Economics 222

Assignment #4

 

1. Consider two trading partners, a home and a foreign country. Use the two-country IS-LM-FE model to describe what happens in each country in the following scenarios.

a) The domestic central bank follows a contractionary monetary policy. [7 points]

b) A fiscal contraction in the foreign country brings about a recession there. [7 points]

 

2. This question deals with exchange rates and the money supply.

(a) What happens to the fundamental value of a country's exchange rate when it raises its money supply in a fixed exchange rate system? Does this make the currency over-valued or under-valued if originally the official exchange rate equaled the fundame ntal value? Use diagrams. [5 points]

(b) What happens to the fundamental value of a country's exchange rate when the foreign country raises its money supply in a fixed exchange rate system? Does this make the currency over-valued or under-valued if originally the official exchange rat e equaled the fundamental value? Use diagrams. [5 points]

(c) If a country wants to maintain its official rate equal to its fundamental value, what must it do when a foreign country raises its money supply? What happens to inflation? [5 points]

 

3. Suppose that for the economy of Chou,

Tax revenues = 2000 + 0.1 GDP

Transfers = 1500 - 0.05 GDP

Government purchases = 3000

Interest payments = 200

Full employment GDP = 15,000

Actual GDP = 16,000

a. How much is the budget deficit? [5 points]

b. How much is the primary budget deficit? [5 points]

c. How much is the full-employment budget deficit? [5 points]

 

4. Suppose that all workers place a value on their leisure of 75 goods per day. The production function relating output per day Y to the number of people working per day N is

Y = 500 N - 0.4 N2

and the marginal product of labour is

MPN = 500 - 0.8 N

A 35% tax is levied on wages.

a. How much is output per day? [6 points]

b. In terms of lost output, what is the cost of the distortion introduced by this tax? [7 points]

 

5. Consider the following misperceptions model of the economy:

AD Y = 600 + 10(M/P)

SRAS Y = Yfe + P - Pe

Okun's Law (Y - Yfe) / Yfe = -2(u - ufe)

Let Yfe = 750, ufe = 0.05, M = 600, and Pe = 40.

a. What is the price level? [5 points]

b. Suppose there is an unanticipated increase in the nominal money supply to 800. What is the short-run equilibrium level of output [3 points] , the unemployment rate [3 points], and the price level [3 points] ?

c. When price expectations adjust fully, what is the price level? [5 points]

 

6. Last term, the Governor of the Bank of Canada (Gordon Thiessen) presented the 1998 Gibson Lecture at Queen's University. The topic of the Governor's presentation was "The Canadian Experience with Targets for Inflation Control". Read the paper at the Bank of Canada website,

(http://www.bank-banque-canada.ca/english/sp98-5.htm)

Based on the information found in the paper, what are three major benefits of inflation control targets? Explain each of the benefits in two or three sentences. [12 points]

 

7. The definition of the Bank Rate has changed since the textbook was published. Read the information backgrounder produced by the Bank of Canada

(http://www.bank-banque-canada.ca/english/bg-p-3.htm)

Define the Bank Rate. Be sure to mention the following issues:

a) How does the Bank Rate relate to the "overnight lending rate"? [4 points]

b) What is the "operating band"? [4 points]

c) Why do changes in the Bank Rate often lead to changes in the commercial banks' prime rate? [4 points]

 

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Solutions to Assignment 4

Assignment 4 Answers

Economics 222

 

Q1. This answer should include clear and correctly-labeled IS-LM-FE diagrams which are consistent with the written analysis.

a) A CONTRACTIONARY MONETARY POLICY IN THE HOME ECONOMY:

Home Economy: a reduction in money supply shifts the LM curve to the left.

In the short-run (Keynesian) solution: the economy moves to the intersection of the new LM and old IS curves. Domestic income (Y) declines and domestic interest rate (r) increases. Domestic currency appreciates (e rises) for two reasons: (1) The reduction in Y leads to a fall in imports (M) which reduces demand for foreign currency and thus the supply of domestic currency on the foreign exchange market; (2) The increase in r increases demand for domestic assets and domestic currency.

There are two competing effects on NX. (1) The fall in Y reduces M and increases NX. (2) The increase in e (appreciation of currency) reduces NX.

If one assumes that theY effect dominates, NX rises (this is the case in the text). If one assumes that the exchange rate effect dominates, NX falls. The different implications for the foreign economy are discussed below.

In the long-run: prices fall (inflation slows); LM shifts back to its original position. All real variables are unaffected (e, Y, NX). This is another example of monetary neutrality. The nominal exchange rate appreciates (enom = e*Pfor / P) as P has declined.

