export Tency improves the trade all-Lerner condition is as domestic goods cheaper s net exports. The rise in sidents. If real imports f the
The extended Mundell-Fleming model By using (11.25)-(11.29) the IS curve for the model is obtained:Y = aS20Q 1-" [A(r, + + EXoQI which can be written in loglinearized form as:=(1— cox) [coce +
This is the famous Marshall-Lerner condition: if the sum of the elasticities of export and import demand exceeds unity, a depreciation of the currency improves the trade account, so that XQ > 0. The
A second feature of (11.30) is that we can now be more precise about the Marshall-Lerner condition. Indeed, by differentiating (11.30) with respect to the real exchange rate Q (holding A + G) fixed,
The Foundation of Modern Macroeconomics and causes a trade account surplus. To restore equilibrium on the trade account, income (and hence imports) must rise.
X [r, Y, Q, G, EX0] EX0Q° - Q(1 - a)S-20Q-a [A(r, Y) + G] , (11.30)where A(r, Y) C(Y) + I(r). Several features are worth noting in the comparison between (11.30) and the net export function used
By defining net exports (in real terms) by X EX - -(EP* /P)[Cf + If + Gf], noting(11.25)-(11.27) and assuming that the demand for exports depends on the real exchange rate, EX = EX0 (E-P7 9 =
which shows (more clearly than (11.1)) that only domestically produced goods enter into the aggregate production measure for the domestic economy. In summary, by looking in more detail at the
Real exports are denoted by EX and are sold to the ROW at the same price that domestic customers pay for these goods (P), and spending on imported goods (in terms of domestic currency) equals EP*(Cf
By using the same approach for investment and government spending, we obtain expressions for Id, If, Gd, and Gf :4 EP* ) 1-a EP* -a= aS20 p I(r), If = (1a) S20 p 1(r), EP* 1-a EP* -a= a S20 G, Gf =
Chapter 11: The Open Economy and Cr such that total no:ized given the restriction_ lex (CPI) for which an expr, 0-'imal ratio between Cd a:e of the two goods:
which shows (more clear into the aggregate prodL looking in more detail lar in form to (11.9))equilibrium.By defining net export(11.25)-(11.27) and as_ exchange rate, EX = EX0 EPP-* )13(where EX0
Real exports are denote domestic customers p ..terms of domestic currc identity (11.1) can be aPY PcC + Pcl += PCd Pld + PC Y Cd + Gd
3 Constant spending shares are a feature of the Cobb-Douglas specification for composite consumptionC, given in (11.21). This sharp prediction is altered if (11.21) is changed to, for example, a
For a given real exchange rate, a rise in real income raises the demand for bothdomestic and foreign consumption goods. For a given level of aggregate income, the real exchange rate determines
which is intuitive: if the relative price of foreign goods rises, households choose a larger proportion of consumption goods from domestic sources. By substituting(11.22) into the budget restriction,
The Foundation of Modern Macroeconomics and EP*, respectively, the households decide on Cd and Cf such that total nominal consumption spending, PAC PCd + EP*Cf, is minimized given the restriction
In the decision about sourcing, the households wish to attain the composite consumption level C (that is determined by (11.20) once Y is known) as cheaply as possible. Since the (domestic currency)
The Armington approach Now that we wish to model the production side of the economy, we have to be more precise about the various price indexes. There are two goods, a domestic good with price P, and
We use a model inspired by Argy and Salop(1979), Armington (1969), and Branson and Rotemberg (1980) to demonstrate the importance of supply-side effects. This model will also be used (in simplified
Chapter 11: The Open Economy 11.1.4 Aggregate supply considerations Up to this point we have assumed that domestic and foreign price levels are constant(P = P* = 1). Whilst this may be appropriate
- - a tical results in Table 11.1 the case of monetary policy c credit shifts the LM curve are too high and net capital is deficit (B < 0), whiche. The domestic currency Es ), and the BP curve shifts
We now need to coy.the households know I real terms, the next is(and the same holds fo trick that was devised I fact "constructed" out produced goods (labelli substitutes, we cannot the same as a
Of course, since the results of Table 11.1 are derived for any value of Klr , the polar cases of immobile and perfectly mobile capital can be obtained as special cases from the table by setting KIr =
In order to demonstrate the link between the mathematical results in Table 11.1 and the graphical representation in Figure 11.7, consider the case of monetary policy under flexible exchange rates.
