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2013

1.A)

Y=C+I+G

Y=700+0.6Yd+800+0.2Y-1000i+600

Y=2100+0.6 Yd+0.2Y-1000i

Y=2625+0.75(8500-5000i)-1250i

Y=9000-5000i

Yd=Y-T

Yd=2125+0.75Yd-1250i-500

Yd=2125+0.75Yd-1250i

Yd=8500-5000i

The IS-curve is downward sloping because as the interest rate decreases, more

people will be able to borrow money, and when more money is being borrowed,

more money is being spent, which in turn increases the output (GDP).

B)

LM-curve

MD/P=MS/P

0.2Y-1000i=1300

Y=6500+5000i

The LM curve has an upward slope because as income increases, money demand

increases while bond demand decreases for any interest rate. But because money

supply and bond supply dont change, equilibrium in the market requires the

interest rate to increase bond demand and reduce money demand to get back to

the equilibrium levels.

C)

LM=IS in equilibrium

6500+5000i=9000-5000i

I=0.25

GDP=C+I+G

GDP=9000-5000i=9000-1250=1150

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I=800+0.2(7750)-250=2100

Yd=8500-1250=7250

C=700+0.6(7250)=5050

D)

Private saving: Yd-C=7250-5050=2200

Public saving: T-G=500-600=-100 -deficit

I=(Yd-C)+(T-G)=2200-1100=1100so yes it is in equilibrium

E)

T-G>=0 G=600 T>=600

Yd=2625-0.75Yd-1250i-600

Yd=8100-5000i

Y=C+G+I=2625+6075-3750i-1250i=87000-5000i

LM=IS

Y=6500+5000i

6500+5000i=8700-5000i

i=0.22

GDP=8700-1100=7600I=800+0.2(7600)-2200=120

C=700+0.6(7000)=4900

Both a change in tax or in government spending will have the same effect on the

economy if everything else is kept in equilibrium. Generally expansionary policies

are better in the long run.

Expansionary policy-increased government spending so in this case, the

government used a contractionary policy.

F)

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Government deficit spending has the same effect of a lower saving rate or

increased private investment; so a higher demand for goods at each individual

interest rate. An increase in the deficit by the government, causes a shift of the IS

curve to the right. Thus the equilibrium interest rate is raised (from i1 to i2) and

national income (from Y1 to Y2), as demonstrated in the graphs.

It is evident that rising interest rates leads to discouragement from private fixed

investments, which in turn hurts long-term growth of supply and thus of output.

Now if the government deficits are spent on productive public investment than

the spending is increased directly and eventually raises the potential output. A

move in the IS curve along a relatively flat LM curve can upsurge output

considerably with little change in the interest rate. While an vertical shift in the IS

curve along a vertical LM curve will lead to higher interest rates, but no change in

output.Rightward shifts of the IS curve usually result from exogenous changes to an

economy.

2.

A)

Because in a system of flexible exchange rates on an open economy, central banks

allow the exchange rates to be determined by market forces, thus when the

exchange rates change, so does the peoples borrowing behavior, ultimately

changing the GDP, as more borrowing results in more spending, causing

ultimately a downward sloping IS-curve.

B)

The IP curve represents the inflatory expectations, and it is upward sloping

because it is influenced by risk and insecurity of the inflation rate in an openeconomy.

C)

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A fixed exchange rate may minimize instabilities in economic movements.

On a smaller scale, a country with ill developed or non-liquid money markets may

fix their exchange rates to provide people with artificial money market with the

liquidity of the markets of the country that provides the intermediary currency. A

fixed exchange rate reduces volatility in the relative prices of goods. It helps

eliminate exchange rate risk by lowering uncertainty. It imposes castigation on

the monetary authorities. It helps facilitate international trade.

The main drawback of a fixed exchange rate is that flexible exchange rates serve

to create equilibrium. When a deficit occurs, there will be increased demand forthe foreign while domestic currency wont be sought after, thus itwill push up the

price of the foreign currency used as medium in terms of the domestic currency.

This in turn makes the price of foreign goods less attractive to the domestic

market and thus it decreases the trade deficit.

D)

A government, when having a fixed rather than dynamic exchange rate, cannotuse monetary or fiscal policies with a free hand. For instance, the use of

reflationary tools to set the economic machine the government risks creating a

trade deficit.

Fixed exchange rates do not allow the automatic correction of imbalances in the

economy as the interest rate changes are not dictated by the market. The

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announced exchange rate might not coincide with the natural exchange rate thus

creating surpluses or deficits.

E)

The optimum currency area is a geographical region in which it would maximize

economic efficiency to have that region share the same currency.

It describes the optimal characteristics for the creation of a new currency in the

entire geographic region.

An optimal currency area is often larger than a country, which is demonstrated by

its works in the European Union, which adopted the Euro as the optimum region

currency.

The criteria are:High labor and capital mobility.

Price and wage flexibility across the region.

Ability of the government to transfer funds or adjust taxation across the region.

3.

A)Housing prices determine the wealth of individuals. The falling housing prices in

2008, followed by a decrease in general wealth of individuals, forced consumption

down. A lower expected budget and wealth affects consumption today, and

tomorrow in economic terms.

B)

^diagram above IS-LM curve.

Lower taxes and lower governmental spending will have nearly the same effect as

a higher governmental spending and higher taxes, but in the same time hurtsmoney liquidity within the economy. With lower taxes investments will get lower,

while the interest rate will go up. This in turn my hurt the general output of that

economy.

C)

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A fixed interest rate would push the economy towards a surplus or deficit if that

exchange rate does not mirror the natural exchange rate into the new economy.

If the economy is in equilibrium and the exchange rate is adequate then there

might be an increase in output.

D)

If the Ricardian equivalence holds, than the amount of taxation does not influence

consumption of the population, thus the government will definitely have to

impose a contractionary policy instead of the expansionary one, as it seem futile.

4.

A)

The real interest rate creates an equilibrium between the savings supply and the

demand for investment funds. The nominal interest rate is the actual rate of

interest charged by the suppliers and paid by the demanders. The nominal rate of

interest differs from the real rate of interest. The first being a premium due to

inflationary expectations and the second being a premium due to issuer and issue

risks.

B)

To avoid purchasing power erosion through inflation, investors consider the real

interest rate, rather than the nominal rate. One way to estimate the real rate of

return in a country is to observe the interest rates on government issued bonds

and government protected securities. The difference between the yield on a

government bond and the yield on government protected security of the same

maturity provides an estimate of inflation expectations in the economy, thus

influencing investment in a country.

C)