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Question 1. In 2001, President George W. Bush and Federal Reserve Chairman Alan Greenspan were both concerned about a sluggish U.S. economy. They also were concerned about the large U.S. current account deficit. To help stimulate the economy, President Bush proposed a tax cut, while the Fed had been increasing U.S. money supply. Compare the effects of these two policies in terms of their implications for the current account. If policy makers are concerned about the current account deficit, discuss whether stimulatory fiscal policy or monetary policy makes more sense in this case. Then, reconsider similar issues for 2009–10, when the economy was in a deep slump, the Fed had taken interest rates to zero, and the Obama administration was arguing for larger fiscal stimulus. Why might many believe that the Fed should keep interest rates at near zero levels in 2016 and beyond as growth remains stagnant? (8 marks: 4 marks for the graphs and 4 marks for the explanation)

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Question 2. Suppose that American firms become more pessimistic and decide to reduce investment expenditure today in new factories and office space.

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How will this decrease in investment affect output, interest rates, and the current account? (8 marks: 4 marks for the graphs and 4 marks for the explanation)

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Question 3. In the late 1990s, several East Asian countries used limited flexibility or currency pegs in managing their exchange rates relative to the U.S. dollar. This question considers how different countries responded to the East Asian currency crisis (1997–1998). For the following questions, treat the East Asian country as the home country and the United States as the foreign country. Also, for the diagrams, you may assume these countries maintained a currency peg (fixed rate) relative to the U.S. dollar. Also, for the following questions, you need consider only the short-run effects.

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a. In July 1997, investors expected that the Thai baht would depreciate. That is, they expected that Thailand’s central bank would be unable to maintain the currency peg with the U.S. dollar. Illustrate how this change in investors’ expectations affects the Thai money market and the FX market, with the exchange rate defined as baht (B) per U.S. dollar, denoted E_B/$. Assume the Thai central bank wants to maintain capital mobility and preserve the level of its interest rate, and abandons the currency peg in favor of a floating exchange rate regime. (8 marks: 4 marks for the graphs and 4 marks for the explanation)

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b. Indonesia faced the same constraints as Thailand—investors feared Indonesia would be forced to abandon its currency peg. Illustrate how this change in investors’ expectations affects the Indonesian money market and FX market, with the exchange rate defined as rupiahs (Rp) per U.S. dollar, denoted E_Rp/$. Assume that the Indonesian central bank wants to maintain capital mobility and the currency peg. (8 marks: 4 marks for the graphs and 4 marks for the explanation)

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c. Malaysia had a similar experience, except that it used capital controls to maintain its currency peg and preserve the level of its interest rate. Illustrate how this change in investors’ expectations affects the Malaysian money market and FX market, with the exchange rate defined as ringgit (RM) per U.S. dollar, denoted ERM/$. You need show only the short-run effects of this change in investors’ expectations. (8 marks: 4 marks for the graphs and 4 marks for the explanation)

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