Sample answer:

1. (i) The fact that labor productivity is growing means that firms can produce a greater output using the same amount of inputs. Thus at each given price level firms will expand their production which corresponds to a rightward shift in the aggregate supply curve and, as the graph below illustrates, will result in lower prices.

P AS₁

AS₂

P₁

P₂

AD

Y

(ii) With the nominal wage rate fixed and prices falling the real wage rate which is the ratio of the two (w^r=w/p) will certainly increase, indicating that workers are now able to buy more goods with the money they are paid.

2. (i) Since productivity of labor in Country X is growing slower than in other countries, it takes increasingly more labor to produce goods in Country X compared to the rest of the world. This, in turn, implies that goods manufactured in Country X are becoming relatively more expensive and therefore less competitive than those produced abroad. Consequently, the demand for domestic goods by foreigners will decline leading to a fall in the country’s exports. Conversely, the demand for foreign goods by the residents of Country X will grow causing imports to rise.

(ii) With decreased exports the demand for Country X’s currency, which is used to pay for the exported goods, will go down. Coupled with an increase in imports and a corresponding rise in the supply of the domestic currency, this will result in the depreciation of Country X’s currency, unless, of course, the Central Bank is committed to a fixed exchange rate.

(iii) Even though the negative effect on the trade balance of the slow-down in productivity growth will be partially offset by decreased value of the domestic currency, the total impact on the aggregate demand will be negative and the AD curve will shift to the left. However, since productivity of workers is still rising, the AS curve will shift to the right, so that the ultimate effect on output and employment is indeterminate: they may either increase or decrease, depending on which of the effects predominates (see the following graph):

P AS₁

A AS₂

B point B may lie either to the left or to the

AD₁ right of A, depending on which curve

AD₂ shifts further.

Y

Problem 6 (APT'2000, P2)

Assume that the United States and France are the only two countries in the world and that exchange rates between the two countries are flexible.

Price of a dollar

i n terms of franks

Supply

Demand

Quantity of dollars

1. Assume that there is an increase in the United States demand for French goods. Explain how this increase in demand will affect each of the following.

1. The supply of dollars

2. The international value of the dollar

2. Assume that there is an increase in real interest rates in the United States, but not in France. Explain how this increase in interest rates will affect each of the following.

1. The international value of the dollar in the foreign exchange market

2. The quantity of dollars supplied in the foreign exchange market

Sample answer:

2. i) With increased demand for French goods, Americans will need more francs to pay for the imports. To get these francs, however, Americans will have to sell their dollars. As a result, the supply of dollars goes up:

$/franc S₁

S₂

E₁

E₂

D

Quantity of dollars

ii) As the above graph shows, the increase in the demand for French goods will produce a depreciation of the domestic currency ( the international value of the dollar decreases).

3. i) With no restrictions on the capital movements, higher interest rates in the United States will attract capital from abroad. However, foreigners, wanting to invest their money in this country, will have to transfer francs into dollars, so that the demand for dollars will increase causing appreciation of the United States currency:

$/francs

S

E₂

E₁

D₂

D₁

Q₁ Q₂ Quantity of dollars

ii) As one can see from the above diagram, the increase in real interest rates in the United States will increase the quantity of dollars supplied (from Q₁ to Q₂).