Download Econ202 Sp14 answers 1 2 3 4 5 6 to final exam group C

Student No._______________________
Name____________________________
KOÇ UNIVERSITY
ECON 202 / SPRING 2014
FINAL EXAM / GROUP C
May 27th
CLOSED BOOK AND NOTES
ANSWER ALL QUESTIONS
SHOW YOUR REASONING
TOTAL TIME: 120 MINUTES
Question (1)
Question (2)
Question (3)
Question (4)
Question (5)
Question (6)
Question (1)
This question is about the LM curve for a closed economy. Answer the following questions:
(a) (3 points) What is the LM curve?
(b) (2 points) What does each point on a given LM curve represent or correspond to?
(c) (1 point) What does the positive sign of the slope of the LM curve show?
(d) (14 points) Using graphs, explain why the LM curve is positively sloped (in effect, you are
asked to give a graphical derivation of the LM curve).
(e) (6 points) Using your derivation and graph(s) in your answer to part (d), explain in what
direction and why the LM curve shifts as
(1) the nominal amount of money supplied increases
(2) the general price level increases
(3) the expected inflation rate increases
while all other things remain the same.
Answer
(a)
(each yellow box is worth 1 point)
(3 points)
The LM curve is the combination of all pairs of Y and r
that keep the money market in equilibrium
for any given set of M, P, expected inflation rate, Wealth and other variables that determine the
demand for real money.
(b)
(2 points)
Each point on a given LM curve represents (or correspond to) a different equilibrium in the
money market
in the sense that Y and r are both different, but everything else is the same.
(c)
(1 point)
The positive sign of the slope of the LM curve show that, as Y is larger, r has to be also larger in
order that the money market is again in equilibrium.
(d)
(14 points)
If Y is larger, the demand for real money is larger at any nominal interest rate (therefore, the
demand for real money curve, also called the liquidity function, shifts to right). As a result, the
equilibrium nominal interest rate increases in the money market. Since expected inflation rate is
the same, this higher nominal interest rate corresponds to a higher real interest rate. Therefore,
the equilibrium real interest rate corresponding to a larger Y is also larger. (If only this
explanation is given, 5 points only)
The graphical analysis that corresponds to the above reasoning and that is the required answer is
as follows:
(please see next page)
i, nominal interest rate
r, real interest rate
LM
i2
π
r2
i1
π
r1
L(Y2, …)
L(Y1, …)
MS / P
M/P
Y1
Y2
Y
Notice that M (that is, MS), P, and expected inflation rate π are constant along the LM curve (among
other variables such as wealth etc). There would be a different LM curve if any of M or P or π were
different.
The figure on the left side tmust include:
Real amount of money M / P along the horizontal axis
Nominal interest rate along the vertical axis
Real supply of money as a vertical line
Demand for real money (or liquidity) function at Y1
Demand for real money (or liquidity) function at Y2
Money market equilibrium point with i1
Money market equilibrium point with i2
The figure on the right side must include:
Real GDP Y along the horizontal axis
Real interest rate along the vertical axis
LM curve
Point with Y1 and r1 on the LM curve
Point with Y2 and r2 on the LM curve
The real interest rate = nominal interest rate – expected inflation rate
(that is, r1 = i1 – π and r2 = i2 – π )
(e)
(6 points)
(1)
As the nominal amount of money supplied increases, real amount of money supplied
increases, the equilibrium nonimal interest rate decreases for any given Y,
therefore the equilibrium real interest rate decreases for any given Y, which means
that the LM curve shifts down (or to right).
(2)
As the general price level increases, real amount of money supplied decreases, the
equilibrium nonimal interest rate increases for any given Y,
therefore the equilibrium real interest rate increases for any given Y, which means that
the LM curve shifts up (or to left).
(3)
As the expected inflation rate increases, real amount of money supplied is the same, the
equilibrium nonimal interest rate is the same for any given Y,
but since expected inflation rate is higher, the equilibrium real interest rate decreases
for any given Y, which means that the LM curve shifts down (or to right).
