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Phillips Curve and International Macro

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2. A 1991 The Wall Street Journal cover page article entitled "Foreign Rate Increases May Worsen Slump" explained how the German central bank raised domestic interest rates in order to reduce inflation below the 3% level. At the same time, the U.S. central bank reduced domestic interest rates to fight the deepening recession in the United States.
a. Explain the pressures that rising German interest rates put on the other European Union (EU) countries' currencies. Specifically, assume exchange rates within the EU were absolutely fixed. Explain the economic effects a rise in the real German interest rate put on the DM/FF exchange rate and what the French central bank (i.e., the Bank of France) would have to do to keep the exchange rate fixed.
b. Explain the economic effects the rise in German interest rates put on the DM/FF exchange rate and what the German central bank (i.e., the Bundesbank) would have to do to keep the exchange rate fixed.
d. What is the Phillips Curve? Are your results in question (1a) consistent with the Phillips Curve?
3. In 1991, Argentina adopted a currency board that had the responsibility to maintain a fixed exchange rate between the Argentine peso and the U.S. dollar ($1 = 1 Argentine Peso). Through the Convertibility Law, Argentina also established that each peso in circulation had to be 100% collateralized with reserves in the Central Bank, assuring 100% coverage of Argentine monetary base. Assume the government promised to reduce the surging unemployment rate by trying to stimulate significant new economic growth by means of expansionary monetary policy. Since it would be constrained by the Convertibility Law from increasing the monetary base, suppose the central bank expanded the money supply by reducing the reserve ratio. Explain the economic effects that expansionary monetary policy would have on Argentina's real and nominal GDP, monetary base, money supply, real and nominal interest rates, current account, financial account, level of international reserves, real investment spending, unemployment rate, inflation rate, and velocity of money.

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Solution Summary

Explain the economic effects the rise in German interest rates put on the DM/FF exchange rate and what the German central bank (i.e., the Bundesbank) would have to do to keep the exchange rate fixed.

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2. England has not joined the European Monetary Union, but it is a member of the European Union. As a result, England has a flexible exchange rate and retains its own currency, the pound sterling. Suppose England's unemployment rate began to rise and the government passed an investment tax credit to help stimulate the economy. Explain the effect this policy would have on the nation's real and nominal interest rates, real and nominal GDP, gross private domestic investment, unemployment rate, inflation rate, exchange rate, current account balance, financial account, and reserves and related items account. (Definition of Investment Tax Credit: A company may claim an investment tax credit for a percentage of the net costs paid in a taxable year for tangible assets that qualify under government rules. In short, if you invest, a portion of your investments can be used to reduce taxes and increase your after tax profits. Usually, these assets are eligible for depreciation or amortization treatment, like new buildings and machinery)
3. How would your answer to question #2 change if a politically unstable country (e.g., Zimbabwe) and not England passed an investment tax credit. To answer this question, think in terms of how capital mobility facing an unstable county is different from England and the effect it would have.
4. How would your answers to questions #2 change if England pursued contractionary monetary policy?
5. What factors will increase or decrease the level of international capital mobility between one nation and the rest of the world?

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