(a) Calculate velocity if Y=600 and i=3.

(b) If the money supply is 1200 then what is the price level?

(c) Suppose that the money supply rises to 1400. If Y and i are unchanged what happens to the price level? Hence what is the rate of inflation?

(d) Is it reasonable to suppose that the nominal interest rate will remain unchanged in such a scenario? If not, would your prediction for inflation in part (c) be too high or too low?

2. This question studies a key business cycle indicator: the seasonally adjusted unemployment rate. Retrieve this variable monthly for 1976-1996. To answer this question you will need to plot and print this time series, using Netscape or some software package with graphics, such as Harvard Graphics, Lotus, Quattro Pro, or Minitab. You will find these packages on the machines in the MC B4-level computing site, for example.

(a) Is the unemployment rate procyclical or countercyclical?

(b) In your opinion, is the unemployment rate leading, coincident, or lagging?

(c) Has the decline in the unemployment rate since the last recession been slower than after the previous two recessions?

3. Suppose the Bank of Canada's short-run response to any change in the economy is to change the money supply to maintain the existing real interest rate. What would happen to the money supply if there were a reduction in government purchases? Given the Bank of Canada's policy, what would happen in the very short run (before general equilibrium is restored) to output and the real interest rate? What must happen to the LM curve and the price level to restore general equilibrium?

4. Consider a closed economy, which is modelled with the following equations:

C = 79 + 0.8(Y-T) - 5r
I = 61 - 10r
T = 30 + 0.25Y
M / P = 0.5Y - 8r

Suppose also that full employment output is 600.
Initially G=199 and M=1104.

(a) Find expressions for the IS and LM curves.

(b) Find the general equilibrium values of consumption, investment, the real interest rate, the price level, and the government budget constraint (assume there is no outstanding debt and there are no transfer payments).

(c) A new government is elected, which seeks to reduce the budget deficit to 1% of GDP. What level of government spending must it set? Find the short-run (before prices adjust) and longer run effects of this policy.

5. Most analysts forecast an appreciation of the Canadian dollar against the U.S. dollar during 1997.

(a) What are three-month treasury bill interest rates in Canada and the U.S. currently? What appreciation would you forecast from the theory of interest rate parity?

(b) What are the inflation rates in Canada and the U.S.? What appreciation would you forecast from the theory of purchasing power parity?

(c) Is PPP a good guide historically?

6. Suppose that you work for a bank that does business in the Sweden. You know that members of the EU are about to tighten fiscal policy in order to meet the deficit targets of the Maastricht treaty. Use the IS-LM-FE model diagram to predict the effects on Sweden.

7. Imagine the following classical economy, in which prices are completely flexible. In the domestic economy, the money market is described by:
M / P = 0.5Y
while in the foreign economy it is given by:
M ^* / P ^* = 0.5Y ^*.
The real exchange rate is constant at 1.0, while Y=100 and Y ^*=300.

(a) Suppose that the domestic money supply is 700 and the foreign money supply is 600. Find the price level in each country, and the nominal exchange rate.

(b) Suppose that the domestic central bank raises its money supply to 770. What happens to the price level and nominal exchange rate?

(c) Suppose that the foreign central bank thought that movements in the nominal exchange rate disrupted trade. How precisely could it maintain a constant nominal exchange rate?

1.(a) V=4/3
(b) P=2.67
(c) Now P=3.5 so the inflation rate is pi = 16.67%.
(d) If the increase in the money supply is expected then it will be reflected in pi^e and so i will rise. That will reduce money demand, and make the inflation rate higher than in part (c).

2. (a) It is countercyclical.
(b) It appears to be coincident, or perhaps coincident at peaks and perhaps lagging at troughs.
(c) [Your argument here.]

3. The decrease in G shifts the IS curve down. The Bank of Canada reduces the money supply and shifts the LM curve up so r does not change. But output declines in the very short run. To restore general equilibrium the price level must fall to shift the LM curve down. If the Bank of Canada wanted to keep the price level from changing so much its correct policy would have been to increase the money supply, not decrease it.

4.(a) The IS curve is:
0.4Y = 116+G - 15r.
The LM curve is just given the rewriting the money-market equilibrium condition.
(b) C=390; I=11; r=5; P=4.25; G-T = 19.
(c) At full employment T=180 so G must be reduced to 186. This shifts the IS curve down and to the left. To find the short run effect, we use the intersection of the IS and LM curves:
0.4Y = 116+186 - 15r
276 = 0.5Y-8r
The answer is: Y=590.28 and r=4.39.
In the long run Y=600 and r=4.133.
The price level is 1.87. C and I have both increased.

5.(a) Three-month Tbill rates are roughly 3% and 4.5% which predicts a 1.5% appreciation.
(b) Depending on the measurement and time period, the inflation rates are roughly 1.5% and 3%. PPP predicts that the real exchange rate is constant, which again would require a 1.5% appreciation.
(c) In practice there are large movements in real exchange rates, so PPP is not a good guide.

6. This is simply the reverse of the case discussed in the textbook (pages 376-378). The EU IS curve shifts down and to the left (the FE line also may shift left if taxes rise and labour supply falls). Thus r and Y fall in the EU. Net exports rise. Then in Sweden NX falls so the IS curve shifts down and to the left. There will be a recession if prices are slow to fall. In the long run, real interest rates will be lower.

7.(a) P=14; P^*=4; e_nom=0.2857.
(b) P=15.4; e_nom = 0.2597, which is a depreciation.
(c) It could increase its money supply to 660.