Running head; MACROECONOMIC THEORY AND POLICY

MGEB05 – LEC 01

Macroeconomic Theory and Policy

Assignment 2

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Question 1 (20 points: 10 points for each part, A & B) – Chapter 3 & 5

Suppose you are an economic expert who works as an economic analyst in a small open

economy (SOE) that presently has perfect financial capital mobility and no risk premium. The

government of a large open economy (LOE) is considering adopting one of the following

economic policies:

1) A subsidy geared to the construction of investment within the economy of the LOE; or

2) An increase in taxes to help lower the government budget deficit of the LOE.

Draw a pair of diagrams, one for the domestic loanable funds market of the SOE and one for

the market for foreign exchange, that depict the impact of the proposed LOE polices on the

SOE (i.e. two sets of two diagrams in total).

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In the figure above equilibrium is approached when the quantity of saving that

corresponds to supply of loanable funds equal investment as well as the net capital outflows that

is the demand of the loanable funds.

The supply of loanable funds (SLF) always slopes upwards this is because the higher the real

interest rates the higher the returns one get from giving or loaning his or their own money. The

demand for loanable fund (DLF) on the other hand slopes downwards, this is because the higher

the real interest rate the higher the price someone has to pay for a given loan.

a) Suppose you are hired by the association of homebuilders of the SOE. Use your diagrams

to provide an analysis of the impacts of each potential LOE policy on their industry. In

your expert opinion which potential LOE policy is most preferred (by this group)?

Explain why. Which policy is less preferred (by this group)? Explain why.

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When the government increases taxes t increases the quantity of available loanable funds aimed

at purchasing assets thus shifting the demand curve (DLF) to the right, and hence increasing the

real interest rate. On the other hand this affects the foreign exchanges, since individuals will

want to more secure currency the supply of the foreign currency will increase and hence shifting

the supply curve to the right.

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On the other hand a subsidy geared construction of investment will lead to reduction of the

quantity of the available loanable funds, and hence shifting the S LF to the left. Shift in the

supply of loanable funds will lead to increase of real inters rates to i 1. An increase in the interest

rates will results to reduction of the capital outflows and hence reducing the quantity of foreign

currency supplied which results to ultimately appreciation of exchange rates. The best policy in

this case is the tax increase that reduces the government deficit. This police stimulates the

growth in the economy by increasing the demand of loanable funds and hence increasing the

aggregate demand in the commodity market.

b) Suppose instead, you are hired by the association of importers of the SOE. Use your

diagrams to provide an analysis of the impacts of each potential LOE policy on their

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industry. In your expert opinion which potential LOE policy is most preferred (by this

group)? Explain why. Which policy is less preferred (by this group)? Explain why.

Imports quota reduces imports at a given real exchange rets and he net export rises.

Therefore, foreigners need to buy more home currency in order to buy more home products

and hence shifting the demand of the home currency (D€) to the right. This will increase the

real exchange rate but will have no effect on the market for loanable funds and hence the real

interest rate will remain at a constant. Since the real interest doesn’t alienate the net cash

capital outflow will not change. But the appreciation of the home currency will increase the

imports but reduces the exports and hence returning the demand of home currency (D€) to its

initial position. In this case therefore, there is no preferred policy because the trade policy

don’t affect the trade balances.

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Question 2 (35 points) – Chapters 6, 10 & 11

The closed economy of Temptation Island is characterized by the following equations:

Consumption: C = 6000 + 0.85(Y – T)

Investment: I = 1500 – 300r

Government spending: G = 5000

Taxes: T = 4500

Real money demand: L = 0.65Y – 500i

Expected inflation: e = 0

Production function: Y = K1/2L1/2

The nominal money supply = 35000

Note: Interest rates, both i and r, are expressed in percentage points, i.e., if r = 5.5, then the real

interest rate is interpreted as being equal to 5.5%.

