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

Student No._______________________
Name____________________________
KOÇ UNIVERSITY
ECON 202 / SPRING 2014
FINAL EXAM / GROUP D
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 IS curve for a closed economy. Answer the following questions:
(a) (3 points) What is the IS curve?
(b) (2 points) What does each point on a given IS curve represent or correspond to?
(c) (1 point) What does the negative sign of the slope of the IS curve show?
(d) (12 points) Using graphs, explain why the IS curve is negatively sloped (in effect, you are asked
to give a graphical derivation of the IS curve).
(e) (6 points) Using your derivation and graph(s) in your answer to part (d), explain in what
direction and why the IS curve shifts as
(1) government purchases of goods and services G are increased (the increase being financed
by raising current taxes),
(2) current taxes T are increased (expected future taxes without being affected),
(3) expected future income increases
while all other things remain the same.
Answer
(a)
(each yellow box is worth 1 point)
(3 points)
The IS curve is the combination of all pairs of Y and r
that keep the goods market in equilibrium
for any given set of G, T, expected future income, expected future taxes, Wealth, and other
variables that determine the expected future profitability of physical investment.
(b)
(2 points)
Each point on a given IS curve represents (or correspond to) a different equilibrium in the goods
market
in the sense that Y and r are both different, but everything else is the same.
(c)
(1 point)
The negative sign of the slope of the IS curve show that, as Y is larger, r has to be smaller in
order that the goods market is again in equilibrium.
(d)
(12 points)
If Y is larger, national saving is larger at any real interest rate (therefore, the saving function
shifts to right). But investment expenditure is negatively related to the real interest rate. As a
result, the equilibrium real interest rate decreases in the goods market. Therefore, the
equilibrium real interest rate corresponding to a larger Y is smaller. (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)
r, real interest rate
r, real interest rate
S(Y1, ...)
S(Y2, …)
IS
r1
r1
r2
r2
I
I1
I2
S, I
Y1
Y2
Y
G, T, expected future income, and expected future taxes, Wealth, and expected future profitability of
investment are constant along the IS curve. There would be a different IS curve if any of G or T or
expected future Y etc were different.
The figure on the left side tmust include:
Saving S and Investment I along the horizontal axis
Real interest rate r along the vertical axis
Investment function as a negatively sloped curve
(vertical or positively sloped) Saving function at Y1
(vertical or positively sloped) Saving function at Y2
Goods market equilibrium point with r1
Goods market equilibrium point with r2
The figure on the right side must include:
Real GDP Y along the horizontal axis
Real interest rate r along the vertical axis
IS curve
Point with Y1 and r1 on the IS curve
Point with Y2 and r2 on the IS curve
(e)
(6 points)
(1)
As government purchases of goods and services G are increased (the increase being
financed by raising current taxes),
national saving decreases at any real interest rate and for any given Y,
therefore the equilibrium real interest rate increases for any given Y, which means that
the IS curve shifts up (or to right).
(2)
As current taxes T are increased (expected future taxes without being affected),
national saving increases at any real interest rate and for any given Y,
therefore the equilibrium real interest rate decreases for any given Y, which means
that the IS curve shifts down (or to left).
(3)
As expected future income increases,
national saving decreases at any real interest rate and for any given Y,
therefore the equilibrium real interest rate increases for any given Y, which means that
the IS curve shifts up (or to right).
Question (2)
Consider a closed economy that is in short run equilibrium. Suppose that, for some reason, prices of
some major inputs suddenly increase causing production costs to rise sharply, and most producers
respond to this by quickly increasing their prices so that the price level P also increases sharply.
(a) (5 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 initial increase in P on the real GDP Y and the real
interest rate r.
(b) (13 points) Suppose that the government uses fiscal policy to restore the real GDP level that
prevailed before the sharp increase in P. What exactly does the government do? Determine the short
run and long run effects of the government'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 sharp rise in P 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) (5 points)
IS curve stays the same.
As P increases, real supply of money MS / P decreases and 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
IS1,2
Y2
Y1
Y
(b) (13 points)
The government increases its purchases G
demand for goods and services.
and / or decreases taxes T to stimulate aggregate
In the diagram, IS curve shift right (or up) to IS3.
LM curve stays the same at LM2.
In the short run, Y increases from Y2 back to Y1 and r increases further from r2 to r3.
P stays the same (since we are in the short run) at its new level after its initial increase due to the
rise in production costs.
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 sharp rise in P 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 does not change either.
r
LM2,3
LM1
r3
r2
r1
IS3
IS1,2
Y2
Y1
Y
Question (3)
Consider a closed economy that is in short run equilibrium. Suppose that, for some reason, people
begin to expect higher inflation (expected inflation rate π increases), 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 increase 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 increase 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 rise 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 increases, LM curve shifts right (or down).
