Tutorial, Week 11— ECOS3007 Semester 1 2023
Topics: The global …nancial crisis (Topic 7) and COVID-19 (Topic 8)
1. Indicate whether the following statement is true, false, or uncertain. Provide an expla-
nation (using words, diagram, etc.) for your answer. Marks are awarded for explanation
only. A correct true, false, or uncertain designation with an incorrect explanation will
receive zero marks.
Suppose a central bank would like to conduct a (non-sterilized) foreign-exchange in-
tervention and appreciate the domestic currency by a given, …xed amount by selling
either domestic-currency assets or foreign-currency assets. Under the imperfect asset
substitutability case considered in the course, if the bank intervenes by selling domestic-
currency assets, it would need to sell more of these assets, compared to when the in-
tervention is conducted through foreign-currency asset sale.
2. Consider the extended DD-AA model with …nancial frictions (credit market channel)
for the U.S. economy discussed in Week 10 lecture.
(a) In a DD-AA diagram AND in words, describe the e¤ect of an unexpected de-
struction of bank capital (credit crunch/"GFC shock") on the U.S. economy. For
this part, assume that the central bank responds to the shock by conducting a
monetary expansion, but the government does not provide any …scal response (G
and T are constant).
(b) In addition to the events in part (a), suppose that the foreign economy is also
su¤ering from a recession that reduces their output (Y #) and prompts the foreign
central bank to reduce their interest rate (R #). Would these new events mitigate
the e¤ect of the GFC shock on the U.S. economy (output)? Explain in a DD-AA
diagram AND in words.
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3. Consider the DD-AA model with output and risk-premium shocks, consisting of the
following equations (for the domestic economy):
Y = C + I +G+ CA+ h"y
C = (1 s)Y
CA = aE mY
M s
P
= L(R; Y )
R = R +
Ee E
E
+ "R
"y is the aggregate output shock (which encompasses both demand and supply shocks)
and "R is the relative risk-premium shock (shock to the asset market). The parameters
s, a, m, h are all > 0. The variables are as de…ned in the course. I is exogenous and
constant. Assume unchanged (constant) P and Ee throughout.
Two ECOS3007 students— Mary and Martha— are arguing over how to best character-
ize the COVID-19 pandemic shock(s) and their impact on the Australian (domestic)
economy. Mary believes that the pandemic is best represented by a negative output
shock ("y < 0), with no direct impact on the asset market ("R = 0).
(a) Using the DD-AA diagram, characterize Mary’s hypothesis and show the impact
on Y and E in the short run. What happens to CA (and explain why)? [Note:
assume for now that there is no monetary and …scal policy responses (M s and G
are unchanged).]
Meanwhile, Martha believes that in addition to the negative output shock, it’s
also the case that "R < 0, i.e. the riskiness of Australian-dollar (domestic) assets
has declined relative to foreign-currency assets, perhaps owing to Australia’s suc-
cessful containment of the virus. Martha’s belief also stems from her observation
of the data regarding the impact of the pandemic: output declines (Y #) but the
Australian dollar remains stable (E is unchanged).
(b) Using the DD-AA diagram, characterize Martha’s hypothesis and show the impact
on Y and E in the short run, consistent with the data. What happens to CA (and
explain why)? [Note: assume for now that there is no monetary and …scal policy
responses (M s and G are unchanged).]
(c) Which hypothesis (Mary’s or Martha’s) results in a larger impact on Y and CA?
Explain why, in regard to your answer in (a) and (b).
Continuing the debate, Mary now argues that the reason behind the stable E in
the data is the timely Australian government’s …scal subsidy (e.g. the JobKeeper
payment) AND monetary expansions (increase in money supply), domestically
and abroad. This is in addition to her original hypothesis that "y < 0 and "R = 0.
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(d) Using the DD-AA diagram, characterize Mary’s revised hypothesis and show the
impact on Y and E in the short run, consistent with the data. What happens to
CA now, relative to in Mary’s original hypothesis?
(e) Assuming that I stays constant and the central bank can always maintain a stable
and unchanged E, what would be the appropriate size of …scal subsidy (increase
in G) to keep Y at the same level as the pre-pandemic level? [Hints: (i) you
should …rst solve for the equilibrium output level as a function of other variables
and parameters, (ii) your answer should be a function of "y.]
(f) How does your answer in part (e) change if instead the Reserve Bank manages to
depreciate the Australian dollar?