07 May EXPLAIN IN WORDS WHETHER THIS ADDITIONAL FORCE WORKS TO ASSIST OR TO UNDERMINE THE EXPERTS’ CLAIM.
Macroeconomic Theory and Policy
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• Total marks: 100 points.
Question 1 (20 points) – Chapter 3 &5
Suppose you are an economic expert who works as an economic analyst in a small open economy (SOE) that presently has perfect financial capital mobility and no risk premium. The government of a large open economy (LOE) is considering adopting one of the following economic policies:
1) A subsidy geared to the construction of investment within the economy of the LOE; or
2) An increase in taxes to help lower the government budget deficit of the LOE.
Draw a pair of diagrams, one for the domestic loanable funds market of the SOE and one for the market for foreign exchange, that depict the impact of the proposed LOE polices on the SOE (i.e. two sets of two diagrams in total).
a) Suppose you are hired by the association of homebuilders of the SOE. Use your diagrams to provide an analysis of the impacts of each potential LOE policy on their industry. In your expert opinion which potential LOE policy is most preferred (by this group)? Explain why. Which policy is less preferred (by this group)? Explain why. (10 points)
b) Suppose instead, you are hired by the association of importers of the SOE. Use your diagrams to provide an analysis of the impacts of each potential LOE policy on their industry. In your expert opinion which potential LOE policy is most preferred (by this group)? Explain why. Which policy is less preferred (by this group)? Explain why.(10 points)
Question 2 (35 points) – Chapters 6, 10 & 11
The closed economy of Temptation Island is characterized by the following equations:
Consumption: C = 6000 + 0.85(Y – T)
Investment: I = 1500 – 300r
Government spending: G = 5000
Taxes: T = 4500
Real money demand: L = 0.65Y – 500i
Expected inflation: ?e = 0
Production function: Y = K1/2L1/2
The nominal money supply = 35000
Note: Interest rates, both i and r, are expressed in percentage points, i.e., if r = 5.5, then the real interest rate is interpreted as being equal to 5.5%.
Suppose the IS-LM model can be to describe Fantasy Island, and answer the following questions. Keep your answer to at least THREE decimal points if necessary.
a) Derive the IS and LM equations for this economy. (4 points)
b) Suppose we are in the base period, so the price level is fixed at 1.00. Calculate the resulting short-run equilibrium values of real output, real interest rate, investment, consumption, the government budget balance, and price level. (3 points)
c) Suppose, in the long-run, 64000 (real) units of capital are utilized and 36000 workers are employed. Calculate the resulting full-employment values of real output, real interest rate, investment, consumption, the government budget balance, and the price level. (3 points)
d) Suppose the government decides to change the level of taxation to create budget surplus of 600. Calculate the resulting (new) short-run equilibrium values of real output, real interest rate, investment, and consumption. Determine the unemployment rate that results in short-run equilibrium.(6 points)
e) Suppose, instead, we are also told that when the economy was in long-run equilibrium (in part C, above) 1500 people were unemployed. Further, when the shock hit the economy (in part D, above) in net termsno people have exited the labour force. Determine the unemployment rate that results in the short-run equilibrium from part D. What portion this unemployment is represented by cyclical unemployment and what portion is comprised of those in the natural rate (level of) unemployment (NRU). (4 points)
Hint: Cyclical unemployment is the level of unemployment that results from deviations of output from the full-employment level, i.e., Actual unemployment = Cyclical unemployment + NRU.
f) When the economy returns to long-run equilibrium what unemployment rate should we expect to see? Explain why/when this makes sense. (4 points)
g) Determine the (new) LR equilibrium values of real output, real interest rate, investment, consumption, and the real money supply that result due to the shock described in part D (above). (6 points)
h) Draw one well labeled IS/LM diagram that depicts the initial LR, the new SR and new LR equilibria for this economy. Be sure to clearly identify the different equilibrium points on your diagram, but no further written explanation is required. (5 points)
Question 3 (25 points) – Chapter 5, 9& 11
The closed economy of North Korea is experiencing a debate about the strength and appropriateness of certain government policies. Significant debate is occurring among different groups within the country. The economy is presently in a short-run equilibrium in which a significant portion of the labour force is cyclically unemployed. The debate is raging as to what mix of government policies would be most effective at meeting the governments’short-run and long-run economic objectives.
Expert #1 has proposed that the government should use changes in government spending on goods and services to achieve the unemployment goal.
Expert #2 counters that changes in taxes are better as long as they are accompanied by an equal and opposite change in the money supply (that is, if taxes rise by $1, then the government also reduce the money supply by $1, and vice versa).
a) This part focuses on the governments two short-run objectives of ensuring unemployment is not too high and keeping the size of government saving from becoming too small. Which of these policy mixes is most effective at meeting the governments’ short-run goal? Explain, using words and a single AS/ADdiagramand a single IS/LM diagram, the degree of effectiveness of each of the policy mixes.(9 points)
b) This part focuses on the governments two long-run objectives of keeping inflation form getting too high and ensuring investment is not too low in the longer term. Which of these policy mixes is most effective at meeting the governments’ long-run goals? Explain, using words and your single AS/AD diagram and single IS/LM diagram (from part A), the effectiveness of each of the policy mixes.(10 points)
c) Suppose you are an expert having studied ECMB05H. Then, all things considered, which of these policy mixes would you recommend the government adopt? Explain why.(6 points)
Question 4 (20 points) – Chapter 10 & 11
Presently many European countries are in the middle of an economic slump, where output has fallen below potential output (by a large degree in the case of some countries). Suppose one of these countries decides to follow the advice of a noted economic expert who claims what the economy needs to boostoutput and employment in the short-run is the passage of a properly designed government austerity package. By austerity we mean a package where the government attempts to improve the size of their budgetary deficit. The expert claims that a properly designed and executed austerity package will created beneficial changes to consumer and business confidence.
We assume this country is large enough that we can easily use the closed economy IS/LM model to describe its economic conditions.
a) Draw one IS/LM diagram that depicts the initial short-run equilibrium along with any (and all) shifts in the short-run that are implied by the experts’ arguments. Explain in words how and why each curve shift has occurred. Does it seem the expert claims are reasonable or not? Explain.(10 points)
b) Draw a second IS/LM curve that depicts what would occur in the short-run, if in addition to the shock in part A, agents also tend to demand more money the larger the government budget deficit. Explain in words whether this additional force works to assist or to undermine the experts’ claim.(10 points)
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