 

Foreign economy:

In the short-run (Keynesian) solution: If we assume that domestic NX rises, then foreign NX falls and the foreign IS curve shifts left. Foreign income (Yfor) falls; foreign interest rate (rfor) falls.

If we assume that domestic NX falls, then foreign NX rises and the foreign IS curve shifts right. Foreign income (Yfor) increases; foreign interest rate (rfor) rises.

In the long-run: the foreign IS curve shifts back to its original position as all real variables (including NX) return to their original levels.

 

b) A FISCAL CONTRACTION IN THE FOREIGN ECONOMY:

 

Foreign economy: The reduction in government spending shifts the foreign IS curve left.

In the short-run (Keynesian) solution: the economy moves to the intersection of the new IS and old LM curves. Income (Yfor) falls; interest rate (rfor) falls. These changes have offsetting effects on the real exchange rate. The reduction in income reduces the demand for imports and the demand for home currency, raising the exchange rate. The reduction in the interest rate makes foreign assets less attractive and reduces the demand for foreign currency, lowering the exchange rate. If the first (income) effect is stronger, e increases and foreign NX fall. If the interest-rate effect is stronger, e falls and foreign NX rises.  

In the long-run: Prices fall. LM shifts back to restore full employment. There is then a lower rfor, and a lower Pfor than in the original equilibrium.

[Note: the FE line could shift to the left as well, due to a labour supply response to tax-changes related to reduced government spending].

 

Home economy:

i. If foreign NX increases, domestic NX falls, shifting the IS curve to the left.

In the short-run: Both income (Y) and the interest rate (r) fall.

In the long-run: P falls and the LM curve shifts down to restore general equilibrium. We end up with a lower r, and a lower P.

ii. If foreign NX falls, the domestic NX increases, shifting the IS curve to the right.

In the short-run: Both income (Y) and the interest rate (r) rise.

In the long-run: P rises and the LM curve shifts right to restore general equilibrium. We end up with a higher real interest rate (r), and a higher price level (P), than in the original equilibrium.

 

Q2. Please see pp. 387-8 in the textbook.

a) Fundamental value falls below the official rate; the currency is overvalued.

b) Fundamental value increases above the official rate; the currency is undervalued.

c) The country must raise its money supply. This leads to inflation worldwide.

 

Q3.

a) Deficit = expenditure - revenue.

= G + TR + INT - T

= 3000 + 1500 - 0.05(16,000) + 200 - 2000 - 0.1(16,000)

= 300

 b) Primary deficit = expenditure - net interest - tax revenue

= G + TR - T

= 3000 + 1500 - 0.05(16,000) - 2000 - 0.1(16,000)

= 100

c) Full employment deficit is the deficit evaluated at full-employment GDP.

= 3000 + 1500 - 0.05(15,000) + 200 - 2000 - 0.1(15,000)

= 450.

 

Q4.

a) Use supply and demand for labour to determine the employment level.

Supply: workers set their marginal benefit (after-tax wage) equal to marginal cost (value of leisure).

(1) w(1-t) = 75.

Demand: firms hire workers until the wage equals the marginal product of labout.

(2) w = 500 - 0.8N.

Letting t= 0.35 in (1) yields w = 115.4. Substituting into (2) yields N = 480.75. Thus output Y = 147927.

 

b) Calculating employment and output without the tax. The labour demand equation is unchanged, while labour supply changes to:

(1) w = 75.

Substituting into (2) yields N = 531.25. Thus Y = 152734. In the absence of the tax, output is 4807 units higher.

 

Q5.

a) Set AD = SRAS to find the price level P.

Yfe + P - Pe = 600 + 10 (M/P)

750 + P - 40 = 600 + 10(600/P)

110 + P = 6000/P

Multiply both sides by P, rearrange and factor:

P2 + 110 P - 6000 = 0

(P + 150)(P - 40) = 0.

The nonnegative solution is P = 40.

[Note: here the actual price level equals the expected price level ( P = Pe). Output and the unemployment rate are thus at their long-run equilibrium values (Y = Yfe; u = ufe).

 

b) Set AD equal to SRAS with M = 800:

600 + 10(800/P) = 750 + P - 40

P2 + 110P - 8000 = 0

(P + 160)(P - 50) = 0.

The nonnegative solution is P = 50.

The SRAS gives:

Y = 750 + 50 - 40 = 760.

The unemployment rate is from Okun's law:

[(Y - Yfe) / Yfe ] = -2 ( u - ufe )

Substituting,

(760 - 750)/750 = -2 (u - 0.05)

Which solves for u = 0.043.

c) In long-run, Pe adjusts to equal P; Y = Yfe and u = ufe. Find P from the AD curve:

750 = 600 + 10 (800/P)

P = 53.333

 

Q6, Q7 Answers will be evaluated individually. A good explanation will suffice.

 

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