Consider a closed economy in which the population

Subject: Economics / Microeconomics
Question
1. Consider a closed economy in which the population grows at the rate of 1% per year. The per-worker production function is y = 6k 1/2, where y is output per worker and k is capital per worker. The depreciation rate of capital is 14% per year.

a. Households consume 90% of income and save the remaining 10% of income. There is no government. What are the steady-state values of capital per worker, output per worker, consumption per worker, and investment per worker?

b. Suppose that the country wants to increase its steady-state value of output per worker. What steady-state value of the capital-labor ratio is needed to double the steady-state value of output per capita? What fraction of income would households have to save to achieve a steady-state level of output per worker that is twice as high as in Part (a)?

2. An economy is described by the following equations:

AD Y = 4000 + 2(M/P)

SRAS Y = YFE + 100(P –Pe)

Okun’s law (Y – YFE)/YFE = -2(u – uN).

In this economy full-employment output YFE equals 6000 and the natural unemployment rate uN equals 0.05.

a. Suppose that the nominal money supply has long been constant at M = 4000 and is expected by the public to remain constant forever. What are the equilibrium values of the price level, P, the expected price level, Pe, expected inflation, output, and the unemployment rate?

b. A totally unexpected increase in the money supply occurs, raising it from 4000 to 4488. What are the short-run equilibrium values of the price level, expected price level, output, and unemployment rate? What are the values of cyclical unemployment and unanticipated inflation?

c. What is the slope of the expectations-augmented Phillips curve in this economy?

3. Consider the following classical economy:

Desired consumption Cd = 300 + 0.5Y – 200r.

Desired investment Id = 200 – 300r.

Government purchases G = 100.

Net exports NX = 150 – 0.1 Y – 0.5e.

Real exchange rate e = 20 + 600r.

Full-employment output Y = 900.

a. What are the equilibrium values of the real interest rate, real exchange rate, consumption, investment, and net exports?

b. Now suppose that full-employment output increases to 940. What are the equilibrium values of the real interest rate, real exchange rate, consumption, investment, and net exports?

4. A positive supply shock, hits the economy. Using IS-LM-FE analysis, answer the following questions:

a) Suppose that the shock is temporary. Determine long-run effects of this shock on output, interest rate, saving, investment, consumption, price level.

b) Now, suppose that the shock is permanent. Determine long-run effects of this shock on output, interest rate, saving, investment, consumption, price level.

5. Investor pessimism causes a fall in desired investment.

a. Determine the effects of this change on output, the real interest rate and the price level using the IS-LM model. Distinguish between the short-run and the long-run assuming price stickiness in the short run.

b. Suppose you are a classical macroeconomist. Would you expect this demand shock to cause a recession? Why or why not? What would be your policy recommendation to the government in response to the shock?

c. Suppose you are a Keynesian macroeconomist. Would you expect this demand shock to cause a recession? Why or why not? What would be your policy recommendation to the government in response to the shock?

d. Suppose that the government wants to stabilize output, i.e. keep the level of output constant, in the short run. How can it use monetary and fiscal policies for this purpose? Explain and show the effects of these policies on the IS-LM diagram.

e. Now suppose that the government aims to stabilize the real interest rate, i.e. keep the real interest rate constant, in the short run.

6. Determine the effects of each of the following on nominal exchange rate

a. Central bank increases money supply which causes a fall in interest rates.

b. A terrorist attack hits the country which increases the riskiness of investments in the country

c. For some reason, people start to believe that the domestic currency will appreciate in near future.

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