Download Answer Key for Problem Set 4

Answer Key for Problem Set 4
1. (Chap 17). Suppose the economy starts from the long run equilibrium with output equal to
the full-employment output level. Suppose there is a permanent fall in world demand for a country’s
output (which also reduces the relative demand of home-produced goods to that of foreign-produced
goods).
(a) What is the e¤ect on the output of the home economy and the exchange rate of the home
currency in the short run and the long run?
(b) What government policy response would you recommend?
Hints: Compare this with a permanent decrease in government spending.
Answer:
(a). A permanent reduction in world demand of a country’s output shifts this country’s DD
curve leftward. In the short run, the exchange rate increases and the output decreases. The
equilibrium is at Point 3. In the long run, with a higher expected exchange rate, AA curve will
shift rightwardly to AA’. The new equilibrium is at point 2 where the output is at full employment
level and the exchange rate is higher than the short run level.
(b). In the short run, to restore the level at full employment level, the government can conduct
either temporary expansionary …scal or monetary policy. The only di¤erence is the implied level of
2
exchange rate. In the long run, as the output will be at the full employment level, there is no need
for government to implement any policy.
2. (Chap 17). A new government is elected and announces that once it is inaugurated, it will
increase money supply permanently.
(a) Use the DD-AA model to study the economy’s response to this announcement. (Hint: the
announcement is news about future, so it does not change the current economic conditions)
(b) What is the further e¤ect (short-run and long-run) on the economy when the monetary
expansion is actually implemented as promised?
Answer:
(a). After government’s announcement, if the public believe it, they would expect the long-run
exchange rate will increase. As a result, the AA curve shift rightwardly. The new equilibrium is at
point 2. Both the output and the exchange rate will increase.
(b), After implementing the monetary expansion, the AA curve will further shift rightwardly
to AA’. In the short run, the output and the exchange rate will increase, see Point 3. Suppose that
the full employment level is Y f as shown by the dashed line. In the long run, the price will steadily
increase. This will shift DD’ and AA curves to the left until the new equilibrium is reached, see
red lines and Point 4.