Under fixed exchange rates, on the other hand, the exchange rate is exogenous (and the column for dE is moved to the right-hand side of (11.19)) and (11.19) determines dY, dr, and dM, as a function
Notes: 101 XQ Ry (1 — Ar/ Klr) — Lr(1 AY)/K1,1 > 0 in - A y - Xy +ArXy /KI, > 0 money supply is exogenous (and the column for dM is moved to the right-hand side of (11.19)) and (11.19) determines
The Foundation of Modern Macroeconomics Table 11.1. Capital mobility and comparative static effects dG dM dr*Flexible exchange rates dY > 0 LA/K4 4(1 - Ar/K1r) > 0'Al Xy/KIr >0(1 -AoxaKir < 0 Irl -
Of course, equation (11.19) cannot be used to solve for all four variables appearing on the left-hand side since we only have three equations. This "problem" is solved however, by specifying the
The IS, LM, and BP curves have been drawn in Figure 11.7, where the BP curve has been drawn flatter than the LM curve. Instead of discussing fiscal and monetary policy under fixed and flexible
If financial capital is imperfectly mobile, we have a weighted average of the two pre-.vious extreme cases. The balance of payments curve is upward sloping (see (11.14))and points to the left (right)
Chapter 11: The Open Economy ands, the Dutch exchange'der flexible exchange rates.ke economy. If all countries, demand policies, the world omv even if it is operating the rise in r* shifts the YY
Imperfect capital mobi If financial capital is imp vious extreme cases. The and points to the left :ments surplus (deficit). 1 where the BP curve has fiscal and monetary pol means, we present the in
The Foundation of Modern Macroeconomics to a decrease in the demand for exports from the Netherlands, the Dutch exchange rate will depreciate and no output effects will occur under flexible exchange
An immediate policy consequence of this ineffectiveness result is that the small open economy operating under flexible exchange rates is, in a sense, insulated from foreign spending disturbances
Figure 11.5. Fiscal policy with perfect capital mobility and flexible exchange rates YY(G0) to YY(G 1 ). This puts upward pressure on domestic interest rates and at point e' massive capital inflows
Fiscal policy, in the form of a bond-financed increase in government spending, turns out to be entirely ineffective (as was to be expected from the discussion surrounding the LL and YY curves). In
Monetary policy is highly effective in this case. In terms of Figure 11.4, an increase in domestic credit shifts the LM curve in panel (a) from LM(M o) to LM(M1 ) and the LL curve from LL(M0) to
4. How can we introduce forward-looking behaviour into the model?
3. How are shocks transmitted across countries and how does international policy coordination work?
2. What are the implications of openness on the effects of fiscal and monetary policy?How do the degree of capital mobility and the exchange rate system affect the conclusions?
1. How do we add the international sector to the IS-LM model? The Mundell-Fleming contribution.
4. How can the taxation of capital give rise to dynamic inconsistency?
3. Why does it sometimes pay to appoint a conservative to head the central bank?
2. How can reputation effects come to the rescue if the optimal policy is inconsistent?
1. What do we mean by dynamic inconsistency. When is economic policy dynamically inconsistent and hence not credible?
5. What is prospect theory? Have you ever suffered a setback early in a process (for example, seeking a job or applying for college) that caused you to alter your behavior later on? (p. 17)
4. Economists use the ultimatum game to test judgments of fairness. What result does economic theory predict? (p. 17)
3. How does the status quo bias reduce the potential utility that consumers enjoy? (p. 17)
2. What are the hot hand fallacy and the gambler’s fallacy? Give an example of each. (p. 17)
1. What is bounded rationality? How is this concept relevant to economic modeling? (p. 17)
5. A friend mentions to you that the campus coffee shop offers a 10% discount each Thursday morning before 10 a.m. Is this discount more likely to cause a significant substitution effect or a
4. Describe what happens to your budget constraint if the price of one item in your budget decreases. Show the result on a graph. (p. 17)
3. What is the difference between an economic“good” and an economic “bad”? (p. 17)
2. If your budget increases, is it possible for your utility to fall? Explain your response. (p. 17)
1. If your budget increases, what generally happens to the amount of utility you experience? (p. 17)
13. A health study found that patients who experience severe pain may feel better if they curse as a coping mechanism. Based on what you have learned about economics, would you expect to see a
12. Do you agree with Henry David Thoreau’s quote, “Happiness is like a butterfly; the more you chase it, the more it will elude you, but if you turn your attention to other things, it will come
11. Everyone wears underwear, but comparatively few people wear ties. Why are ties so much more expensive than underwear if the demand for underwear is so much greater than the demand for ties? (p.
10. You and your friends are considering vacationing in either Cabo San Lucas or Cancun for spring break. When you first researched the cost of your hotel and flights, the total price was $1,000 to
9. Imagine that the total utility from consuming five tacos is 10, 16, 19, 20, and 17 utils, respectively. When does marginal utility begin to diminish? (p. 17)
8. How do dollar stores survive when none of the items sold brings a high amount of total utility to consumers? (p. 17)
7. In consumer equilibrium, a person buys four cups of coffee at $2 per cup and two muffins at $2 per muffin each day. If the price of a cup of coffee rises to $3, what would you expect to happen to
6. You are considering either dining at Cici’s, an all-you-can-eat pizza chain, or buying pizza by the slice at a local pizzeria for $2 per slice. At which restaurant are you likely to obtain the
5. Use the table in problem 3. What is the consumer optimum if the price of cookies rises from $1 to $1.50 and the price of pretzels remains at $1.00? (p. 17)
4. Use the table in problem 3. Suppose that you have a budget of $8 and that cookies and pretzels cost $1 each. What is the consumer optimum? (p. 17)
3. Fill in the missing information in the table below:Total Marginal Total Marginal Number utility of utility of Number utility of utility of of cookies cookies cookies of pretzels pretzels pretzels
2. Suppose that the price of trail mix is $4 per pound and the price of cashews is $6 per pound. If you get 30 utils from the last pound of cashews you consume, how many utils would you have to get

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