Suppose the IS-LM model can be to describe Temptation Island, and answer the following

questions. Keep your answer to at least THREE decimal points if necessary.

a) Derive the IS and LM equations for this economy. (4 points)

+I+ G

Y= income

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C=consumption

I= investment

G= government expenditure

CURVE WILL BE

Deriving the LM curve

Md= Ms

Md= demand for money

Ms=supply for money

Ms= 35000

LM equation;

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b) Suppose we are in the base period, so the price level is fixed at 1.00. Calculate the resulting

short-run equilibrium values of real output, real interest rate, investment, consumption, the

government budget balance, and price level. (3 points)

At equilibrium IS=LM

Re= equilibrium interest rates

Ye= equilibrium income

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c) Suppose, in the long-run, 64000 (real) units of capital are utilized and 36000 workers are

employed. Calculate the resulting full-employment values of real output, real interest rate,

investment, consumption, the government budget balance, and the price level. (3 points)

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d) Suppose the government decides to change the level of taxation to create budget surplus of

600. Calculate the resulting (new) short-run equilibrium values of real output, real interest

rate, investment, and consumption. Determine the unemployment rate that results in short-

run equilibrium. (6 points)

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e) Suppose, instead, we are also told that when the economy was in long-run equilibrium (in

part C, above) 1500 people were unemployed. Further, when the shock hit the economy

(in part D, above) in net terms no people have exited the labour force. Determine the

unemployment rate that results in the short-run equilibrium from part D. What portion this

unemployment is represented by cyclical unemployment and what portion is comprised of

those in the natural rate (level of) unemployment (NRU). (4 points)

Hint: Cyclical unemployment is the level of unemployment that results from deviations of

output from the full-employment level (Actual U = Cyclical U + NRU).

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f) When the economy returns to long-run equilibrium what unemployment rate should we

expect to see? Explain why/when this makes sense. (4 points)

g) Determine the (new) LR equilibrium values of real output, real interest rate, investment,

consumption, and the real money supply that result due to the shock described in part D

(above). (6 points)

h) Draw one well labeled IS/LM diagram that depicts the initial LR, the new SR and new LR

equilibria for this economy. Be sure to clearly identify the different equilibrium points on

your diagram, but no further written explanation is required. (5 points)

Question 3 (25 points) – Chapter 9 & 11

The closed economy of North Korea is experiencing a debate about the strength and

appropriateness of certain government policies. Significant debate is occurring among

different groups within the country. The economy is presently in a short-run equilibrium in

which a significant portion of the labour force is cyclically unemployed. The debate is raging

as to what mix of government policies would be most effective at meeting the governments’

short-run and long-run economic objectives.

Expert #1 has proposed that the government should use changes in government spending on

goods and services to achieve the unemployment goal.

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Expert #2 counters that changes in taxes are better as long as they are accompanied by an

equal and opposite change in the money supply (that is, if taxes rise by $1, then the

government also reduce the money supply by $1, and vice versa).

a) This part focuses on the governments two short-run objectives of ensuring unemployment

is not too high and keeping the size of government saving from becoming too small.

Which of these policy mixes is most effective at meeting the governments’ short-run goal?

Explain, using words and a single AS/AD diagram and a single IS/LM diagram, the

degree of effectiveness of each of the policy mixes. (9 points)

LRAS
Expansionary fiscal policy
Price level

SRAS

AD2
AD1

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The above government fiscal policy is aimed at kick-starting the economy during the recession

period. On this case North Korea is trying its best to cover up the unemployment rate, imposing

less tax and increasing the government expenditure boost the aggregate demand, an increase in

government expenditure will lead to a shift of demand curve to the right. On the other hand, the

reduction of taxes will lead to more disposable income and hence causing an increase in saving.

Thus an increase in saving leas to shifting of the demand curve to the right. An extensive

increase in government spending, as well as reduction of taxes, leads to a significant shift of

Aggregate Demand to the right. Reduction of taxes, on the other hand, affects the IS demand also

by increasing the disposable income of individuals and hence raising the demand of individuals.