Question (2)
Consider a closed economy in the short run equilibrium. Suppose the government increases its
purchases by ΔG and changes its tax revenue by ΔT (suppose that taxes are reduced, so ΔT < 0). At
the same time, the Central Bank increases the nominal supply of money. Do an IS-LM analysis
(drawing the necessary diagram) to answer the questions below. (Assume that everything else,
including, especially, expected inflation and expected future taxes, remain the same, and the Marginal
Propensity to Consume is MPC.)
(a) (2 points) How does the IS curve shift? What factor causes it to shift?
(b) (6 points) What is the horizontal shift in IS curve equal to? Explain starting from an equilibrium
condition.
(c) (2 points) How does the LM curve shift? What factor causes it to shift?
(d) (5 points) How do the equilibrium real GDP and the equilibrium real interest rate change?
(e) (3 points) Suppose the Central Bank increases the nominal amount of money supplied in such a
way that the equilibrium real interest rate does not change. By how much does the equilibrium real
GDP change? Explain.
Answer
(each yellow box is worth 1 point)
(a) (2 points)
IS curve shifts right
because G is increased and T is decreased.
(b) (6 points)
The horizontal shift in the IS curve is equal to (ΔG – MPC ΔT) / (1 – MPC).
Starting with the goods market equilibrium condition for the closed economy which is
Y = C+I+G
where Y, C, I, and G are each planned or desired quantities, and then considering the changes in those
quantities as G and T are changed as r stays constant since we consider the horizontal shift in IS
(which is the same thing as the change in Y as r stays constant):
ΔY = ΔC + ΔI + ΔG
ΔY = MPC (ΔY – ΔT) + 0 + ΔG
ΔI = 0 because we consider the change in I as r stays constant.
Solving for ΔY, we obtain ΔY = (ΔG – MPC ΔT) / (1 – MPC).
(c) (2 points)
LM curve shifts right
because the nominal supply of money MS (or, the nominal amount of money supplied) is
increased.
(d) (5 points)
Denoting the real GDP by Y and the real interest rate by r,
since both IS and LM shift right,
Y increases
unambiguously
whereas r can increase, decrease, or stay the same
depending on the relative magnitude of horizontal shifts in IS and LM.
(e) (3 points)
Equilibrium real interest rate will not change if IS and LM shift by exactly the same amount.
But if they shift by the same amount, then the change in Y will also be equal to the shift in any one
of these curves.
So, ΔY = (ΔG – MPC ΔT) / (1 – MPC).
It is possible to answer the question by drawing a diagram and indicating the answers on the diagram.
In that case, the diagram should be as follows (but the possibility that r can increase, decrease, or stay
the same should be expressed separately, unless three different shifts in LM relative to IS are shown
on the diagram – below, only the possibility that LM shifts exactly as much as IS is shown).
r
LM1
LM2
IS1
IS2
r1
Y1
Y2
(ΔG – MPC ΔT) / (1 – MPC)
Y
Question (3)
Consider a closed economy that is in short run equilibrium. Suppose that, for some reason, people
begin to expect lower inflation (expected inflation rate π decreases), everything else remaining the
same.
(a) (4 points) Do an IS-LM analysis (by drawing a diagram) to show how the IS and LM curves will
shift and to determine the short run effects of the decrease in π on the real GDP Y and the real interest
rate r.
(b) (10 points) Suppose that the Central Bank uses monetary policy to restore the real GDP level that
prevailed before the decrease in π. What exactly does the Central Bank do? Determine the short run
and long run effects of the Central Bank's policy on the real GDP Y, the real interest rate r, and the
price level P. (Assume that the real GDP level that prevailed before the fall in π was equal to the long
run real GDP level which you can assume to be constant over time to simplify your analysis.)
Answer
(each yellow box is worth 1 point)
(a) (4 points)
IS curve stays the same.
As π decreases, LM curve shifts left (or up).
In the short run, real GDP Y decreases and real interest rate r increases.
r
LM2
LM1
r2
r1
IS1
Y2
Y1
Y
(b) (10 points)
The Central Bank increases the nominal amount of money supplied to stimulate (or to increase)
aggregate demand for goods and services.
In the diagram, LM curve shifts back right (or down) to LM1.
IS curve stays the same at IS1.
In the short run, Y increases from Y2 back to Y1 and r decreases back from r2 to r1.
P stays the same (since we are in the short run).
