ECON222: Macroeconomic Theory - IS and LM Curves for the Economy - Money Demand Equation - Economic Assignment Writing Help

Economic Assignment Writing Answer Question 1: IS-LM-AD in a closed economy The following represent the key equations for a closed economy: M^d/ P = 18 + 0.5Y ? 450r     Money demand C^d = 6 + 0.8(Y ?T)? 250r     Desired consumption I^d = 33? 200r                          Desired investment G = T                                       Initial budget position u ? u = ?0.3 Y ?Y Y ? ? ? ? ?  Okun's Law a) Write out the equations for the IS and LM curves for this economy, with the real rate of interest (r) on the left-hand side. Next, use these relationships to find the AD curve, written with output (Y) on the left-hand side. Based on your model, describe briefly how, in the short run, output (Y) would respond to a rise in G and why? How would output respond in the short run to a cut in taxes and why? b) You are given the following information: G = 15; the velocity of money (V) is 2; and the price level (P) is one. Use this information to find real output, the real interest rate and the nominal money supply (M). Verify that your values of Y and r will give values of C and I that are consistent with the national accounts identity. Assume that the level of output you found in part b) is the economy’s long-run full-employment level, defined as Y. c) Now suppose that the efficiency of the payments systems has improved. We can capture this by assuming that the constant term in the money demand equation falls from 18 to 10. At the same time, the central bank is unaware of this change and keeps the nominal money supply constant at the level you found in part b). Find the short-run effects of this change on Y and r. If the natural rate of unemployment, u, is 6%, what is the actual rate of unemployment, u, following the change in the efficiency of the payment system? Provide a brief explanation Cd = 6 + 0.8(Y ?T)? 250r I d = 33? 200r G = T 2 of your results. For simplicity, you can assume that wages remain constant in the short run. d) What are the longer-term implications of this change in the efficiency of the payments system? In particular, what happens to the price level? What happens to the unemployment rate during this process? What is the new value of the real money supply? Be sure and describe the process at work. e) Suppose that the government decides to use fiscal policy to offset the effect of the change in the efficiency of the payments system.

• 1) Holding the level of taxation (T) constant, by how much would G have to change in order to keep the economy at full employment in the short run?
• 2) For comparison, hold G constant and now use taxation (T) to maintain the economy at full employment.
• 3) Comparing the two policy instruments, which had a larger effect on the government’s budget balance and why?

Question 2: The open economy version of the IS-LM-AD model with flexible exchange rates (35 Marks) The following 4 equations describe the main behavioral relationships for a small open economy with flexible exchange rates. M^d/P = 5+ 0.6Y ?100rw:- Money demand C^d = 30 + 0.5(Y ?T)? 200rw:- Desired consumption I^d = 40 ? 200rw:- Desired investment NXd = 31? 0.1Y ? 5e:- Desired net exports a) Use the equations above to derive the IS and LM curves for this economy, with the world real interest rate ( ) on the left-hand side. Find the value of the real world interest rate and the real exchange rate, using the following: Y = 150; M/P = 90; G = 20; and the government has a deficit of 10. Based on your results, is the economy using foreign savings? b) The nominal money supply (M) is 135 and the foreign price level ( ) is 1. Use this information to find the nominal exchange rate ( ). c) Suppose that the economy is hit by a negative shock that lowers net exports. In particular, the constant term in the net exports equation falls from 31 to 30. How will the economy adjust? In particular, what will happen to both the real and nominal exchange rates in the short and long run? d) Start again with the constant term in the net exports equation back at 31 and assume that, due to innovations in the banking system, individuals in this economy decide to hold smaller money balances in relation to Y and rw and this is reflected in a drop in the constant term in the money demand equation from 5 to 4. Use the model to find the short-run effects on Y, e, and P and then the long-run effects. e) In your view, if the government wanted to keep the price level unchanged, should monetary or fiscal policy be used to offset the shock to the money demand equation? Explain why. Question 3: The open economy version of the IS-LM-AD model with fixed exchange rates For this question, you will continue to use the above model, reproduced here: M^d/P = 5+ 0.6Y ?100rw:- Money demand C^d = 30 + 0.5(Y ?T)? 200rw:- Desired consumption I^d = 40 ? 200rw:- Desired investment NXd = 31? 0.1Y ? 5e^4:- Desired net exports You can assume that Y = 150 is the long-run equilibrium level of output, that is, Y and that the initial price level (P) is 1.5. a) Suppose that the government decides to peg the nominal exchange ( enom ) at 0.60, which is below its equilibrium value. Calculate the short-run as well as the long run effects on output and the price level. Determine as well what would happen to the real exchange rate in the short run and then the long run compared with the value you found in Question 2, part b). b) As economists in the Department of Finance, you advise the government that in the long run, the policy of pegging the exchange rate will not have a lasting effect on Y. That said, because it is below its equilibrium value, the short-run increase in demand does provide an opportunity to lower the fiscal deficit while keeping the economy at full employment. 1) Use in turn a cut in G and then an increase in T to keep the economy at full employment (that is, cut G holding T constant, and then separately raise T holding G constant, in each case by enough to offset the expansionary effect of the devaluation). 2) Which policy results in the most improvement in the budget deficit? Describe (no calculations required) the effects of each policy on components of Y. 3) Do the policies have different effects on the composition of demand (e.g., consumption, investment, and net exports)? c) Start again with the conditions as they were in part a). Assume that the economy experiences an increase in potential from Y = 150 to Y = 153. Use the model to find the long-run effect of this change on the real exchange rate (e), net exports (NX) and consumption (C). As well, find the new level of the nominal money supply needed to maintain long-run equilibrium. Did the nominal money supply rise or fall? What has happened to the real money supply? d) Assume again that the economy is back to its initial equilibrium as described in part a) above. Now suppose that the world interest rate falls from 5% to 4%. How will this affect the economy in the short and long run? In the economy’s new long-run equilibrium, what has happened to net exports, consumption, and investment? Find as well the new price level. Has the reduction in the world interest rate been inflationary or disinflationary for the economy?

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