Q1. 
a) False.  In an open economy, Sd=Id is not required
           rather S=I+CA  (assume NFP=0)

b) False.  rw increases => NX increases => CA increases
           (see diagram 1b)

c) True.  Imports increase by 20K, exports increase by 20K => NX no change
          =>no change in CA

d) False.  The country IS a net lender, but CA + KA (+stat discrepancy)= 0
           so if CA is positive then we would expect KA to be negative

e) False.  MPKf increases causing desired capital stock to
           increase (Id shifts to the right), this causes net
           exports to decrease which implies a decrease in CA 
           (see diagram 1e)


Q2.

a) The equilibrium condition in large open economy case is that desired
international lending (in one country) must equal desired international
borrowing (in another country).  So CAh=-CAf(NFP=0)

b) Recall CA=S-I

So CAh= -10 +400r  and   CAf= -35+500r
In equilibrium CAh= -CAf
so:

-10 + 400r = 35 - 500r
      900r = 45
         r = 45/900 
         r = 0.05  or 5%

=>CAh = -10 + (400*0.05) = 10
  CAf = -35 + (500*0.05) = -10
  Sh = 20 + (200*0.05) = 30
  Sf = 40 + (100*0.05) = 45
  Ih = 30 - (200*0.05) = 20
  If = 75 - (400*0.05) = 55

c) Ih rises by 45:  Ih = 75-200r

Now CAh = 20 + 200r -75 + 200r = - 55 + 400r
recall: CAh=-CAf in equilibrium so:

-55 + 400r = 35 - 500r
      900r = 90
         r = 0.1

=>CAh = -55 + 40 = -15
  CAf = -35 + 50 = 15
  Sh = 20 + 20 = 40 
  Sf = 40 + 10 = 50
  Ih = 75 - 20 = 55
  If = 75 - 40 = 35

Comments:  Home's desired investment has increased for all levels of r;
therefore, at any r they are more likely to borrow so they can invest
more.  Thus, CA is lower at any given r.  In large open economies, the
interest rate will adjust to this increase in investment demand by home,
by increasing (to balance supply=demand in international lending).
(See graph 2c)


Q3.  Increased government spending that is not financed by taxes implies
that the government deficit increases.  If desired investment increases at
the same time we'll find the following for the small open economies and
large open economies.

a) If the country under analysis is a small open economy then we see that
the increase in gov't spending and desired investment will cause the CA to
decrease, so there will be twin deficits.  Algebraically, S=Y-C-G, if
G decreases and taxes are unchanged, then aftertax income is unchanged so
C is unchanged.  Thus S decreases.  CA = S - I, so if S is decreasing
and I is increasing, CA will decrease. It will either become a smaller 
positive number or a larger negative number, depending on whether the
country was a net lender/borrower before.(See graph 3a)

b) If the country under analysis is a large open economy then we see that
an increase in gov't spending and desired investment will cause the CA to
decrease, so there will be twin deficits here as well.  However, the
magnitude of the CA deficit will be diminished by the fact that r will
adjust upward.  The reason for this adjustment is that as Savings decrease
in the large open economy, and Investment increases, (as we saw in
question 2) r will increase in order to bring the international lending
market into equilibrium.  Note that we can tell that r will not adjust so
much as to cancel the CA deficit effect because if we look at the foriegn
country, their CA will improve, and since CAh=-CAf
we know that the home countries CA is decreasing. (See graph 3b)

Q4.  The asset market equilibrium condition is:

M/P = L(Y, r + p)

Therefore in equilibrium the price level is proportional to the money
supply.  P= the ratio of the nominal money supply, M, to nominal money
demand, L(Y, r + p).

a) M increases because the government prints money to finance its
expenditures.  If M increases P increases since P=M/L(Y, r + p).  Note: L(Y, r + p) is not
changed since we are not looking at the changes that would occur in 
the all markets in a general equilibrium, just the changes that occur in
the asset market equilibrium.

b) An increase in the uncertainty of stock market returns will increase
money demand, L(Y, r + p) because the higher risk
of alternative asset markets will make money more attractive.  As the
denominator term, L(Y, r + p), increases, P
will decrease.