So, YSR = Y1 again, where YSR denotes the short run real GDP, and, as the question asks you to
assume that the real GDP level that prevailed before the fall in π was equal to the long run real GDP
level, Y1 = YLR, where YLR denotes the long run real GDP.
In the long run, since the question allows you to assume the long run real GDP level to be constant
over time, we still have YLR = Y1, and, consequently, YSR = YLR,
therefore P does not change in the long run.
Therefore, Y does not change and r do not change either.
r
LM2
LM1,3
r2
r1
IS1
Y2
Y1
Y
Question (4)
Consider a closed economy that is initially in general equilibrium. Doing an AD-AS analysis
(drawing the necessary diagram), analyze the effects of the shock that occurs in the parts below and of
the monetary policy actions that the Central Bank can take in response to this shock. Suppose that the
economy experiences a negative demand shock due to, say, a decrease in the velocity of money.
(a) What is the effect of this shock on AD, SRAS, LRAS, Y, and P in the short run? Answer these
questions first in words (5 points) AND then show them by drawing a diagram (9 points).
(b) (2 points) Suppose that the Central Bank is concerned only about the level of real GDP (its goal is
to restore the initial level of real GDP). What monetary policy action should it take?
(c) (3 points) Suppose that the Central Bank is concerned only about the stability of the price level
(its goal is to maintain the initial price level). What monetary policy action should it take?
(d) (2 points) Do the monetary policy actions taken for stabilizing Y and stabilizing P conflict in the
case of a demand shock?
Answer
(each yellow box is worth 1 point)
(a) (14 points)
In the short run, SRAS stays the same,
LRAS stays the same,
but the effect of a decrease in velocity (or of any negative demand shock) is to shift AD to left. As a
result, Y decreases but P stays the same.
P
LRAS
P1
SRAS
AD2 AD1
Y2
Y1
Y
Note that, in the above diagram, initial AD, SRAS, and LRAS all intersect at the same and a single
point because the economy is initially in general equilibrium.
The diagram drawn must include:
Real GDP Y along the horizontal axis
Price level P along the vertical axis
Initial AD curve (negatively sloped)
SRAS (horizontal)
LRAS (vertical)
Y1 at the intersection of initial AD, SRAS, and LRAS
P1 at the intersection of initial AD, SRAS; and LRAS
New AD curve (negatively sloped) to the left of the initial AD
Y2 at the intersection of new AD and SRAS
(b) (2 points)
In order that Y increases back to its initial level, AD curve must be shifted back to its initial position.
The Central Bank can do this by increasing the nominal supply of money. As a by product of this, the
price level P stays at P1 in the short run as well as in the long run.
(c ) (3 points)
If the Central Bank does not take any policy action, P will fall in the long run because YSR = Y2 is
less than YLR = Y1.
In order that P is kept at its initial level, AD curve must be shifted back to its initial position so that Y
increases back to Y1 and YSR = YLR again.
The Central Bank can do this by increasing the nominal supply of money. Meanwhile, the real GDP
will be restored to its initial level as well.
(d) (2 points)
In both (b) and (c), the monetary policy action to be taken is the same: increase the nominal
supply of money.
Therefore, policy actions necessary to be taken for stabilizing Y and stabilizing P do NOT conflict in
the case of a demand shock.
Question (5)
Consider a small open economy with perfect capital mobility in the short run in which the Central
Bank follows a floating (or flexible) exchange rate system. Suppose that the world real interest rate r*
increases.
(a) (7 points) Do an IS*-LM* analysis (drawing a diagram) to show how the IS* and LM* curves
will shift and to determine what will happen to the real GDP Y and the nominal exchange rate e in the
new short run equilibrium.
(b) (13 points) Describe what sequence of events will take place as Y and e reach their new short run
equilibrium values.
Answer
(each yellow box is worth 1 point)
(a) (7 points)
As r* increases, investment I decreases at any nominal exchange rate e,
and the IS* curve shifts left.
The LM* curve shifts right
because the real amount of money demanded decreases as r* increases,
and Y will have to increase so that real amount of money demanded increases again and the money
market equlibrium is reached again with the unchanged amount of real money supplied.
As the new short run equilibrium is reached, Y increases and e decreases.
e
LM*1
LM*2
e1
e2
IS*2 IS*1
Y1
Y2
Y
(b) (13 points)
When r* increases, it becomes temporarily larger than the domestic real interest rate rD.
