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05 Jun Question Page 1 of 3

Question
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Question 1

What will happen if the government reduces the tax rate (t)? Use the following models to answer

the question.

a) The short-run fix-price IS-LM model.

b) The classical model with wage and price flexibility.

Question 2

Classical economists believe in the separation of the monetary and real sides of the economy.

This is called the classical dichotomy. Use the IS-LM-AD-AS model to show that the classical

dichotomy holds when wages and prices are fully flexible.

Question 3

Use the IS-LM-AD-AS model to show that the classical dichotomy does not hold in the short-run

when wages and prices are rigid.

Question 4

There is one thing we have not analyzed in the class. Suppose that due to a technological

advance the potential GDP increases. What will be the effect of this event on the endogenous

variables of the model? (Assume a one-time increase in Y*).

Question 5

Keynes has famously said, “In the long run we are all dead”. What did he mean by this

statement? Use an AD-AS model to demonstrate this.

Question 6

Friedman has said, “Inflation is always and everywhere a monetary phenomenon”. Use an

appropriate model to demonstrate the meaning of this statement. For this statement to be true,

does it matter whether wages and prices are flexible or not?

Question 7

What is the meaning of “monetary neutrality”? Would money be neutral if wages and prices

were rigid?

Question 8

What is the “crowding out effect”?

a) How does the extent of crowding out depend on the interest sensitivity of demand for

real balances?

b) How does the extent of crowding out depend on the interest sensitivity of investment

demand?

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Show these cases graphically (use the fix-price IS-LM model).

Question 9

Derive the aggregate demand function assuming that demand for real balances is interest

insensitive (L = kY).

Question 10

Still remember the expenditure multiplier? Recall that we derived the multiplier under the

assumptions of fixed prices and interest rates. Compared to the fixed price and fixed interest rate

cases, what will be the size of the multiplier in the following models?

a) Model with a fixed price but endogenous interest rate (in other words, the fix-price ISLM

model).

b) The classical model with wage and price flexibility?

Question 11

We always hear the phrase that inflation is a monetary phenomenon. Why is nobody saying that

inflation is a fiscal phenomenon? Can the government of a country create long-term inflation by

continuously increasing its purchases (G) over time?