Problem 2 (apt’94, p3)

Assume that United States labor becomes more productive because of major technological changes.

1. Using the aggregate supply and aggregate demand model, explain how the increased productivity will affect each of the following for the United States.

1. Output

2. Price level

3. Exports

2. Explain how the change in exports you identified in (c) will affect the international value of the dollar.

Sample answer:

1. If labor becomes more productive, the aggregate supply curve will shift to the right indicating the increased ability of firms to produce more goods with the same resources:

AS1

P AS2

P₁

P₂

AD

Y₁Y₂ Y

As we observe in the above diagram, the technological improvement will bring about (a) an increase in output and (b) a decrease in the price level.

(c) The reduction in domestic prices will make indigenous goods relatively cheaper, and therefore more competitive, thus increasing foreign demand for the country’s exports.

2. Provided that the demand for the United States exports is price elastic, so that the total value of exports increases when prices fall, the demand for domestic currency will go up (foreigners will need more dollars to pay for the goods they buy from the United States). This, as the following graph shows, will induce the dollar to appreciate:

   Foreign exchange market

E

S

E ₂

E ₁ D2

D1

Q₁ Q₂ Quantity of dollars

Problem 3 (APT’96)

Year	Dollar	Yen	Franc	Mark
1	1	350	4.0	1.8
2	1	350	5.8	2.3

1. Given the change in the value of the dollar between year 1 and year 2, as indicated in the table above, describe the effects this will have on United States tourism overseas.

2. Using an aggregate supply and aggregate demand graph, explain the impact of the change in the value of the dollar on the price and output levels in the United States.

3. Explain what impact the change in the value of the dollar will have on the United States balance of trade.

Sample answer:

1. Since exchange rate between the dollar and the yen remained the same there will be no change to the tourism between the United States and Japan. However, the value of the dollar with respect to the franc and the mark has gone up between year 1 and year 2, making holidays in France and Germany less expensive in dollar terms. As a result, there will be an increase in the number of Americans going on holiday to these two countries.

2. As follows from the table, the value of the dollar has increased with respect to two of the three currencies and not changed with respect to the remaining one. This means that, in general, the dollar has appreciated. Consequently, the price of domestically produced goods has gone up in terms of foreign currencies, whereas foreign goods have become less expensive in terms of dollars and therefore more attractive to American consumers. As a result, we would expect a reduction in the United States exports and an increase in their imports. Hence, aggregate demand curve will shift in, pushing prices down and causing output to contract.

P

SAS

P ₁

P ₂ AD₁

AD₂

Y₂ Y₁ Y

3. Balance of trade is the difference between a country’s exports and its imports. In so far as the value of the United States exports has gone down, while the value of the imports has increased, there will certainly be a deterioration in the balance of trade.

Problem 4 (APT’97, P3)

Assume an economy is in a recession.

1. Identify one monetary policy action and one fiscal policy action that could be used to help the economy out of the recession. Explain the effect of each policy on the price level and the equilibrium level of output.

2. Given your answer in part (a) on the price level effect, explain the effect the policy actions you identified in part (a) would have on the economy’s imports and its exports.

3. Given your answer in part (a) on the output effect, explain the effect the policy actions you identified in part (a) would have on the economy’s imports and its exports.

4. Given your answers above, explain what effect the policy actions would have on the international value of the dollar.

Sample answer:

1. Since economy is in a recession, it produces below its potential level. To bring it out of the recession the government has to boost aggregate demand, which can be achieved either through expansionary monetary policy (e.g. buying out bonds in the open market) or expansionary fiscal policy (e.g. cutting personal income taxes). The monetary policy will push the interest rate down encouraging more investment, while the fiscal policy action will increase disposable income thereby boosting consumption demand. The ultimate effect of these two policies will be the same: they will increase aggregate demand causing both the equilibrium level of output and the price level to go up.

P

SAS

P ₂

P ₁ AD₂

AD₁

Y₁ Y₂ Y

2. The increase in prices will make domestic goods relatively more expensive and therefore less competitive thus producing a decrease in the level of the economy’s exports and an increase in its imports.

3. The increase in output we identified above will have absolutely no effect on the economy’s exports, as they depend exclusively on the income of the rest of the world and the correlation between domestic and international prices. Imports, however, are directly related to income, so that the result of the increase in output will be to increase the economy’s imports.

4. On the one hand, with increased imports, the supply of dollars in the foreign exchange market will go up. On the other hand, the fall in exports will reduce the demand for dollars. Altogether this will bring the international value of the domestic currency down, i.e. the dollar will depreciate:

E S₁

S₂

E₁

E₂ D₁

D₂

Quantity of dollars

Problem 5 (APT’98, P3)

In country X, labor productivity is growing at 3.2 percent per year, and the nominal wage is constant.

1. Discuss the impact of this rate of growth in productivity on each of the following.

1. The price level

2. Real wage rate

2. Now, the rate of growth of labor productivity in country X falls to 2.0 percent per year, while the rate of growth of labor productivity in other countries remains constant and higher that in Country X. Discuss the consequences of Country X’s decline in relative productivity on each of the following.

1. Exports of Country X

2. The international value of Country X’s currency

3. Employment in Country X in the short run