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Homework 3
Economics 503
Foundations of Economic Analysis
Assigned: Session 6
Due: Session 7
1.
Construct an AS-AD model of the economy. Begin by assuming the economy is
in a long-run level of equilibrium with the aggregate supply curve crossing the aggregate
demand curve at the level of potential output. Use the model to describe how each of the
events will change the macroeconomic equilibrium in the short-run. Suppose that
policymakers allow the self correction mechanism to bring GDP back to the long-run
equilibrium. Use the model to describe how each of the events will change the economy
in the long-run. Illustrate with diagrams.
a.
An increase in the level of GDP of a leading trading partner.
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b.
The central bank increases the money supply.
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2.
In December 2010, China increased their reserve requirement. Assume this
increases the demand for reserves. Draw a graph of the interbank market when a central
bank increases the reserve ratio while maintaining a fixed money level of reserves. If
there is a given level of reserves and the reserve to deposit ratio rises, what effect will this
have on the money supply. Draw a graph of the money market to show the impact of a
rising reserve ratio.
The increase in the reserve ratio will increase the demand for reserves at any level of
deposits. The equilibrium interest rate will rise.
iIBOR
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The money multiplier would be reduced by an increase in the reserve to deposit ratio.
The liquidity available from the national banking system would be reduced and
money market interest rates will rise.
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Real Balances
3.
Estimate the current real interest rate in Hong Kong. There are two steps: 1) get
the nominal interest rate; and 2) estimate the future inflation rate.
a.
To measure current interest rates, i, Use the end of period 12 Month HIBOR
(Hong Kong Interbank Offered Rate) rate from December, 2011 found in Table 6.3.1 of
the Hong Kong Monetary Authorities Monthly Statistical Bulletin from January, 2012.
This can be found at this webpage: HKMA Monthly Statistics
0.75% or i = .0075
b.
To estimate the future inflation rate, πt+1, use the % growth of the Composite
Consumer Price Index for November, 2011 relative to November, 2010 from Hong Kong
Statistics from Bureau of Census and Statistics. This can be found on this webpage Hong
Kong Department of Census and Statistics .
CPI
102.4
108.2
Nov 2010
Nov 2011
 tE1   t 
Pt  Pt 1 108.2  102.4

 .0566
Pt 1
102.4
rt  it   tE1  .0075  .0566  .0491
4.
For the country of Elbonia, there is a saving curve which shows the relationship
between national supply of loanable funds from the private sector at any real interest rate:
S = 300*r . The private sector level of demand for loanable funds is also a function of the
interest rate, D = 20-100*r.
a.
Assume government savings is 0. Assume Elbonia’s loanable funds market is
closed so supply and demand for loanable funds are equal. Solve for the equilibrium real
interest rate and quantity in the loanable funds market.
Supply and demand are equal so S = 300*r = 20-100*r = D.
20
300r  20  100r  400r  20  r 
 .05 so S = 300r = 15.
400
b.
Assume that Elbonia is part of a global capital market and the world real interest
rate is rW = .06. Calculate Elbonian supply of loanable funds, demand for loanable funds
and capital inflows.
S = 300*.06 = 18.; D = 20-100*.06 = 14. So KA =-4.
c.
The Elbonian government runs a deficit and has government savings of -20.
Calculate, supply and demand of Elbonian loanable funds at an interest rate of rW = .06.
What are capital inflows.
Now, D = 20-100r+20 = 40-100r = 34, so KA = 16.