**Exercise 6 (Chapters 16-17-18)**
**Econ 202**
**Macroeconomic Theory**
**G. Ertan Özgüzer**
1) Explain what decisions and calculations a firm must make when it is considering the purchase of new capital (i.e., making an investment decision).
2) First, briefly explain what the user cost or rental cost of capital represents. Second, explain what factors would cause an increase in the user cost or rental cost of capital.
3) Explain what decisions and calculations a very foresighted consumer must make to determine her consumption decisions in any period.
4) Explain why current consumption is likely to respond less than one for one to changes in current income.
5) A pretzel manufacturer is considering buying another pretzel-making machine that costs $100,000. The machine will depreciate by 8% per year. It will generate real profits equal to $18,000 next year, $18,000 (1-8%) two years from now(that is, the same real profits but adjusted for depreciation), $18,000 (1-8%)^{2} three years from now, and so on. Determine whether the manufacturer should buy the machine if the real interst rate is assumed to remain constant at 5% and at 15%.
6) Suppose that at age 22, you have just finished college and have been offered a job with a starting salary of $40,000. Your salary will remain constant in real terms. However, you have also been admitted to a professional school. The school can be completed in two years. Upon garaduation, you expect your starting salary to be 10% higher in real terms and remain constant in real terms thereafter. The tax rate on labor income is 40%.
If the real interest rate is zero and you expect to retire at age 60 (i.e., if you do not go to professional school, you expect to work for 38 years total), what is the maximum you should be willing to pay in tuition to attend this professional school?
7) Explain what effect an increase in future expected output will have on the IS curve and LM curve in the current period.
8) Explain what effect a reduction in the future expected interest rate will have on the IS curve and LM curve in the current period.
9) Suppose the central bank implements a monetary expansion in the current period and is expected to continue this monetary expansion in the future. Use the IS-LM model to illustrate graphically and explain the effects of this policy on current output and the current interest rate.
10) Suppose the central bank announces that it will pursue a monetary expansion in the current period and a monetary expansion in the future. Explain how the credibility of the central bank might influence the effectiveness of this monetary policy action and announcement of a future monetary policy action.
11) What are the differences between the real exchange rate and nominal exchange rate? Explain.
12) Suppose you are considering the purchase of a bond issued in another country. What calculations must you do to calculate the expected return on a foreign bond? Explain.
13) Suppose the interest parity condition holds. Also assume that the one-year interest rate in the United States is 5% and that the one-year interest rate in Canada is 6%. What does this imply about the current versus future expected exchange rate (for the U.S. and Canadian dollars)? Explain.
14) What is uncovered interest parity? Explain.
15) Suppose the one-year nominal interest rate is 2.0% in the United States and 5.0% in Canada. Should you hold Canadian bonds or U.S. bonds? Explain.
16) Consider two fictional economies, one called the domestic country and the other the foreign country. given the transactions listed in (a) through (g), construct the balance of payments in each country. If necessary, include a statistical discrepency.
a) The domestic country purchased $100 in oil from the foreign country.
b) Foreign tourists spent $25 on domestic ski slopes.
c) Foreign investors were paid $15 in dividends from their holdings of domestic equities.
d) Domestic residents gave $22 to foreign charities.
e) Domestic businesses borrowed $65 from foreign banks.
f) Foreign investors purchased $15 of domestic government bonds.
g) Domestic investors sold $50 of their holdings of foreign government bonds.
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