As a result, there is a shift in the IS curve to the right.

b) This part focuses on the governments two long-run objectives of keeping inflation form

getting too high and ensuring investment is not too low in the longer term. Which of these

policy mixes is most effective at meeting the governments’ long-run goals? Explain, using

words and your single AS/AD diagram and single IS/LM diagram (from part A), the

effectiveness of each of the policy mixes. (10 points)

Inflation fluctuation always occurs mostly during or just after the economic booms. If the

aggregate demand continues to shift t the right when the economy is already at the full potential,

they will be forcing of pushing macroeconomic equilibrium to the steep portion of the aggregate

supply curve. The below diagram shows the new equilibrium at E1 as well as high price level

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than the original one. At this level, the economy has soared so much that the firm in the economy

is not able to produce additional output because labor and capital-output are fully employed. It is

at this point the government need to reduce its government spending and increase the taxes and

hence returning back to the previous price level.

When the government increases its spending with the aim of tackling the employment rate

affects the IS curve by raising the aggregate demand for goods and services and hence causing a

shift of the IS curve outwards. With this the interest rates shift from i1 to i2 and hence

equilibrium shifting from the E1 to E2.

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c) Suppose you are an expert having studied ECMB06H. Then, all things considered, which

of these policy mixes would you recommend the government adopt? Explain why. (6

points)

The best policy that should be utilized by the North Korea government is that the government

should use government spending on good and service to achieve the unemployment goal. The

main reason is that this will majorly impact the private sector by developing the crowding

effects. On the other hand, increase government expenditure directly induces the money to the

economy and hence increasing the money supply and thus leading to high aggregate demand for

goods and services. An increase in demand will lead to high demand in the labor sector due to

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less supply as compared to the demand and hence fulfilling the objective of the government of

reducing unemployment.

Question 4 (20 points: 10 points for each part, A & B) – Chapter 10 & 11

Presently many European countries are in the middle of an economic slump, where output

has fallen below potential output (by a large degree in the case of some countries). Suppose

one of these countries decides to follow the advice of a noted economic expert who claims

what the economy needs to boost output and employment in the short-run is the passage of a

properly designed government austerity package. By austerity we mean a package where the

government attempts to improve the size of their budgetary deficit. The expert claims that a

properly designed and executed austerity package will created beneficial changes to consumer

and business confidence.

We assume this country is large enough that we can easily use the closed economy IS/LM

model to describe its economic conditions.

a) Draw one IS/LM diagram that depicts the initial short-run equilibrium along with any

(and all) shifts in the short-run that are implied by the experts’ arguments. Explain in

words how and why each curve shift has occurred. Does it seem the expert claims are

reasonable or not? Explain.

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Basing on the point of full-employment situation where IS and LM crosses, in this case there is

a decline on the desires to invest in the economy and hence the IS curve shift downwards to IS'.

During the shot-run before adjustment of the prices, the real interest rates will drop from r1  to  r2

and output as well as the income fall from their point Y1 which is the full-employment levels.

Basing on the aspects argument the that the government need to improve their government

budget it is reasonable, this is because increase in government budgetary will shift IS' to IS and

hence increasing output and employment from Y1 to YF.

b) Draw a second IS/LM curve that depicts what would occur in the short-run, if in addition

to the shock in part A, agents also tend to demand more money the larger the government

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budget deficit. Explain in words whether this additional force works to assist or to

undermine the experts’ claim.

The above graphs depict more shock outline by the increase in budgetary of the government.

Anthe more the budgetary the more the imposition of aggregate supply in the economy and

hence forcing the IS curve to further more to the above red dotted position and increasing in the

output and unemployment in the economy. Excessive additional of these forces is not good for

the economy and the larger market at large this is because of more increase in interest rate and

hence leading to more inflation in the market.

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