QUESTIONS You will find the answers to the questions marked with 10. What role does weak financial regulation and super- an asterisk in the Textbook Resources section of your vision play in causing financial crises MyEconlab. *1 1. Why do debt deflations occur in advanced countries 1. How can the bursting of an asset- price bubble in the but not in emerging-market countries stock market help trigger a financial crisis? 12. What technological innovations led to the develop- 2. How does an unanticipated decline in the price ment of the subprime mortgage market? level cause a drop in lending? *13. Why is the originate-to-distribute business model 3. When can a decline in the value of a country's cur- subject to the principal-agent problem? reency exacerbate adverse selection and moral haz- 14. True, false, or uncertain: Financial engineering ard problems? Why? always leads to a more efficient financial system. 4. How can a decline in real estate prices cause Explain your answer. deleveraging and a decline in lending? *15. How did a decline in housing prices help trigger the 5. How does deterioration in balance sheets of finan- subprime financial crisis of 2007-2008? cial institutions and simultaneous failures of these 16. How can opening up to capital flows from abroad institutions cause a decline in economic activity? lead to a financial crisis? 6. How does a general increase in uncertainty as a $17. Why are more resources not devoted to adequate result of a failure of a major financial institution lead prudential supervision of the financial system to to an increase in adverse selection and moral haz- limit excessive risk taking when it is clear that this and problems? supervision is needed to prevent financial crises $7. What are the two ways that spikes in interest rates 18. Why does the 'twin crisis* phenomenon of currency lead to an increase in adverse selection and moral and banking crises occur in emerging- market coun- hazard problems tries? 8 How can government fiscal imbalances lead to a $19. How can a currency crisis lead to higher interest financial crisis? rates ". How can financial liberalization lead to financial 20. How can deterioration in bank balance sheets lead crises to a currency crisis?QUESTIONS You will find the answers to the questions marked with gram. If the public believes him, predict what will an asterisk in the Textbook Resources section of your happen to the Canadian dollar exchange rate. MyEconlab. "8. If the British central bank prints money to reduce 1. When the euro appreciates, are you more likely to unemployment, what will happen to the value of drink Canadian or French wine? the pound in the short run and the long run? 2. "A country is always worse off when its currency is 9. If the Indian government unexpectedly announces weak (falls in value). " Is this statement true, false, or that it will be imposing higher tariffs on foreign uncertain? Explain your answer. goods one year from now, what will happen to the 3. In a newspaper, check the exchange rates for value of the Indian rupee today? the foreign currencies listed in the Financial News #10. If nominal interest rates in Canada rise but real inter- box, Foreign Exchange Rates, on page 496. Which est rates fall, predict what will happen to the of these currencies have appreciated and which Canadian exchange rate have depreciated since January 2009? 11. If Canadian auto companies make a breakthrough "4. If the Japanese price level rises by 5%% relative to the in automobile technology and are able to produce price level in Canada, what does the theory of a car that gets 100 kilometres to the litre, what will purchasing power parity predict will happen to the happen to the Canadian exchange rate? value of the Japanese yen in terms of dollars? "12. If Canadians go on a spending spree and buy 5. If the demand for a country's exports falls at twice as much French perfume, Japanese TVs, the same time that tariffs on imports are raised, will English sweaters, Swiss watches, and Italian wine, the country's currency tend to appreciate or depreci- what will happen to the value of the Canadian ate in the long run? dollar? *6. In the mid- to late-1970s, the yen appreciated 13. If expected inflation drops in Europe so that inter- relative to the U.S. dollar even though Japan's infla- est rates fall there, predict what will happen to the tion rate was higher than America's. How can this exchange rate for the Canadian dollar. be explained by an improvement in the productive "14. If the European Central Bank decides to contract ity of Japanese industry relative to American indus- the money supply in order to fight inflation, try? what will happen to the value of the Canadian__3. Summarize the key political and economic points that relate to the SE. Asian cunency_ crisis. (WSJarticies and in class discussion]. What