Question: Trade between Olympios (O) and the Democratic Republic of Terrania (T) accounts for the majority of international trade for Olympios.

1. Trade between Olympios (O) and the Democratic Republic of Terrania (T) accounts for the majority of international trade for Olympios.

Discuss 2 key reasons why the government of Olympios might consider restricting its trade with the Democratic Republic of Terrania.                      [6]

2. The relationships between demand and supply of the Olympios Dollar and the exchange rate with the Terranian Credit are given by the following functions:

E = 8.75 – 0.03D$ E = 0.02S$ – 3.50

where: E

D$ S$

= Exchange rate:

= price of Olympios dollar

(Terranian credits / Olympios dollars) = index of demand for Olympios dollar

= index of supply of Olympios dollar.

a) i)    Determine the exchange rate that would prevail under a clean float.

ii) Explain what this exchange rate would mean for the balance of payments of Olympios. [3]

b) The government of Olympios elects instead to fix the exchange rate with the Terranian credit at E=1.5 credits per dollar.

i)    Describe what actions the central bank will need to take in the short run to maintain this exchange rate, and the state of the balance of payments.

ii) Explain what measures would be required if the government wishes to maintain this exchange rate in the long run.                     [6

[Total: 9]

3. The chair of the government exchequer in Olympios has announced, and written into law, the spending plans for 2022: government spending on capital projects is planned as $80 billion, and government current spending will be $235 billion. Taxes have been set at 20% of income.

Private investment in the economy is forecast at $145 billion. Autonomous consumption (independent of income) is estimated at $20 billion, and the marginal propensity to consume goods and services out of disposable income is 0.75. Imports and exports are projected to generate cashflows of $320 billion and $285 billion respectively.

a) Write down a function for consumption of domestically produced goods and services as a function of national income Y.                            [1]

b) Determine the equilibrium level of national income for the economy in 2022. [3]

c) Calculate the projected tax receipts and budget surplus/deficit for 2022.

[2]

d) A senior economic advisor proposes that the government run a deficit of

$50 billion in 2022, while maintaining the level of national income calculated in part b).

Assuming that all private money flows remain the same, calculate the new tax rate that would be required to achieve this, and the new level of government expenditure that would result.                               [4]

[Total: 10]

4. Banks in the country of Olympios have been required for many years to hold a cash reserve ratio of 10%. Over the last two years, the amount of cash held by the general public outside of the banking sector has reduced significantly as debit cards and mobile devices are increasingly used for transactions.

a) Discuss the impact that the change in the amount of cash held outside of the banking system will have had on the broad money supply in the economy, assuming that the stock of high-powered money is unchanged.            [3]

b) Compare the effectiveness of an expansionary monetary policy strategy in Olympios at the current time relative to three years prior, if the government’s aim is

to stimulate aggregate demand.                                                                  [4] Total: 7