ECON 2102 Assignment 2 – In the long-run model

ECON 2102 Assignment 2 – In the long-run model

Subject: Economics    / General Economics
Question

Econ 2102H – Winter 2017
Dana Galizia, Carleton University Assignment 2
(in class) A True or false (9 marks total)
For each of the statements in Section A, determine whether it is true or false, then explain in a few sentences why that is the answer. Note: no marks will be given for answers that do
not include an explanation.
1. (3 marks) In the long-run model of chapter 4, the real money supply is exogenous.
2. (3 marks) When inflation is below its anticipated level, lenders typically gain at the expense
of borrowers.
3. (3 marks) The LM curve gives the short-run equilibrium combination of r and Y . B Short answer (25 marks total)
Answer each of the questions in Section B. Answers should typically be no more than 2-3 sentences in length.
1. (5 marks) Consider the long-run model of chapter 4, and suppose inflation increases. How
might this affect demand for real money balances? Explain.
2. (5 marks) Define the ex ante and ex post real interest rates, and explain why they might be
different.
3. (5 marks) What is the difference between the nominal interest rate and the real interest rate?
As part of your answer, define these two interest rates.
4. (5 marks) In our model of chapters 9-10, we said that output was “supply-determined” in the
long run, but “demand-determined” in the short run. Explain in your own words what this
means.
5. (5 marks) Explain why the IS curve is downward-sloping using the goods-market approach. 1 Econ 2102H – Winter 2017
Dana Galizia, Carleton University C Problems (66 marks total)
1. (18 marks total) Assuming output Y is determined exogenously, and demand for real money
balances is given by (M/P )d = kY , answer the following:
(a) (2 marks) Suppose k changes exogenously from period to period. Using the quantity
equation M V = P Y , show how inflation is related to money growth, output growth,
and growth in k.
(b) (2 marks) Holding the money supply M and output Y constant, does a fall in k lead to
inflation, deflation, or no change in the price level? Explain in words why this is.
(c) (2 marks) What, if anything, should the central bank do in response to a decrease in k
(assuming Y does not change) if it wishes to maintain zero inflation?
(d) (12 marks) Fill in the blanks in the following table: Year %?Y %?M 1 3% 5% 2 2% %?k -1% r 6% 3% 7% 5% 3% 4 5% -2% 6% -1% 1% 1% 6 -1% 5% i 4% 3
5 ? -4% 2%
8% 5%
5% 6% 2. (32 marks total) Consider the AD-AS model of chapter 9, with the AD curve derived from
the QTM. Suppose the economy is initially in long-run equilibrium, when a technological
improvement in the banking sector causes people to want to hold a lower level of real balances
for any given level of output. Assume that firms cannot immediately adjust their prices to
this shock.
(a) (2 marks) What happens to velocity as a result of this shock? What will happen to the
AD curve?
(b) (3 marks) Show the initial AD, LRAS and SRAS curves in a graph, and then show how
the AD curve shifts in response to this shock.
(c) (2 marks) Explain what happens to the amount of labour firms employ L, output Y ,
and the price level P upon arrival of this shock (i.e., in the short run). In the graph you
drew in part (a), show the short-run equilibrium combination of Y and P .
(d) (3 marks) In the long run, assuming no further changes in AD, what must happen to L,
Y , and P ? Show the new long-run equilibrium in the graph you drew in part (a).
2 Econ 2102H – Winter 2017
Dana Galizia, Carleton University (e) (2 marks) Explain in words how and why the economy transitions from the short-run
equilibrium to the long-run equilibrium. Be sure to explain the role that firms’ motivations play in this transition.
(f) (3 marks) Suppose the central bank wishes to have Y be at its long-run level Y¯ at all
times. What policy should it enact in response to the shock? Show in a graph how this
policy works.
(g) (2 marks) Suppose the central bank wishes to have P return eventually to its pre-shock
level. What policy should it follow in response to the shock? How, if at all, is this policy
different from the one you found in part (f)? Based on your answer, does the central bank
face any trade-off between stabilizing short-run output and stabilizing long-run prices in
response to shocks of this sort?
(h) (15 marks) Re-do parts (b)-(g), except instead of a shift in the AD curve, suppose there
is a shock that lowers firms’ prices, which shifts the SRAS curve down (e.g., for (b) show
the initial equilibrium, and the effect of the shock on the SRAS curve, etc.).
3. (16 marks total) Using the IS-LM model discussed in chapter 10, suppose you’re given the
following information:
• The consumption function is given by C = 20 + 0.75 (Y ? T ).
• The investment function is given by I = 25 ? 2.5r.
• T = 40, and G = 30.
(a) (2 marks) Find planned expenditure P E as a function of Y and r.
(b) (4 marks) For the case where r = 4, find the value of Y that produces equilibrium in
the goods market. Draw a Keynesian cross diagram that shows graphically how this
Y is determined. Be sure to clearly label all axes, curves, intercepts, slopes, and the
equilibrium.
(c) (4 marks) Find the IS curve using the Keynesian cross approach. In particular, rearrange
the goods market equilibrium condition to find the equilibrium value of r as a function
of Y . Then, in a graph with Y on the horizontal axis and r on the vertical axis, plot this
IS relationship. Be sure to clearly label all axes, intercepts, and slopes.
(d) (3 marks) Suppose G increases to 40. For any given value of r, how much does Y change?
What is the government spending multiplier?
(e) (3 marks) In response to the increase in G from part (e), does the IS curve shift? If so,
in what direction and by how much? 3