Homework 5-
1. Money Market and the Quantity Theory of Money:
Suppose that demand for money in the country of Monia depends on the interest rate r. Money demand in Monia is represented by the function MD = 1400 + (10/r). The current supply of money in Monia is M=1500. Note that the interest rate, r , is written as a decimal (e.g., an interest rate of 1% would be written as 0.01 in the equation).
a. Suppose the money market in Monia is in equilibrium. What is the initial equilibrium level of interest rate in Monia?
b. Suppose that the central bank in Monia determines that the equilibrium interest rate should be equal to 5%. What is the level of the money supply required for the interest rate to be at this level? Assume that the demand for money remains unchanged.
c. Now, suppose that the current interest rate in Monia is 10% and that the Fed has pursued monetary policy so that the supply of money is at the level that should result in an equilibrium interest rate of 5% (this is the level of money supply you determined in part (c) of this problem). At an interest rate of 10%, what is the amount of excess supply of money or excess demand for money? How will the market adjust to the new equilibrium? Describe this process making sure that you make reference to what is happening in the bond market.
d. Given the initial money supply and the initial information, suppose that the government of Monia wants to maintain an interest rate of 8%. What action would the government of Monia need to take in order to ensure an interest rate of 8% in equilibrium?
e. Suppose that in Monia the level of prices is 30 and real income is 300. Calculate the velocity of money in Monia when the interest rate is equal to 10% and when the interest rate is equal to 5%. Assume that the money market is in equilibrium for each calculation.
2. Short-run and Long-run effects using the aggregate demand and aggregate supply model:
Consider the following events:
i. A major new oil field with high quality oil is discovered-this oil field has the potential to supply 30% of the current oil production
ii. Major fraud in the financial markets is uncovered by investigators and this leads to widespread concern about the integrity of all financial market transactions
iii. The government increases its deficit spending in an effort to increase its success in the two wars it is fighting
Assume the economy is at the full employment level of equilibrium before these events and for each one, determine:
- if the event causes a shift in the aggregate demand curve (AD), the short run aggregate supply (SRAS) curve, and/or the long run aggregate supply (LRAS) curve for the United States;
- if the event is followed by an inflationary gap or a recessionary gap; and then
- describe the long run adjustment process that occurs as a result of the event including what happens to aggregate output and what happens to the aggregate price level.
3. Keynesian Model:
The economy is populated by three people: Enrique, Michael, and Chao. The following table reports the level of expenditures for each of the people in this economy. Assume that there are no net taxes or government spending, no foreign sector, and that the level of business spending on investment is equal to zero in this economy. Note that the first column specifies the level of individual income.
|
Level of Individual Income (Aggregate Income in this economy would be 3*Individual Income for each level of income given in this table)
|
Enrique's Spending
|
Michael's Spending
|
Chao's Spending
|
|
5000
|
3000
|
3500
|
5500
|
|
20000
|
9000
|
12,500
|
17,500
|
a. Calculate the aggregate consumption function for this economy.
b. Find the Aggregate Expenditure (AE) function for this economy. This AE equation should be written with respect to aggregate production (Y).
c. What is the level of the income-expenditure equilibrium (assume that there is no government sector, no foreign sector, and that business spending on investment is equal to 0)?
Review Questions:
4. Carolyn can spend her afternoon solving equations or preparing for class. In twenty minutes, Carolyn can either solve 10 equations while doing no class notes or prepare 24 pages of class notes for her discussion while not solving any equations. Today, Carolyn has 1 hour to dedicate to either solving equations or preparing for class, and she would like to solve 12 equations from her linear algebra textbook and 40 pages of class notes.
Is this combination efficient? Draw a graph where the y-axis shows the number of equations that Carolyn can solve in one hour and the x-axis shows the number of pages of class notes she can write in one hour. Explain your answer.
5. Suppose you have the following Demand and Supply equations for a country in autarky (recall that this is a term that refers to the country being a closed economy):
Demand: P=20
Supply: Qs= P -6
Draw a graph of this market and determine the consumer surplus and producer surplus. Explain why the consumer surplus and producer surplus have these values.
6. Use the classical long-run model and the loanable funds framework developed in class to answer this question. In this economy assume that consumption depends upon the level of disposable income (disposable income is equal to total income minus net taxes). Assume the economy described in this question is initially in long run equilibrium. Suppose the government decides to decrease net taxes and government spending by the same amount in this economy. Describes what happens to government savings, disposable income, private savings, consumption, interest rates and investment in this economy with this change in policy. What is the impact of this policy change in the long run? You might find it helpful to remember several things before you answer this question:
- This is a classical model: what do you know about aggregate output in that framework?
- What is the effect of this change in policy on disposable income? How does this change impact the loanable funds market?
- You may find it helpful to draw a graph of the loanable funds market as you work on answering this question.
a. What is the effect of this policy change on government savings?
b. What is the effect of this policy change on disposable income?
c. What is the effect of this policy change on private savings and consumption?
d. How does the change in private savings affect the loanable funds market?
e. What happens to the interest rate and the level of investment because of this policy change?
f. What is the long-run effect of this policy?
7. Chang and Nate produce two goods: X and Y. and both have linear PPFs. Nate has the comparative advantage in the production of good X and his PPF is shown below.
Based on this information, which of the following is a possible equation for Chang's PPF? Explain your answer.
a) 12Y = 24 - 2X
b) Y = 24 - X
c) 4Y = 20 - X