ECON30029: A Corollary Of The Policy Trilemma Is That To Have An Independent Monetary: International Macroeconomics, MU, Australia

Part A: Short Answer Questions. 

1. A corollary of the policy trilemma is that to have an independent monetary policy a country must have a floating exchange rate. This is consistent with evidence that suggests that world gross credit flows are strongly positively correlated and explained by United States monetary policy.

2.  The Ricardian Equivalence Hypothesis states that a temporary increase in government purchases should leave national savings unchanged.

3.  A country that runs sustained fiscal deficits, can always afford to do so but may have to abandon its nominal exchange rate peg.

4.  In a two-country model with perfect capital markets, a temporary increase in productivity in one country increases consumption in both countries.

5.  In a small open economy model in which the country’s interest rate on the international market depends on the amount of borrowing, capital controls will always be welfare improving.

6.  Froot and Frankel’s analysis using survey data on exchange rate forecasts concludes that future expectations of the nominal exchange rate move less than one-for-one with current exchange rates. Speculative trade is therefore stabilizing.

1. Consider a two-period small open economy. Households are endowed with QT 1 unit of trades in period 1 and QT 2 units of tradable in period 2. The country interest rate is r1, the nominal exchange rate fixed and equal to 1 and the nominal wage rate is downwardly rigid and takes the known value W1 in period 1. Suppose the economy starts period 1 with no assets or debts carried over from the past.

(a)  Write down the households flow budget constraints in period 1 and period

2. Derive the intertemporal budget constraint.

(b)  Write down the Lagrangian for household maximization. Derive the first-order conditions that characterize optimal household decisions. Eliminate the Lagrange multiplier and interpret the three optimality conditions.

(c)  Write down and solve the profit maximization problem for nontradable firms in periods 1 and 2. Derive the supply curve for non-tradable goods. How does it depend on the level of nontradable goods technology?

(d)  Derive expressions for the equilibrium levels of consumption of tradables and the trade balance in periods 1 and 2.

(e)  Suppose initially that in period 1 the nominal wage and consumption demand is consistent with full employment. Derive expressions for the equilibrium relative price of non-tradables, tradable and nontradable consumption as a function of the real wage in units of the tradable goods, the real interest rate, the preference parameter  and the level of technology A1.

(f) Plot the supply and demand of non-tradables in (p1,h1). Explain what factors lead to shifts in each curve.