Question 2: 

Exchange rates and interest rates are important for macroeconomic decision making. 

1. How does an increase in Japan’s government budget deficit affect each of the following? 

1. The real interest rate in the short run in Japan. Explain. 
2. (Private domestic investment in plant and equipment in Japan 

1. Draw a correctly labeled graph of the foreign exchange market for the euro, and show the effect of the change in the real interest rate in Japan from part (a)(i) on each of the following. 

1. Supply of euros. Explain. 
2. Yen price of the euro 

1. To reverse the change in the yen price of the euro identified in part (b)(ii), should the European Central Bank buy or sell euros in the foreign exchange market? 

Consider the relationship between the Japanese yen (¥) and the U.S. dollar ($). Let the exchange rate be defined as $ per ¥, E = $/¥. Apply the money market – foreign exchange market diagrams to answer the following questions. On all graphs, label the initial equilibrium point A.
1) Illustrate how a temporary decrease in Japan’s money supply affects the money and FX markets. Label your short-run equilibrium point B and your long-run equilibrium point C.
2) Refer to the diagram from (1), state how each of the following variables changes in the short-run (increase/decrease/no change): U.S. interest rate, Japanese interest rate, spot exchange rate E, expected future exchange rate F, and U.S. price level.
3) Refer to the diagram from (1), state how each of the following variables changes in the long run (increase/decrease/no change relative to their initial values at point A): U.S. interest rate, Japanese interest rate, E, F, and U.S. price level.

Suppose Europeans began purchasing real assets in the United States. How would this impact the foreign exchange market for the euro and the U.S. dollar price of the euro? Supply of euros / U.S. dollar price of euros

A. Increase / Increase

B. Increase / Decrease

C. Decrease / Increase

D. Decrease / Decrease

E. Decrease/ Not Change

1. What happens when the price level rises?
a. The value of money rises, and exchange rates and interest rates also rise.
b. The value of money rises, while exchange rates and interest rates fall.
c. The value of money falls while exchange rates and interest rates rise.
d. The value of money falls, and exchange rates and interest rates also fall.

2. Which of the following best describes what happens when the price level rises?
a. Households increase foreign bond purchases, and the supply of dollars increases.
b. Households increase foreign bond purchases, and the supply of dollars decreases.
c. Households decrease foreign bond purchases, and the supply of dollars increases.
d. Households decrease foreign bond purchases, and the supply of dollars decreases.

3. In which of the following situations does investment spending increase?
a. when the price level rises, causing interest rates to rise
b. when the price level rises, causing interest rates to fall
c. when the price level falls, causing interest rates to rise
d. when the price level falls, causing interest rates to fall

4. If a government started with a deficit and moved to a surplus, which of the following best describes the
effects of these changes?
a. Domestic investment and the real exchange rate would rise.
b. Domestic investment and the real exchange rate would fall.
c. Domestic investment would rise, and the real exchange rate would fall.
d. Domestic investment would fall, and the real exchange rate would rise.

5. Suppose the economy is in long-run equilibrium. In a short span of time, there is a sharp increase in the
minimum wage. In the short run, what would we expect to happen?
a. the price level to rise, and real GDP to fall
b. the price level to fall, and real GDP to remain unchanged
c. the price level to remain unchanged, and real GDP to fall
d. the price level to fall, and the real GDP to rise the same