PART 1 Answer the following questions with TRUE, FALSE or UNCERTAIN and Justify your answer. 1. A country with negative net exports gets into debt vis--vis the rest of the world. 2. According to the Mundell-Fleming model of a small open economy, if the government raises taxes, the domestic currency depreciates in the long run. In order to return the exchange rate to its original level, the central bank must lower its interest rate. 3. If a small open economy has a flexible exchange rate, a rise in interest rates abroad implies a fall in net exports in equilibrium. 4. An increase in the minimum wage should cause the natural rate of unemployment to fall. 5. A real depreciation of the domestic currency implies that domestic goods are cheaper relative to foreign goods. 6. An increase in the generous Employment Insurance should bring down the natural rate of unemployment. 7. An expansionary monetary policy in a small open economy will lead to a depreciation of the domestic currency if the exchange rate is flexible. 8. In an economy with perfectly indexed wage contracts, monetary policy is neutral even in the short term. 9. Monetary policy affects the level of GDP in the short term, but in the medium term, only the composition of GDP is used. 10. Fiscal policy is neutral over the medium term. 11. An increase in the minimum wage should increase natural GDP because more people will want to work. 12. An expansionary fiscal policy in a small open economy with perfect capital mobility increases net exports in equilibrium if the exchange rate is flexible PART 2

Exercise 1

Assume a closed economy whose labor market is characterized by the following equations: : / = ^e/ ((40/100) + - 10)

of : = 2

y of insurance : = 60/100

Active population: = 500

profit margin: = 1 and whose demand is characterized by the equations: sumption: = 40 + 0.1 ( - )

ment: = 1420

Government spending: = 40

taxes: = 40

expected inflation: ^ = 0

nominal monney stock: =1000

Actual cash request: ^/=120

1. What is the natural unemployment rate and natural GDP of this economy? 2. What is the equation of the aggregate supply curve (OA)? 3. What is the equation of the IS curve? 4. What is the equation of the LM curve? 5. What is the equation for the aggregate demand curve (AD)? 6. What is the medium-term balance? 7. Suppose the central bank increases the stock of money to =2000 no effect on expected inflation. What will be the short-term and medium-term effect of this policy change on the price level, GDP, and real interest rate? Illustrate your answer graphically. 8. Back to =1000. Suppose the government increases its spending to G=500. What will be the short-term and medium-term effect of this policy change on the price level, GDP, and real interest rate?

Exercise 2

Suppose a small open economy with perfect capital mobility faces rising real interest rates abroad (for some non-foreign-directed reason). Inflationary expectations are assumed to be constant around the world. a) If this small economy is open to a flexible exchange rate, what will be the effects on its real GDP, real interest rate, exchange rate and net exports? b) If this small economy is open to a fixed exchange rate (and decides to keep it fixed), what will be the effects on its real GDP, real interest rate and net exports? c) If the government wants to protect the value of the currency in part a), what fiscal policy would you recommend? What will be the consequence on domestic GDP? d) If the government wants to protect the value of the currency in a) but prefers to do so through monetary policy, what would you recommend? What will be the consequence on domestic GDP?

Exercise 3

In class, we always assumed that natural GDP is constant. Suppose that through technological innovations, the productivity of labor increased. This is represented by the production function Y = AN or A > 0. The case treated in class corresponds to A = 1. 1. Analyze the effect on the labor market (the WS and PS curves) of an increase in A. 2. What happens to the natural unemployment rate and the natural GDP? 3. Using the AS-AD diagram, price level and GDP impact analyzer in the short and medium term of an increase in productivity.

Exercise 4

The United States is concerned about its trade deficit with China. They find that the yuan (the Chinese national currency) which is fixed against the American dollar is at a level that is much too low. Secretary of the Treasury (the US equivalent of the Minister of Finance) John Snow, in a letter sent to some senators on September 12, that he would like the value of the yuan to be fixed in the markets and that interventions be kept at a minimum and that the low value of the yuan is hurting the American economy. 1. Using the Mundell-Flemming model, explain why the low value of the yuan could hurt the US economy. 2. Why could China agree to have a more flexible exchange rate? Could the same result be obtained by changing the parity of the exchange rate?

Exercice 5

In our description of the labor market, we have assumed that workers and firms negotiate at the beginning of each period the nominal wage for the period. We will now assume that real contracts are possible, i.e. workers and firms negotiate the real wage at the beginning of each period. Another way to interpret this is that the contracts are perfectly indexed. Thus, the real wage is known at the beginning of the period. 1. In class, we derived the wage determination curve, WS, as: /=(^/)(,) How is this equation modified by the presence of real contracts? 2. The pricing curve, PS, is unaffected. This is therefore given by: =(1+) Using these two curves, the definition of the unemployment rate and the production function Y=N, give the equation of the aggregate supply curve (which is a relationship between P and Y). Draw his graph. 3. Suppose the economy is in medium-term equilibrium and the central bank decides to increase the stock of money. Find the effect of this policy change on GDP and the price level in the short and medium term. 4. Suppose the economy is in medium-term equilibrium and the government decides to lower taxes. Find the effect of this policy change on GDP and the price level in the short and medium term. Question 6 Assume a small open economy with perfect capital mobility and a flexible exchange rate. This economy is facing a global recession (decrease in Y*) 1. What is the impact on the IS curve of the domestic country of this global recession? 2. Graphically illustrate the situation and the new equilibrium. Find the effect on the equilibrium values of GDP and the domestic interest rate as well as the exchange rate. 3. What is the effect on domestic net exports? 4. What fiscal policy should be followed to erase the effect of foreign recession on domestic GDP? 5. What monetary policy should be followed to erase the effect of foreign recession on domestic GDP?