Challenges a bank may face in the process of stimulating economy recovery to its long-run equilibrium

Chapter 25 1. Read the case study of China Pegs the Yuan, and answer the questions below: 1) Suppose that yuan was initially fixed at $0.12 USD per yuan, describe how “success as an exporter” and “non-Chinese private investors’ eager to shift funds into China” has led yuan undervalued, illustrate in a demand and supply diagram. 2) Use a demand and supply diagram to show how China’s foreign exchange market intervention has managed to keep yuan at a fixed exchange rate with the USD. 3) Use demand supply diagrams to show how each of the following policy changes might eliminate the disequilibrium in the foreign exchange market for yuan. i. An appreciation of the yuan. ii. Placing restrictions on foreigners who want to invest in China. iii. Removing restrictions on Chinese who want to invest abroad. iv. Imposing taxes in Chinese exports. 4) “China’s trading partners feel that China is, in effect, subsidizing Chinese exports”. Explain how subsiding happened. Chapter 26 2. Use the figure provided to solve questions below, assuming that Initially, the short-run aggregate supply curve is SAS0 and the aggregate demand curve is AD0. 1) Some events change aggregate demand from AD0 to AD1. Describe two events that could have created this change in aggregate demand. What is the equilibrium after aggregate demand changed? If potential GDP is unchanged, the economy is at what type of macroeconomic equilibrium? 2) Starting from SAS0 and AD0. Some events change aggregate supply from SAS0 to SAS1. Describe two events that could have created this change in aggregate supply. What is the equilibrium after aggregate supply changed? If potential GDP is unchanged, does the economy have an inflationary gap, a recessionary gap, or no output gap? 3) Some events change aggregate demand from AD0 to AD1 and aggregate supply from SAS1 to SAS1, What is the new macroeconomic equilibrium? Chapter 26 3. In Japan, potential GDP is 600 billion yen. The table shows the aggregate demand and short-run aggregate supply schedules. Price level Real GDP demanded Billions of 2007 yen Real GDP supplied in the short run Billions of 2007 yen 75 600 400 85 550 450 95 500 500 105 450 550 115 400 600 125 350 650 135 300 700 1) Draw an AS-AD diagram for Japan’s economy. 2) What is the short-run equilibrium real GDP and price level? 3) What is the long-run equilibrium real GDP and price level? 4) Does Japan have an inflationary gap or a recessionary gap and what is the size of the gap? Chapter 27, 29 4. If Japan’s government wants to close the above gap by increasing government purchases of goods and services (G). Suppose marginal propensity to consumer is 0.75. a. Calculate by how much government needs to increase G in order to close the gap? b. Fill out the blanks in the following table (round up to two decimal points). Yen (billions) Increase in G (government purchases) Second round increase in consumer spending Third round increase in consumer spending Forth round increase in consumer spending ……total increase in real GDP Chapter 30 5. Answer questions below: 1) Suppose that the economy was at its long-run equilibrium. A stock market crash happened and drove economy into a recession. Draw an AS-AD graph to show the effect of this event, state what will happen to inflation rate, unemployment rate and real GDP growth rate during the recession. 2) Suppose that you were the governor of the central bank and the target for the overnight rate was at 1% prior to the stock market crash. What new target for the overnight loans market would you propose as recession started? Justify your choice. 3) State how central bank may reach the new target for overnight rate using both operational band and open market operation? Draw appropriate graph to support your argument. 4) What economy wide ripple effects would you expect following above central bank’s actions? Explain in detail and in chronological order. Draw appropriate graphs (loanable funds market, AS-AD) to support your arguments. 5) What is the main challenge central bank may face in the process of stimulating economy recovery to its long-run equilibrium? Case Study: China Pegs The Yuan In the early years of the twenty-first century, China provided a striking example of the lengths to which countries sometimes go to maintain a fixed exchange rate. Here’s the background: China’s spectacular success as an exporter led to a rising surplus on current account. At the same time, non-Chinese private investors became increasingly eager to shift funds into China, to invest in its growing domestic economy. These capital flows were somewhat limited by foreign exchange controls—but kept coming in anyway. As a result of the current account surplus and private capital inflows, China found its currency yuan under appreciation pressure at the target exchange rate, the demand for yuan exceeded the supply. Yet the Chinese government was determined to keep the exchange rate fixed at a value below its equilibrium level. Although China allowed a small revaluation (appreciation under fixed exchange rate policy is referred as revaluation) of the yuan in 2005, many economists estimated the level of the undervaluation of the yuan at 15 to 25% in 2013. To keep the rate fixed, China had to engage in large-scale exchange market intervention, selling yuan, buying up other countries’ currencies (mainly U.S. dollars) on the foreign exchange market, and adding them to its reserves. From 2011 to 2012, China added US$130.44 billion to its foreign exchange reserves, and by December 2012, those reserves had risen to $3.3 trillion. To get a sense of how big these totals are, in 2012 China’s GDP was approximately US$8.25 trillion. This means that in 2012 China bought U.S. dollars and other currencies equal to about 1.6% of its GDP, making its accumulated reserves approximately equal to 40% of its GDP. Not surprisingly, China’s exchange rate policy has led to some friction with its trading partners, who feel that China is, in effect, subsidizing Chinese exports.                                                                                                                                                                                                                            

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