Macroeconomic Theory and Policy: A Mathematical Approach LEC-01

MGEB06 LEC 01-06

Macroeconomic Theory and Policy: A Mathematical Approach

Assignment 1

Due: On or before Friday, April 4th, 5:00pm

Room: Management department DROPBOX (2nd floor of IC-Building near IC-230)

(Note: Assignments submitted after Friday, April 4th, 5:00pm WILL NOT BE accepted under ANY circumstance.)

All submissions must be in hardcopy form handed into the department of management Drop- Box located on the 2nd floor of the IC-building just to the left of IC-230 & just outside the main entrance to the office wing)

Instructions:

• You may submit an individual or group

• If you submit a group assignment, there should be no more than FIVE students in your group (from ANY section of MGEB06 this term) and you must submit just ONE copy. WORK WITH STUDENTS BELONGING TO THE SAME GROUP ONLY.

• A title page MUST be attached with your assignment; it MUST include the name(s) and student number(s) of ALL group members. (No names will be added after the fact)

• Staple your assignment (Paper clips are not accepted).

• A PENALTY OF 10% OF THE TOTAL MARKS WILL BE IMPOSED IF YOU DO NOT HAVE A TITLE PAGE OR STAPLE YOUR i.e., up to 20% will bededucted if both of these tasks are not completed.

• Label all curves, axis & equilibria in your diagrams/graphs; otherwise, marks will be

• No credit will be given if you do not show your

• Your answer should be structured in a way such that those who know little about economics will have no difficulty in understanding your argument/answer.

• Total marks: 100

The table below should be the cover page of your submitted assignment.

Question 1 (25 points) Chapters 4 & 5

Canada is a small open economy, and the U.S. is a large open economy. Currently, Canada is running a trade surplus with the U.S.

Use the long-run classical model of a small open economy to answer the following questions, and support each part of the question by a set of new diagrams (one for the loanable funds market and one for the foreign exchange market).

1. Recently, there are signals showing that there may be a slowdown of the U.S. economy. In attempt to avoid a potential recession, the U.S. government provides a tax rebate to all American households. What happens to the following variables:
   
   
   • National saving, trade balance, and price level in Canada
   
   
   • National saving and price level in the S.
   
   
   • Real exchange rate, eUS$/C$
   
   
   

Be sure to provide an explanation on whether the values of variables of interest change or remain unchanged (and why this is so). (9 points)

2. Now, instead of providing a tax rebate, in attempt to avoid the recession the Federal Reserve, the U.S. central bank, runs an expansionary monetary policy. Redo part (a). (8 points)

3. Suppose the fiscal and monetary policies in the U.S. remain unchanged. The possible slowdown of the U.S. economy make Canadian households worry that Canada may experience also a slowdown; as a result, they save more and consume less. Redo part (a). (8 points)

Question 2 (25 points) Chapters 3, 4, & 5

Suppose you are given the following information:

In the questions:

• All the growth rates are annual growth

• Exchange rate is quoted as the number of units of foreign currency needed to exchange for (buy) one domestic currency unit, eFC/DC.

• Purchasing power parity

1. Find the growth rate of output in both (Hint: The growth accounting equation). (4 points)

1. What is the inflation rate in Home? In Foreign? (4 points)

1. What is the rate of change in the nominal exchange rate? Which currency is expected to appreciate? At what rate? (4 points)

Now, suppose the government of Home appoints a new governor to the countrys central bank. The newly appointed governor believes that deflation would be harmful to the economy and decides to set an inflation target of 2% per year.

4. What should the central bank of Home do to achieve this inflation target? What would be the new growth rate of domestic money supply? (4 points)

5. Redo part (c) with an inflation target of 2% in Home. (4 points)

Now, instead of having an inflation target, the newly appointed governor of Homes central bank wants to keep the nominal exchange rate from changing (i.e., it wants to have a fixed exchange rate).

6. What should the central bank of Home do to keep the exchange rate fixed? What happens to the domestic inflation rate? What would be the new growth rate of domestic money supply? (5 points)

Question 3 (35 points) Chapters 10 & 11

Consider the following closed economy that is characterized by the IS-LM model: Consumption: C = 2750 + 0.75(Y T) 400r

Investment: I = 3500 600r Taxes: T = 2250

Government spending: G = 1750

Real money demand: L(r + p^e, Y) = 0.25Y 2400r, where p^e = 0. Money supply: MS = 48800

Production function: Y = 0.625K^1/3L^2/3

Note: Real interest rates, r, is expressed in decimal points. For example, if r = 0.5, then r = 50%. Keep your answer to 3 decimal points if necessary.

1. Derive the IS and LM equations for this economy (express both functions in terms of Y). (2 points)

1. The supply of capital and labour in this economy equal to 15625 and 64000 respectively. Compute the long-run values of the output, real interest rate, price level, and investment. (3 points)

Suppose both government spending and taxes fall by 500.

3. Assuming that the economy was initially at full employment as shown in part (b), what are the new values of output, real interest rate, and price level in the short run and the long run? (5 points)

4. Use words and ONE IS-LM diagram to explain your answer in part (c). Note: only the first diagram will be graded. (5 points)

Instead of changes in government spending and taxes, the economy suffers a technological setback such that the state of technology (A) falls by 10%.

5. Assuming that the economy was initially at full employment as shown in part (b), what are the new values of output, real interest rate, and price level in the short run and the long run? (5 points)

6. Use words and ONE IS-LM diagram to explain your answer in part (e). Note: only the first diagram will be graded. (5 points)

Suppose the economy starts at its long-run equilibrium as described in part (b), and there is a change in the preference of holding money. The new real money demand function becomes:

L(r + p^e, Y) = 0.275Y 2400r

7. Assuming that the economy was initially at full employment, what are the new values of output, real interest rate, and price level in the short run and the long run? (5 points)

8. Use words and ONE IS-LM diagram to explain your answer in part (e). Note: only the first diagram will be graded. (5 points)

Question 4 (15 points) Chapters 10 & 11

Determine whether the following statements are True, False, or Uncertain. Each sub-part is a separate question. For each part of the question use words and ONE IS-LM diagram to explain your answer.

Note:

• The economy in question is a closed economy and is initially in its long-run

• For each part of the question, only the first diagram will be

1. It does not matter whether the central bank uses (real) interest rate targeting or (real) output targeting, it can maintain price stability (i.e., a constant price level in both short run and long run) when the shock (i.e., an unexpected change) originated from the market for money. (5 points)

1. When the government runs an expansionary fiscal policy, (real) interest rate targeting would lead to a smaller change in short-run level of investment than (real) output targeting. (5 points)

1. The central bank should target the real interest rate, not real output, if it wants to minimize fluctuations in investment in the short run when autonomous investment falls. (5 points)