are some likely scenarios to follow? What resolutions have been proposed and what is the U5. and Japanese position on these resolutions? {2f} minutes} Assume for questions at, 5, and Er, that CMU is a country that produces apples and computers, where computers are capital intensive; Civ'iU's PPF is bowed out [exhibits increasing relative costs}; CMU is capital abundant, and the standard H-Cl assumptions hold. The other country Is S'U'C. 4. {20 minutes} a. Assume further that (3|le is a small country. Evaluate graphically and describe the impact on welfare, income and production associated with an increase in labor with capital held constant. b. Assume further that CMU is a small country. Evaluate graphically and describe the impact on welfare, income and production associated with an increase in capital with labor held constant. c. Now assume that GMU is a large country. Evaluate graphically and describe the impact on welfare, income, TGT, and production associated with an increase in capital with labor held constant. 5. {2t} minutes] a. Based on the H-0 assumptions, which good does EMU export? b. What trade pattern would occur ifthe Leontief Paradox holds? Which two explanations of the Leontief Paradox mo st strongly support the H-0 theory? c. In autarlcy, according to Dhlin, how does CMU's relative price of labor compare to SUE? :1. Draw CMU's Edgeworth boxput computers in the lower left corner. Show the contract curve and show that it is the locus of Pareto Dptimal points. e. Given trade equates the relative price of labor for Giv'iU to that of SVG's, prove that the absolute real price of labor in CMU will also converge to that of G'v'G's price of labor. 6. {211} minutes] Show the necessary graphs to fully explain all requested effects. a. Given that SW] is a small country, examine the partial equilibrium welfare effects associated with imposing a tariff on their import good given that the production of the imported good yields a positive externality. Would a subsidy have given a more desirable solution? b. Given that EMU is a large country, using offer curves, examine the general equilibrium effects [i.e., show graphically: the welfare effect, impact on the volume of trade, impact on the TGT at home and world, what graphically represents the tariff revenue and tariff rate; describe the impact on absolute prices and the CMU production of the imported good} of an import tariff. Assume that the tariff revenue is spent on the export good. Also graphically show the lvletzler paradox case. For the Meltzler paradox case what is the impact on the TOT, volume of trade, and ClviLI nrnllnfinn t: the. imnnrtnri \"and? 4. (5 points) Let's go back to question I and the market for widgets. Assume that each unit of output also leads to one unit of emission. The EPA have solved question 1 so they realize that too much output is produced, or rather that the production of widgets results in too much emissions. They decide to introduce a system of emission charges (or -fees) per unit of emissions, which we denote by t. (a) What level of t would achieve an efficient amount of emissions? Ip Answer: The optimal fee equals the marginal damage cost at the optimal level of emissions, i.e., t* = MD(e*) = 100. this follows from the assumption that the emission/output ratio is equal to one, so one unit of extra output results in one extra unit of emission, which increases damages by 100kr. (b) Despite the fact that we assumed that the market for widgets is a perfectly competitive market, we assume that there are only two firms (which normally is not enough for competition to be perfect). Each firm can choose to "abate" (ie. reduce) emissions (e) or to pay the emission fee. The marginal savings cost functions of emitting an extra unit of emissions instead of cleaning it up are, MSi(el) = 500 - 20 . el, MS(e2) = 300 - 20 . 42 With no regulation the two firms will emit the same amount of emis- sions as they produce of widgets. With an emission fee they will increase e until the marginal savings equals the marginal cost, i.e., the fee (t). How much will each firm choose to emit with and without a fee? 2pQ1. In what way does a fixed-for-fixed currency swap differ from a spot contract and a reverseQuestion 2 (20 points) The main purpose of monitoring and enforcement is to ensure the desired compliance at the least social costs. The basic formula of monitoring and enforcement is pz- Un-U. S , where p is the monitoring probability, U, and U. the respective utilities to the agent associated with non-compliance and compliance, and S the penalty if found in non-compliance. (a) Explain the rationale for Gary Becker's "hang the quilty with probability zero" propo- sition, and explain why this proposition is difficult to justify in a civilized society when there are a possibility for Type I errors (false positive). (10 points)