Intermediate Macroeconomic Theory II, Fall 2006

Solutions to Problem Set 3 (30 points)

1. (14 points) Indicate, for each of the statements below, whether it is true or false. Briefly explain,
supporting your answer with formulas, graphs, or simple reasoning.

(a) (2 points) Unions can make the job separation rate in the economy lower. If we compare two
countries, similar in all respects but in the job separation rate, country with stronger unions will
have a higher natural rate of unemployment.
(b) (2 points) Technological advances make job finding and job separation rate lower: e.g., internet
may enhance the process of job search for employees and employee search for employers. If
technological progress increases the job separation and job finding rate by the same factor, the
natural unemployment rate will fall.
(c) (2 points) The pool of unemployed in the economy consists of those who are temporarily not
working, those who are actively looking for a job, and those who gave up looking for a job.
(d) (2 points) With introduction of credit cards, the demand for money fell. The quantity theory of
money predicts that the velocity of money should have decreased.
(e) (2 points) If expected inflation is higher than actual inflation, the ex post real interest rate is
higher than ex ante real interest rate.
(f) (2 points) Debtors lose and creditors gain if actual inflation is higher than expected inflation.
(g) (2 points) If, after a financial crisis, the world real interest rate increases, a small open economy’s
trade balance worsens (i.e., N X fall), and the real exchange rate increases (i.e., domestic currency
appreciates in real terms).

Answer:
(a) False. Unemployment rate, U s 1
L = s+f = 1+f /s . In a country with stronger unions s is smaller
and so is the natural rate of unemployment. Note that since s < 1, f /s becomes larger if s
falls, and so 1/(1 + f /s) becomes smaller.
(b) False. Using the formula above, we can see that the natural rate of unemployment will stay
the same.
(c) False. It does not include those who gave up looking for a job. Those are included into the
category of the out-of-the-labor-force population.
(d) False. The quantity theory of money says that (M/P )d = k × Y . Thus, if demand for money
falls, k falls. Furthermore we know that M × V = P × Y , and V = 1/k. Thus, if k falls, V
should increase.
(e) True. Ex post real interest rate—Ex ante real interest rate=(i − π) − (i − π e ) = π e − π > 0,
since we stated that π e > π.
(f) False. In this case, the ex post real interest rate debtors pay—the ex ante real interest rate
debtors expected to pay=(i−π)−(i−π e ) = π e −π < 0, since we stated that actual inflation is
higher than expected inflation. Thus, the real interest rate debtors expected to pay is higher
than the real interest rate they are actually paying, and so they are better off.
(g) False. To the contrary, the trade balance improves (N X increase), and the real exchange rate
falls. For detailed explanation, see p. 227 (fiscal policy abroad).

2. (6 points) Suppose the real money demand function is:

M d 0.01 × Y
( ) = L(Y, r + π e ) = , (2)
P r + πe

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 where Y is the real output, r is the real interest rate, and π e is the expected rate of inflation. Real
output is constant over time at Y = 150 (i.e., ∆YY = 0). The real interest, r, is fixed and is equal to
0.05 per year. Assume that income velocity of money, V , is constant. Suppose that nominal money
supply is 300. The central bank announces that from now on, the nominal supply of money is going
to grow at the rate of 5% per year.
If everyone believes this announcement what are the values of real money supply, the price level, and
the nominal interest rate in the year of announcement? (Hint: What is the expected inflation rate
that enters the demand for money equation?)

Answer:

3. (10 points) Consider an economy described by the following equations:

Y = C + I + G + N X(= EX − IM )
Y =5,000
G=1,000
T =1,000
C=250+0.75×(Y − T )
I=1,000–50×r
EX=600–300×q
IM =100+200×q
r=r∗ =5.

(a) (2 points) In this economy, solve for national saving, investment, trade balance, and the equilib-
rium real exchange rate, q.
(b) (4 points) Suppose that G rises to 1,250. Solve for national saving, investment, the trade balance,
and the equilibrium q. Explain what you find.
(c) (4 points) Now assume that government imposes an import quota—the quantity restriction on
imports—equal to 100, and that G=1,000, as before. Calculate national saving, investment, the
trade balance, and the equilibrium q. Compare the total volume of trade between the countries
(measured as IM +EX) after the quota and before the quota. Summarize the effects of import
quota on the trade balance, the real exchange rate, and the total volume of trade.

Answer:
(a) S = Y − C − G = 5, 000 − (250 + 0.75 × (5, 000 − 1, 000)) − 1, 000 = 750.
I = 1, 000 − 50 × 5 = 750.
From the national accounts identity, N X = S − I = 750 − 750 = 0.
N X = EX − IM = 600 − 300 × q − 100 − 200 × q = 500 − 500 × q = 0. Thus, q = 1.
(b) We know that ∆S = ∆Y − M P C × ∆Y d − ∆G. Since ∆Y d = 0, as nothing happened to
the real income and real taxes, and ∆Y = 0, ∆S = −∆G = −250. Thus, the new level of S
is 750 − 250 = 500. Since investment is a function of the world real interest rate only, and it
has not changed, investment stays the same (I = 750). Using the national accounts identity,
N X = S − I = 500 − 750 = −250. The real exchange rate q is determined from the N X
equation, −250 = 500 − 500 × q, so that q = 3/2.
The increase in government spending reduces national saving but, for a fixed real interest
rate, investment stays the same. Thus, domestic investment now exceeds domestic saving,
so that some investment should be financed by borrowing abroad. At a given real exchange
rate, supply of domestic currency falls short of demand for domestic currency. The value
of domestic currency in terms of foreign currency increases, thereby increasing the nominal
exchange rate e, and q. This, in turn, leads to reduction in N X.
(c) National Saving, S = 750 since output, consumption and government expenditures stay un-
changed. I = 750 since nothing happened to the world interest rate. N X = S − I = 0. q is
defined from N X = 600 − 300 × q − 100 = 0, so that q = 5/3. Thus, the protectionist policies

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raise the equilibrium real exchange between the countries, without any effects on the trade
balance.

Note that before imports restrictions are imposed, EX = 600 − 300 × q = 600 − 300 × 1 = 300,
IM = 100+200×q = 100+200×1 = 300, and the total volume of trade between two countries
is 600. After the trade restrictions are imposed, EX = IM = 100, and the total volume of
trade is only 200.
Thus, import quota does not affect the trade balance, yet reduces the total volume of trade
between the countries, and raises the real exchange rate, i.e., leads to the real appreciation of
domestic currency. Also, although import quota is effective in restricting imports, it effectively
restricts domestic exports as well—perhaps, an unintended consequence of initializing the
quota.