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MGEC61 – LEC 01 & LEC 02
International Economic: Finance
Assignment 2
Due: On (or before) Wednesday, July 31, 5:00pm, Quercus (under MGEC61 Assignment 1)
(Assignment submitted after 5:00pm on July 31 will NOT be accepted)
Instructions:
. You can submit an individual or group assignment. If you submit a group assignment, there must be no more than THREE students in your group, and you just submit ONE copy.
Þ If you are planning to submit group assignment, make sure you form your group on Querucs (under Ass-2
Group
#) before submission.
. Label your graph(s); otherwise, marks will be subtracted.
. Do not write E/q/Ee increases/decreases ( ↑ / ↓ ) in your answer, you have to answer whether the currency appreciates/depreciates. POINTS WILL BE SUBTRACTED IF YOU DO NOT FOLLOW THIS INSTRUCTION.
. No credit will be given ifyou do not show your work.
. Your answer should be structured in a way such that those that know little about economics will have no difficulty understanding your argument/answer.
.
DO NOT USE any notations that are not used in lectures. If you use your own notations and/or abbreviations
that are
not
being
used in lectures,
you
will
receive
a
grade
of zero
for that
question.
. Total marks: 100 points.
Question 1 (30 points) (save your answer as HW2-Q1.pdf)
Canada is a small open economy that adopts a flexible exchange rate. Also, Canada is initially in its long-run equilibrium.
Each part of the question is NOT related to other parts of the question. Also, for each part of the question, support your answer with ONE DD-AA diagram. Assume all components of the BOP are initially in balance for both parts of the question.
a) In the 2024 federal budget, the federal government proposed to increase the corporate capital gains tax inclusion rate from 50% to 66.67% on capital gains realized on and after June 25, 2024. Discuss the effect of this change on Canada’s level of employment and current account balance in both the short run and the long run. ( 15 points)
Note: Exchange rate is quoted as EC$/US$. Use the subscripts “C” and “US” to represent all the terms used for Canada and the U.S., respectively, in your written explanation. You must use these notations; otherwise, you will receive a grade ofZERO for this question.
b) The Bank of Canada (BOC) and the European Central Bank (ECB) both lowered their policy rate on June 5 and June 6, respectively, which were their respective first rate cuts in four years. After the interest rate cuts, some consulting firms surveyed market participants on their opinions on interest rate movements. The results indicate that market participants expect both central banks will continue to cut their policy rates later this year. What happens to the short- run C$/€ exchange rate after the release of these results? What happens to the short-run levels of output and real money balance in Canada? (15 points)
Note: Exchange rate is quoted as EC$/€ . Use the subscripts “C” and “EU” to represent all the terms used for Canada and the European Union, respectively, in your written explanation. You must use these notations; otherwise, you will receive a grade of ZERO for this question.
Question 2 (30 points) (save your answer as HW2-Q2.pdf)
Home is a small open economy. The economy adopts a fixed exchange rate regime and is currently in its long-run equilibrium.
Each part of the question is NOT related to other parts of the question. Also, for each part of the question, support your answer with ONE DD-AA diagram.
a) “To improve their trade balance, the foreign government imposes a tariff on all imported goods (including domestic goods). This change in foreign trade policy will deteriorate the domestic current account.” True/False/Uncertain, explain with the aid of ONE DD-AA diagram (only the first diagram will be graded). (20 points)
b) Suppose the market perceives domestic assets to be riskier than foreign assets. Owing to persistent budget deficits, the debt-to-GDP ratio of Home’s anchor currency country reaches a record high. As a result, credit rating agencies lower the credit rating of Home’s anchor currency country. What happens to the short-run levels of output and real money balance at Home? Explain. ( 10 points)
Note: In the initial long-run equilibrium, all components of the BOP are in balance.
Question 3 (20 points) (save your answer as HW2-Q3.pdf)
“The DD-AA model predicts that if foreign money holders lower the fraction of income held in the form of money permanently, there will be a deterioration of the domestic balance of payments in the short run.” True/False/Uncertain, explain and support your answer with ONE DD-AA diagram.
Note:
. Assume both Home and Foreign are small open economies.
. Compare your answer to the initial long-run equilibrium.
. Only the first diagram will be graded.
. In the initial equilibrium, all BOP accounts are in balance.
Question 4 (20 points) (save your answer as HW2-Q4.pdf)
A small open economy can be described by the following equations:
Full-employment level of output: YFE = 24000
DD equation: Y = 24000 + G – 500P + 250EDC/FC
AA equation: Y = 2400 + 4(P/MS) + 20Ee – 16EDC/FC Note: Keep your answer to 4 decimal places if needed.
Initially, the government collects 15% of the country’s long-run level of output from households as taxes, and the government runs a budget surplus of 600. Also, the level of money supply is 80730.
a) If the initial expected exchange rate is 18 DC per FC, find the long-run equilibrium levels of price and the DC/FC exchange rate. (5 points)
The economy is initially in its long-run equilibrium as shown in part (a). Also, if there is a change in agents ’ expectations, the expected exchange rate will change by 1.4 DC per FC. Suppose there is a once-and-for-all change in the preference for holding money such that the AA equation becomes:
(New) AA equation: Y = 3420 + 4(P/MS)
+ 20Ee – 16EDC/FC
b) Find the short-run equilibrium values of output and the DC/FC exchange rate. (5 points)
Continuing with the permanent change in the preference for holding money as shown above, recent studies indicate that the economy may slow down in the near future. To prevent a potential economic downturn, policy makers want to raise the short-run level of output to 25200.
c) Find the temporary change in the level of money supply that could achieve this goal. (5 points)
d) Find the temporary change in government spending that could achieve this goal. (5 points)