7. Differentiate between devaluation and depreciation.
Solution:
| Points of Difference |
Balance of trade |
| It refers to the fall in the domestic currency under fixed exchange rate. |
It refers to the decline in the domestic currency under flexible exchange rate. |
| It is desired fall. |
It is undesired fall. |
| It promoted export and curbed import |
It result in fiscal deficit and current account deficit. |
8. Would the central bank need to intervene in a managed floating system? Explain why.
Solution:
Managed floating system is a combination of two systems namely fixed and floating exchange rate systems. Foreign exchange rate is determined by market forces. It makes the government or central bank responsible to intervene when the need for the same arises. The government or the central bank is responsible to moderate the exchange rate movements by purchasing and selling of foreign currency. Thus, to avoid dirty floating, the government often exercises its power to intervene, whenever it is required to do so.
9. Are the concepts of demand for domestic goods and domestic demand for goods the same?
Solution:
In a system of closed economy, the demand for domestic goods and domestic demand for goods are similar terms and are used interchangeably. However, in an open economy, these two terms have significantly different meanings. Demand for domestic goods includes both the domestic and foreign demand for domestic goods. Whereas, domestic demand for goods includes only the domestic market demand of a country, which is either produced domestically or abroad (foreign countries).
10. What is the marginal propensity to import when M = 60 + 0.06 Y? What is the relationship between the marginal propensity to import and the aggregate demand function?
Solution:
The amount of extra money spent on imports is known as the marginal propensity to import. The equation given is M = 60 + 0.06Y. Therefore, Marginal propensity to import (m) = 0.06.
It displays influenced imports, the portion of total imports that depends on revenue. Since the marginal tendency to import has a negative impact on the aggregate demand function, aggregate demand declines as wealth rises. This is so that international commodities, rather than domestic ones, are purchased with the extra money.
11. Why is the open economy autonomous expenditure multiplier smaller than the closed economy one?
Solution:
In case of a closed economy, equilibrium level of income is given by
Y = C + cY + I + G
or Y – cY = C + I + G
or Y (1 – c) = C + I + G
or \(Y = \frac{C+I+G}{1-c}\)
Let \((C + I + G) = A_1\)
or \(Y = \frac{A_1}{1- c}\)
or \(Y = \frac{\triangle Y}{\triangle A_1} = \frac1 {1 - c} \quad .....(1)\)
In the case of an open economy, equilibrium level of income is given by
Y = C + cY + I + G + X – M – mY
or Y – cY + mY = C + I + G + X
or Y (1 – c + m) = C + I + G + X
or \(Y = \frac{C + I + G + X}{1 - c + m}\)
Let autonomous expenditure (A2) = C + I + G + X
or \(Y = \frac{A_2}{1- c+ m}\)
\(\frac{\Delta Y}{\Delta A_2} = \frac1{1 -c+m} \quad .....(2)\)
By comparing equations (1) and (2) and the denominators of the given two multipliers, it can be concluded that multiplier in an open economy is smaller as compared to the multiplier in a closed economy, as the denominator in an open economy is greater than the denominator in a closed economy.
12. Calculate the open economy multiplier with proportional taxes, T = tY, instead of lump-sum taxes as assumed in the text.
Solution:
In the case of proportional tax, the equilibrium income would be:
Y = C + c(1 – t)Y + I + G + X – M – mY
Y – c(1 – t)Y + mY = C + I + G + X – M
Y[1 – c(1 – t) + m] = C + I + G + X – M
\(Y = \frac{C + I + G + X - M}{1 -c(1-t) + m}\)
Autonomous expenditure (A) = C + I + G + X – M Therefore, open economy multiplier with proportional taxes
\(Y = \frac A{1 - c(1 - t) + m}\)
\(\frac{\Delta Y}{\Delta A} = \frac A{1 - c(1 - t) + m}\)
13. Suppose C = 40 + 0.8 YD. T = 50, I = 60, G = 40, X = 90, M = 50 + 0.05Y.
(a) Find the equilibrium income.
(b) Find the net export balance at equilibrium income.
(c) What happens to equilibrium income and the net export balance when the government purchases increase from 40 to 50?
Solution:
C = 40 + 0.8YD
T = 50
I = 60
G = 40
X = 90
M = 50 + 0.05Y
(a) Equilibrium level of income
\(Y = \frac A{1 - c + m}\)
where,
\(A = C - cT + I + G + X - M\)
\(Y = \frac{C - cT + I + G + X - M}{1 -c+ m}\)
\(Y = \frac{40-0.8\times50 + 60 + 40 + 90 - 50}{1-0.75}\)
\(= \frac{140}{0.25}\)
\(Y = 560\)
(b) Net exports at equilibrium income
NX = X – M – mY
= 90 – 50 – (0.05 × 560)
= 40 – 28 = 12
(c) When G increase from 40 to 50, Equilibrium income
\(Y = \frac{C - cT + I + G + X - M}{1 -c+ m}\)
\(Y = \frac{40-0.8\times50 + 60 + 40 + 90 - 50}{1-0.8+0.05}\)
\(Y = \frac{40-40+ 60 + 40 + 90 - 50}{0.25}\)
\(= \frac{150}{0.25}\)
\(= 600\)
Net export balance at equilibrium income
NX = X – (M – mY)
= 90 – 50 – (0.05 × 600)
= 40 – 30 = 10.
