1. When a recession occurs, do economists expect it to be a temporary phenomenon? Or is there some degree of permanence? What is the empirical evidence?

2. For each of the following changes, which equilibrium curve (IS, LM, or FE) is shifted? Draw the change in the underlying demand or suppy curves (for example, money demand and supply for the LM curve) and show how the equilibrium curve changes.

(a) Expected inflation increases.

(b) The future marginal productivity of capital increases.

(c) Labour supply decreases.

(d) Future income declines.

(e) There's a temporary beneficial supply shock.

(f) The nominal interest rate on money rises.

3. Use the IS-LM model to determine the effects of each of the following on the general equilibrium values of the real wage, employment, output, the real interest rate, consumption, investment and the price level.

(a) Tougher immigration laws reduce the working-age population.

(b) There's increased volatility in the prices of stocks and bonds.

(c) The government tries to achieve tax equity by an increase in the corporate tax rate.

(d) Increased computerization reduces stock market brokerage costs.

4. Suppose you were a forecaster of the real wage rate, employment, output, the real interest rate, consumption, investment, and the price level. A shock hits the economy, which you think is a temporary adverse suppy shock.

(a) What are your forecasts for each of the variables listed above (rise, fall, no change)?

(b) What if the shock was really due to people's reduced expectations about their future income. Which variables did you forecast correctly, and which did you forecast incorrectly?

5. The nominal exchange rate is 15 crowns per florin, the domestic price level is 6 florins/bottle, and the foreign price level is 2 crowns/bushel.

(a) What is the real exchange rate?

(b) What is the real exchange rate in the foreign country?

(c) If the domestic price level rises to 8 florin/bottle, what must the nominal exchange rate become if the real exchange rate remains unchanged?

6. Suppose the nominal exchange rate is 10, the domestic price level is 8, and the foreign price level is 4.

(a) What is the real exchange rate?

(b) Suppose the real exchange rate rises 10%, the inflation rate in the domestic country is 6%, and the inflation rate in the foreign country is 4%. By what percentage does the nominal exchange rate change?

(c) Suppose the nominal exchange rate rises 5%, the real exchange rate rises 8%, and domestic inflation is 3%. What is the foreign inflation rate?

7. When the real exchange rate rises, what happens to net exports in the short run? In the long run? What explains the difference between the short-run effect and the long-run effect?

8. Describe the effects of a rise in the domestic real interest rate on the exchange rate and on both domestic and foreign net exports.

1. Recent research suggests that recessions may contain permanent components. Some economists argue that only the 1981-82 recession led to a permanent change in the Canadian economy. Other studies suggest that perhaps 70% of changes in real output are permanent and 30% are temporary for postwar Canada.

2. (a) LM shifts down.

(b) IS shifts up.

(c) FE shifts left.

(d) IS shifts down.

(e) FE shifts right.

(f) LM shifts up.

3. (a) The decline in labour supply increases the real wage and reduces employment and output, shifting FE line to the left. The LM curve shifts up as the price level rises to restore equlibrium. As a result, the real interest rate rises, reducing consumption and investment.

(b) Real money demand rises, which shifts the LM curve up. To restore equlibrium, price level must decline, shifting the LM curve down. There's no effect on any other variable.

(c) The higher tax rate reduces investment, shifting the IS curve down. To restore equilibrium, the LM curve shifts down as the price level falls. As a result, the real interest rate declines, so comsumption increases. There's no change in the real wage, employment, or output.

(d) Increased liquidity on nonmoney assets reduces money demand, shifting the LM curve down. The price level rises, to restore equlibrium by shifting the LM curve back up. There's no effect on the other variables.

4. (a) The real wage rate, employment, output, consumption, and investment decline, while the real interest rate and the price level rise.

(b) The IS curve shifts down, instead of the FE line shifting left, so you are wrong about every variable except consumption. The real wage, employment, and output won't change, the real interest rate and the price level will decline, and investment will rise.

5. (a) 45 bushels/bottle.

(b) 1/45 bottles/bushel.

(c) 11.25 crown per florin.

6. (a) 20; (b) 8% ; (c) 0%.

7. In the short-run, net exports rise, while in the long run net exports fall. The difference is the J-curve effect, because quantities are slower to adjust that prices.

8. The rise in the domestic real interest rate leads to a rise in the demand for domestic assests, raising the exchange rate. The rise in the exchange rate reduces domestic net exports and raises foreign net exports.