Q5.  L(Y,i) = 640 + 0.1Y - 5000i
     M = 1000 + 0.1Y - 4000p

in equilibrium:  M=P*L(Y,i)

a) In equilibrium, P is found by:

1000 + 0.1Y - 4000p = 640P + 0.1Y*P - 5000i*P

recall i= r + pe so 
1000 + 0.1Y - 4000p = 640P + 0.1Y*P - 5000(r + pe)*P

=> P = (1000 - 4000p)/(740-5000(r + pe))

if pe = p
=0.03 , Y=1000, r=0.02 then:

P= (1100-120)/(740-250) = 980/490 = 2

b) if p increases to 0.04 while all other
variables remain constant then:

P= (1100 - 160)/(740-250) = 940/490 = 1.92

c) if pe increases to 0.04 while ALL
other variables remain as in PART a, then:

P= (1100-120)/(740-300) = 980/440 = 2.23


Q6. Note: we assume that when the economy is not in general equilibrium
(IS=LM=FE) that the asset and goods markets are in equilibrium.  Thus, in
the short run, Y and r are determined where IS=LM.  In the long run, we
assume that the LM (asset market) is the quickest to adjust.  Therefore
the long run equlibrium is re-established by shifts in the LM curve.


a) Initially the economy is at point A.  A decline in expected future
income will result in an increase in desired savings and a decrease in
desired consumption, so the IS curve will shift to the left. 
(See diagram 6a)  The short run equlibrium is at point B, where r has
decreased to rB and Y has decreased to YB  
At this point there is excess supply in the goods and labour markets, so
W, nominal wages, will decrease and P will decrease causing the LM curve
to shift right/down.
Long Run Equlibrium: Point C, where r has decreased to rc, Y =
Y* (unchanged), I has increased because of the decreas in r, C has
increased (because lower r implies lower S and S=Y-C-G, so if S
decreases, Y and G are constant, C must have increased), real wages, w
remain unchanged since, w=W/P and both P and W have decreased.

b)Initially the economy is at point A.  An increase in G (gov't
purchases) will result in an decrease in desired savings, so the IS curve
will shift to the left. (See diagram 6b)  The short run equlibrium is at
point B, where r has increased to rB and Y has increased to
YB At this point there is excess demand in the goods and labour
markets, so W, nominal wages, will increase and P will increase causing
the LM curve to shift left/up.
Long Run Equlibrium: Point C, where r has increased to rc, Y =
Y* (unchanged), I has decreased because of the increase in r, C has
decreased (because higher r implies higher S and S=Y-C-G, so if S
increases, Y constant, and G is increased, C must have
decreased), real wages, w, remain the same since, w=W/P and both P and W.

c) Initially the economy is at point A.  An increase in the liquidity of
non-money assets will cause a decrease in the demand for money which will 
decrease the LM curve (shift it right).
(See diagram 6c)  The short run equlibrium is at point B, where r has
decreased to rB and Y has increased to YB
At this point there is excess demand in the goods and labour markets, so
W, nominal wages, will increase, and P will increase (until supply=demand
in the goods market) causing the LM curve to shift up/left again.
Long Run Equlibrium: Point A, again, where r has increased back to
rA, Y = Y* (unchanged), I is unchanged because r is unchanged,
C is unchanged because r is unchanged (so S is unchanged), real wages, w, 
will not change since all real variables are unchanged: both P
and W have increased.

d) Initially the economy is at point A.  A tougher immigration law
which decreases the labour force, will result in an decrease full
employment output/supply.(See diagram 6a)  The short run equlibrium is at
point A, where r is at rA and Y is at YA(above full
employment output)
At this point there is excess demand in the goods and labour markets,
so W, nominal wages, will increase and P will increase causing the LM
curve to shift left/up.
Long Run Equlibrium: Point B, where r has increased to rB, Y =
Y*B (unchanged), I has decreased because of the increase in r,
C has decreased (because higher r implies higher S and S=Y-C-G, so if S
increases, Y and G are constant, C must have decreased), real wages, w
have increased since, w=W/P and both P and W have increased, but W will
have had to have increased more than P to bring the labour market into
equilibrium when supply has decreased..


GRAPHS