This causes a capital outflow to begin. As a result of the capital outflow, (loanable funds become
relatively scarce in the domestic economy, and) domestic real interest rate also increases, causing
(physical) investment I to decrease
and, as I decreases, total planned expenditure on goods and services also decreases
causing, in turn, Y to decrease.
At the same time, the capital outflow means that financial investors who want to lend their funds in
financial markets of other countries are exchanging domestic currency into foreign currency causing
the demand for domestic currency to decrease relative to the demand for foreign currency, and
therefore the domestic currency depreciates (loses value against foreign currency), or, in other words,
e decreases. As e decreases, net exports NX increase, causing total planned expenditure increase,
and the increase in total planned expenditure, in turn, causes Y to increase. The increase in Y
causes the demand for real money to increase
and to become at the now higher real interest rate equal to the unchanged supply of real money.
Question (6)
Suppose that the price level relevant for money demand includes the price of imported goods and that
the price of imported goods depends on the exchange rate. That is, the money market is described by
M / P = L(r, Y)
where
P = λ PD + (1 – λ) PF / e
Here, PD is the price of domestic goods, PF is the price of foreign goods measured in the foreign
currency, and e is the exchange rate. Thus, PF / e is the price of foreign goods measured in the
domestic currency. The parameter λ is the share of domestic goods in the price index P. Assume that
the price of domestic goods PD and the price of foreign goods measured in foreign currency PF are
sticky in the short run.
(a) (7 points) Suppose that we graph the LM* curve for given values of PD and PF (instead of the
usual P). Is this LM* curve still vertical? Explain.
(b) Suppose that the government increases its purchases of goods and services. What is the effect of
this on the IS* and LM* curves, and on the equilibrium nominal exchange rate and equilibrium real
GDP under floating exchange rates and in the short run? Answer these questions first in words (4
points) AND then show them by drawing a diagram (7 points).
(c) (3 points) What can you say about the effectiveness of expansionary fiscal policy under floating
exchange rates in this model? Contrast with the standard Mundell-Fleming model.
Answer
(each yellow box is worth 1 point)
(a) (7 points)
As e increases (domestic currency appreciates), PF / e decreases (price of foreign goods measured
in domestic currency decreases).
As a result of this, P decreases (price level is lower).
As P decreases, MS / P increases (amount of real money supplied increases), and the money
market equilibrium requires that amount of real money demanded also increase.
Therefore, the real GDP level that is consistent with the money market equilibrium increases.
Taken all together, these mean that
e and Y that would keep the money market in equilibrium increase together.
This is nothing but saying that the LM* curve is positively sloped.
(ALTERNATIVE ANSWER – reverse the direction of all changes:
As e decreases (domestic currency depreciates), PF / e increases (price of foreign goods measured
in domestic currency increases). As a result of this, P increases (price level is higher). As P increases,
MS / P decreases (amount of real money supplied decreases), and the money market equilibrium
requires that amount of real money demanded also decrease. Therefore, the real GDP level that is
consistent with the money market equilibrium decreases. Taken all together, these mean that e and Y
that would keep the money market in equilibrium decrease together. This is nothing but saying that
the LM* curve is positively sloped.)
(b) (11 points)
The IS* curve shifts right as a result of the increase in G.
The LM* curve stays the same.
As the new short run equilibrium is reached, Y increases and e increases also
e
LM*1,2
e2
e1
IS*1
IS*2
Y1 Y2
Y
The diagram drawn must include:
Real GDP Y measured along the horizontal axis
Nominal exchange rate e measured along the vertical axis
Initial LM* curve (positively sloped)
Initial IS* curve (negatively sloped)
New IS* curve (negatively sloped) to the right of the initial IS* curve
Initial Y and e values at the intersection of the initial LM* and IS* curves
New Y and e values at the intersection of the initial LM* curve and the new IS* curve
(c ) (3 points)
Since Y increases as G is increased (expansionary fiscal policy),
fiscal policy has some effectiveness under floating exchange rates in this model.
In the standard Mundell-Fleming model, fiscal policy is not effectiveness under floating exchange
rates because of the vertical shape of the LM* curve.