Question

Choose the missing words in the following sentences.

a) In a small open economy, if the world real interest rate is above the rate at which national saving equals domestic investment, then there will be a trade surplus / balanced trade / a trade deficit and positive / zero / negative net capital outflow.

b) In the event that an unfavorable supply shock moves the economy away from the natural rate of output, the Central bank faces a dilemma: monetary policy can either return output to the natural rate but with a higher / lower price level, or allow the price level to return to its original level but with a higher / lower level of output in the short run.

c) If the rate of separation is 0.02 and the rate of job finding is 0.08 but the current unemployment rate is 0.10, then the current unemployment rate is above / at / below the equilibrium rate. In the next period it will move toward / stay at / move away from the equilibrium rate.

d) Starting from the natural level of output, an unexpected monetary contraction will cause output and the price level to increase / decrease in the short run. In the long run, the expected price level will increase / decrease, causing the level of output to return to the natural level.

e) A debt-financed tax cut will increase / not change / decrease current consumption in the traditional view and increase / not change / decrease current consumption in the Ricardian equivalence view.

Answer 1

Correct choices in bold, and explanations are as follows:

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a) In a small open economy, if the world real interest rate is above the rate at which national saving equals domestic investment, then there will be a trade surplus and positive net capital outflow.

Explanation:

If world real interest rate is above the national interest rate, capital will flow out of the country. Thus, NCO will rise.

Now, NX = NCO -- basic equality in an open economy

Thus, NX will also rise, creating a trade surplus.

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b) In the event that an unfavorable supply shock moves the economy away from the natural rate of output, the Central bank faces a dilemma: monetary policy can either return output to the natural rate but with a higher price level, or allow the price level to return to its original level but with a lower level of output in the short run.

Explanation:

If SRAS shifts to the left, price level rises. Corrective monetary policy will shift AD to the right. This will raise price levels further. If the Central Bank does nothing, the equilibrium level of output will fall in the short run.

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c) If the rate of separation is 0.02 and the rate of job finding is 0.08 but the current unemployment rate is 0.10, then the current unemployment rate is below the equilibrium rate. In the next period it will move toward the equilibrium rate.

Explanation:

Natural U-rate = s/(s+f)

= 0.02/(0.10) = 0.20 = 20%

The current u-rate is lower than the natural rate.

Slowly over time, it will move towards the natural u-rate, and in the long run it will equal the natural u-rate.

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d) Starting from the natural level of output, an unexpected monetary contraction will cause output and the price level to decrease in the short run. In the long run, the expected price level will increase, causing the level of output to return to the natural level.

Explanation:

A monetary contraction reduces the Money Supply in the economy. This causes AD to fall, and thus real GDP to fall. With time, newer contracts at the lower price level allow output to rise, since cost of production had fallen. This brings back output to the natural level.

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e) A debt-financed tax cut will increase current consumption in the traditional view and not change current consumption in the Ricardian equivalence view.

Explanation:

Under the traditional view, a tax cut will lead to a rise in disposable income, and people will consume more. Under the Ricardian equivalence theory, since the tax cut is debt financed, consumers know that their lifetime consumption is not going to change. They will have to bear the cost later on. Thus, they don't change their consumption.