In the short run, real GDP Y increases and real interest rate r decreases.
r
LM1
LM2
r1
r2
IS1
Y1
Y2
Y
(b) (10 points)
The Central Bank decreases the nominal amount of money supplied to reduce aggregate demand
for goods and services.
In the diagram, LM curve shifts back left (or up) to LM1.
IS curve stays the same at IS1.
In the short run, Y decreases from Y2 back to Y1 and r increases 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 rise 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
LM1,3
LM2
r1
r2
IS1
Y1
Y2
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 an adverse price shock due to, say, an increase in the price of oil.
(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 (11 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) (1 point) 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 price shock?
Answer
(each yellow box is worth 1 point)
(a) (16 points)
In the short run, AD stays the same, LRAS stays the same,
but the effect of an increase in the price of oil (or of any adverse price shock) is to shift SRAS upward.
As a result, Y decreases and P increases (actually, an upward shift in SRAS and a sudden increase in
P, whether due to increasing production costs or due to any other reason, are the same thing).
P
LRAS
P2
SRAS2
P1
SRAS1
AD’
AD
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)
Initial SRAS (horizontal)
LRAS (vertical)
Y1 at the intersection of initial AD, initial SRAS, and LRAS
P1 at the intersection of initial AD, initial SRAS; and LRAS
New SRAS (horizontal) above the initial SRAS
Y2 at the intersection of inital AD and new SRAS
P2 at the intersection of initial AD and new SRAS
New AD curve (negatively sloped, labeled AD' on the above diagram, passing through the intersection
of new SRAS and LRAS) which will be referred to immediately in part (b)
(b) (2 points)
In order that Y increases back to its initial level, AD curve must be shifted to AD’.
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 P2 in the short run as well as in the long run.
(c) (1 point)
If the Central Bank does not take any policy action, P will fall in the long run to P1 because YSR =
Y2 is less than YLR = Y1. In order that P is restored to its initial level P1, AD curve must NOT be
shifted to AD’ so that Y stays less than Y1 and YSR stays less than YLR. The Central Bank can do
this only by not increasing the nominal supply of money and waiting. Meanwhile, the real GDP will
be less than Y1 until the economy goes back to its long run equilibrium.
(d) (2 points)
The monetary policy action to be taken in part (b) (increase the nominal supply of money) is
different than the policy action to be taken in part (c) (do not increase the nominal supply of money
and wait).
Therefore, policy actions necessary to be taken for stabilizing Y and stabilizing P conflict with each
other in the case of a price shock.
Question (5)
Consider a small open economy with perfect capital mobility in the short run in which the Central
Bank follows a fixed 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 also left
because the nominal amount of money supplied MS will have to decrease
in order that e can be kept fixed at the pre-set value ē.
As the new short run equilibrium is reached, Y decreases and e stays the same.
e
LM*2
LM*1
ē
IS*2
Y2
Y1
IS*1
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, either the Central Bank decreases the nominal supply of money MS,
or MS is decreased by the actions of foreign currency speculators (or, arbitrageurs) who buy
domestic currency at the lower e from the foreign exchange market and sell it at the higher ē to the
Central Bank to make profits.
As MS decreases, domestic currency becomes relatively more scarce again
and e increases.
The process of reduction in MS and increase in e continues until e is again equal to ē.
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 political instability increases the country risk premium, and, thereby, the interest
rate. 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 (6 points) AND then show them by drawing a diagram (8 points).
(c ) (2 points) Contrast the result in part (b) with that of 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) (14 points)
The IS* curve shifts left as a result of the increase in the interest rate causing investment to
decrease.
The LM* curve shifts right as a result of the increase in the interest rate causing the real money
demanded to decrease.
As the new short run equilibrium is reached, Y may increase, decrease, or stay the same
depending on the relative magnitude of shifts in IS* and LM* curves,
but e decreases
unambiguously.
e
LM*1 LM*2
e1
e2
IS*2
IS*1
Y2 Y1
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 LM* curve (positively sloped) to the right of the initial LM* curve
New IS* curve (negatively sloped) to the left 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 new LM* and IS* curve
Actually it is possible for the new IS* curve to shift by a larger, smaller, or the same amount relative
to the new LM* curve but it is sufficient to draw only one IS* curve.
(c ) (2 points)
As the real interest rate r* increases,
Y may increase, stay the same, or decrease in this model
whereas Y unambiguously increases in the standard Mundell-Fleming model, because of the
vertical shape of the LM* curve.