Question

a. Assume that the interest parity condition holds. Also assume that the U.S. interest rate is 8% while the U.K. interest rate is 6%. Given this information, financial markets expect the pound to
A) depreciate by 14%.
B) depreciate by 2%.
C) appreciate by 2%.
D) appreciate by 6%.
E) appreciate by 14%.

b. For this question, assume that there are decreasing returns to capital, decreasing returns to labor, and constant returns to scale. Now suppose that both capital and labor decrease by 5%. Given this information, we know that output (Y) will
A) not change.
B) decrease by less than 5%.
C) decrease by 5%.
D) decrease by more than 5% but less than 10%.
E) none of the above

c. Assume that constant returns to scale exists and that N and K both increase by 2%. Given this information, we know that

A) output (Y) will increase by 4%.
B) Y will increase by 2%.
C) Y will increase by less than 2%.
D) Y will increase by less than 4% and more than 2%.

d. Decreasing returns to capital (K) implies that a 4% increase in K will cause
A) a reduction in output per worker (Y/N).
B) a reduction in K/N.
C) Y to increase by exactly 4%.
D) Y to increase by less than 4%.
E) no change in Y/N.

I already know the answers I just need clarifying on how to get them. Thank you

Answer 1

1)

Exchange Rate E=GBP/US$

Pound per 1 US$=(domestic currency), US interest rate = i, British Interest rate = i*

So, 1+i=E(1+i*)1/E^e.

Substituting the values,we have-

1.08=1.06E/E^e or, E^e/E =1.06/1.08, Subtracting 1 from both sides,we have

E^e/E-1=1.06/1.08-1 = -0.02 which means E is expected to decrease by 2%

This shows for 1 US$ we are getting 2% less British pounds,thus the Pound appreciates in value by 2%(OPTION C)

b) The constant returns to scale means that an increase in inputs(capital,labor) will cause the same proportional increase in output.

For example if units of labor/capital is incresed from 10-12 that is 20%,the ouput will increase in the same proportion that is from 20 to 24=20%.

So,if both labour and capital is decreased by 5% here,according to the constant returns to scale,the output will decrease by the same proportion 5% OPTION C

3) The same logic applies in this question so with 2% incresae in K and N,with constant returns to scale, we know that output (Y)will increase by 2% OPTION B

4) Decreasing returns to capital means that a 4% increase in K will cause OPTION D-Y to increase by less than 4%.

As per diminishing returns to scale when input is increased by a certain quantity,the output increases at a diminishing rate because internal and external economes are less than internal and external diseconomies.