Queen's University Department of Economics ECON 222 sections C and D Winter 2001 Assignment #3 Due on Wednesday, March 21, 2001

Q1. (a) Explain why the asset market equilibrium reduces to the condition that the quantity of money supplied equals the quantity of money demanded. [6] (b) Assume that the quantity theory of money holds. Further assume that (velocity) V=3, Y=15,000 and P=1. What is the real demand for money? What is the nominal demand for money? [3] (c) If the nominal money supply is expected to grow at 10% and the real demand for money is expected to grow at 15%, what is the rate of change in the price level? [3] (d) Let (real money demand) L(Y,i) = 0.2Y/i. Suppose Y=500, r = 0.07, (nominal money supply) M = 250, and the growth rate of money = 0.15. Output, Y, is held constant over time. What is the value of expected inflation? What are the values of real money supply(M/P) and price level (P)? [8] (Recall: nominal interest rate = real interest rate + expected inflation)Q2. Assume that prices and wages adjust rapidly so that markets for labour, goods and assets are always in equilibrium. What are the effects of each of the following on output, the real interest rate, and the current price level? (a) An increase in the liquidity of non-monetary assets [6] (b) An increase in wealth [6]Q3. EXPLAIN (include diagrams in each case) how each of the following would affect S^{d}, CA, I and r in a large open economy:(a) A decrease in the willingness to save by individuals in the foreign country. [7] (b) A decrease in domestic government spending. [7] (c) An increase in the income tax rate in the foreign country [7] (d) A decrease in foriegn country's expected future MPK. [7]Q4. Consider a closed economy and the following output, desired consumption and desired investment: Y = 1000 (full employment output) C^{d}= 300 + 0.3Y - 175r I^{d}= 500 - 250r(a) Write down an equation for S^{d}. Find the real interest rate that clears the goods market. [5](b) Suppose now, we introduce G = 100. What is the effect on the real interest rate? How is the desired national savings equation changed? Show this change graphically. [10]Q5. (a) Consider two large open economies, country 1 and country 2. For Country 1: C^{d}= 430 + 0.5(Y-T) - 150r^{w}I^{d}= 210 - 160r^{w}Y = 1600 T = 100 G = 100For Country 2: C^{d}= 380 + 0.5(Y-T) - 225r^{w}I^{d}= 550 - 200r^{w}Y = 2000 T = 250 G = 325What is the equilibrium world interest rate, r^{w}? Calculate C^{d}, I^{d}, S^{d}, and the CA balance for each country. [10](b) Suppose G increases by 50 and T increases 20 in country 1. What are the new equilibrium values of C^{d}, I^{d}, S^{d}, and the CA balance for each country? What is the new world interest rate, r^{w}? Draw a diagram to depict the initial and new equilibrium. Explain the results intuitatively (explain why the real interest rate has to change). [15]****