Download Name IAS 107 Fall 2013 Instructor: Mario Muzzi Problem Set #5

Name _____________________
IAS 107
Fall 2013
Instructor: Mario Muzzi
Problem Set #5 – Due 12/5/13
1) (7pts) Supply Side Economics:
(a) (4pts) Identify two tax based policies supply-side economists advocate and describe
their rationale in support.
(b) (3pts) Describe two separate criticisms of supply-side policies.
2) (12pts) Monetary Policy Debates:
a) (6pts) Monetary Transmission Mechanism: According to the Keynesian school, show
what happens, step by step, when the Federal Reserve sells US treasury bills to US banks.
i) (1.5 pts) Show the impact in the Money Market
ii) (1.5 pts) Show the impact in the Keynesian Cross Diagram
iii) (1.5 pts) Show the impact in the IS-LM graph
iv) (1.5 pts) Show the impact in the AD/AS graph
b) (4pts) Quantity Theory of Money: According to the Monetarists and Rational
Expectations, explain what happens, step by step, when the Federal Reserve sells US
treasury bills to US banks. Describe the impact in words and:
i) (2pts) Show the impact in the AD/AS graph
ii) (2pts) Show the impact in the Phillips curve. (Include Short-run and Long-run)
c) (2pts) What is the difference between the Keynesian view and Monetarist/Rational
Expectations view on the short run and long run effects of discretionary monetary policy?
3) (5pts) Rule Based Monetary Policy: Below draw an AD/AS graph and a money market
graph side-by-side. For the money market, use an upward sloping money supply curve
and assume that the equilibrium interest rate in the money market is 5%. Also, assume
that actual GDP is at full employment and that the equilibrium price level in the AD/AS
graph is 100. Now shift AD to the right based on an increase in animal spirits. Show
how the money market graph will adjust to a new equilibrium. Then explain and show
what happens if the Fed acts to keep the equilibrium quantity of money constant. Is this
rule based policy pro-cyclical or countercyclical? (explain)
4) (10pts) Debts and Deficits:
a) (2pts) (True or False) An increase in income tax rates will always result in an increase
in government tax revenues. (Explain)
b) (2 pts) (True or False) Recessions will often result in a government budget deficit.
(Explain)
c) (6pts) Compare the traditional view versus the view of Ricardian equivalence of the
effects of a debt-financed tax cut on:
i) Current Consumption
ii) Current National Savings
iii) Current Interest rates
5) (6pts) Open Economy: Assume that in a small open economy where full employment
always prevails, national saving is 300.
a) (2pts) If domestic investment is given by I = 400 – 20r, where r is the real interest rate
in percent, what would the equilibrium interest rate be if the economy were closed?
b) (2pts) If the economy is open and the world interest rate is 10 percent, what will
investment be?
c) (2pts) What will the current account surplus or deficit be? What will net capital
outflow be?
6) (6pts) Exchange Rates and Purchase Power Parity:
Country
Nominal
ERfx/$
Price of
Basket
Brazil
(real)
India
(rupee)
Mexico
(pesos)
South
Africa
(rand)
2.1893/$1
520
reals
12,000
rupees
1,800
Pesos
800
rands
46.6672/$1
11.0131/$1
6.9294/$1
Price of
US Basket
($190) in
local
currency
terms
Real
Exchange
Rate
According
to PPP,
will
currency
appreciate
or
depreciate
against $
7) (4pts) Determining the ER in Open Economy Model:
(a) (2pts) Suppose that governments around the world (not including the US) begin to
increase taxes and cut government spending in order to reduce their budget deficits.
Illustrate graphically the impact of this contractionary fiscal policy by foreigners on the
U.S. exchange rate and the trade balance. Assume that the country starts from a position
of trade balance, i.e., exports equal imports. Be sure to label: i. the axes; ii. the curves; iii.
the initial equilibrium values; iv. the direction the curves shift; and v. the new long-run
equilibrium values.
(b) (2pts) Based on your graphical analysis, explain the predicted impact of the foreign
expansionary fiscal policy on the U.S. exchange rate and the U.S. trade balance.