_____An, Name: Min Young______
(Last name, first name)
SID: _______20521696__________
UGBA 101B
Macroeconomic Analysis for Business Decisions
Professor Steven Wood
Summer 2010
Problem Set #3
Due: July 27, 2010 (at the beginning of class)
Please sign the following oath:
The answers on this problem set are entirely my own work. I neither copied from the work of others nor allowed
others to copy from my work.
_______________________________________
Signature
Any problem set turned in without a signature will be assigned a grade of zero.
Problem Set Instructions
1.
When drawing diagrams, clearly and accurately label all axis, lines, curves, and equilibrium points.
2.
Graphs and equations MAY be drawn by hand.
3.
Explanations MUST be word-processed. Your explanations should be succinct and to the point.
Problem Set #3
1/13
A. Multiple Choice Questions (30 points). Circle the letter corresponding to the best answer. (3 points each.)
1.
An increase in expected inflation is likely to cause:
a.
b.
c.
d.
2.
If there is a financial panic and increased uncertainty about the returns in the stock market and bond
market, what is the likely effect on money demand?
a.
b.
c.
d.
3.
Falls by 6%.
Unchanged.
Rises by 6%.
Rises by 8%.
A decrease in the effective tax rate on capital would cause the IS curve to:
a.
b.
c.
d.
5.
Money demand declines first, then rises when inflation increases.
Money demand rises.
The overall effect is ambiguous.
Money demand declines.
If the income elasticity of real money demand is 0.75 and income increases by 8%, by about how much
does the price level change when the asset market is in equilibrium?
a.
b.
c.
d.
4.
A decline in the demand for real money balances.
An increase in the demand for real money balances.
No change in the demand for real money balances.
No change in the demand for real money balances only if the income elasticity of real money
demand is zero.
Shift to the right.
Shift to the left.
Remain unchanged.
Remain unchanged if taxes are fully deductible from income; otherwise, shift to the right.
Banks decide to increase the interest rate they pay on checking accounts from 1% to 2%. This action
would:
a.
b.
c.
d.
Problem Set #3
Increase money demand, shifting the LM curve to the left.
Increase money demand, shifting the LM curve to the right.
Decrease money demand, shifting the LM curve to the left.
Decrease money demand, shifting the LM curve to the right.
2/13
6.
You have just read that the Federal Reserve has increased the money supply to avoid a recession. For a
given price level, you would expect the LM curve to:
a.
b.
c.
d.
7.
An increase in taxeswhen Ricardian equivalence does NOT holdcauses the real interest rate to
______ and the price level to ______ in general equilibrium.
a.
b.
c.
d.
8.
The IS curve to be flatter.
The IS curve to be steeper.
The LM curve to be flatter.
The LM curve to be steeper.
Suppose that the government reduces its expenditures but that the central bank follows a monetary
policy to keep output fixed. After this policy mix, all of the following are true EXCEPT:
a.
b.
c.
d.
10.
Rise; rise.
Rise; fall.
Fall; rise.
Fall; fall.
Suppose that government expenditures decline when the real interest rate increases (and vice versa)
because of higher borrowing costs. This would cause:
a.
b.
c.
d.
9.
Shift to the left as the real money supply falls.
Shift to the left as the real money supply rises.
Shift to the right as the real money supply falls.
Shift to the right as the real money supply rises.
Interest rates are lower.
Investment is higher.
Consumption is lower.
Unemployment does not change.
Suppose that because of labor market reforms, the supply of labor increases at every real wage rate.
Then, in order to keep the economy at its full-employment level of output:
a.
b.
c.
d.
Problem Set #3
The government should decrease its expenditures.
The government should increase taxes.
The central bank should increase the money supply.
The central bank should decrease the money supply.
3/13
B. Answer BOTH of the following questions based on the standard models of analysis developed in class.
1. IS LM Model (35 points). Suppose that the U.S. economy is in general equilibrium.
a. Based only on this information, use an IS-LM diagram to clearly and accurately show the
economys initial equilibrium situation. This diagram should be drawn in BLACK.
Problem Set #3
4/13
b.
Provide a brief economic explanation of what you have shown in your diagram above.
It is given that the U.S. economy is in general equilibrium. Therefore, in its general equilibrium,
labor market, Goods market, and asset market are in equilibrium simultaneously. Therefore, it is at
point A where FE (along which labor market is in equilibrium), IS0 (along which goods market is in
equilibrium) and LM0 (along which asset market is in equilibrium) curves intersect. So, the economy
is initially in general equilibrium with output at Y0 and the real interest rate at r0.
At this point, the level of unemployment is same as the level of natural unemployment. The output
of economy Y0 is equal to its full-employment level of output.
Here, the economy is in general equilibrium when quantities supplied equal quantities demanded
in every market.
Problem Set #3
5/13
c.
Now suppose that one group of the Presidents advisors suggests that he raise income taxes.
Assuming that there is no Ricardian equivalence, on your diagram above clearly and accurately
show the effects on economic output and the real interest rate. This change should be drawn in
RED.
d. Provide a brief economic explanation for the results you have shown in your diagram above. Be
sure to discuss what happens to economic output and the real interest rate and to explain why
these changes take place.
The increase in income taxes would lead to an increase the desired saving (also lead
to decrease in disposable income (Y-T) and desired consumption). As desired saving
increases, the real interest decreases and IS curve shifts down to left. Therefore, as
shown, IS curve shift to the left from IS0 to IS1.
As a result, the output would be at Y1 and the real interest rate at r1. Compared to
initial, output is smaller (Y1<Y0) and the real interest rate is smaller also. (r1<r0).
Problem Set #3
6/13
e.
Another group of the Presidents advisors suggests that he increase government purchases.
Assuming that there is no Ricardian equivalence, on your diagram above clearly and accurately
show the effects on economic output and the real interest rate. This change should be drawn in
BLUE.
f.
Provide a brief economic explanation for the results you have shown in your diagram above. Be
sure to discuss what happens to economic output and the real interest rate and to explain why
these changes take place.
As the government purchases increases, the output of the economy also increases.
The increase in Y leads to increase in income and desired private saving increases.
However, increase in government spending also decreases government saving. As a
result, since the increase in government purchases has greater effect on national saving,
national saving overall decreases. Decrease in national saving shifts IS curve to right
from IS0 to IS2. As the desired saving is now less than the desired investment, the real
interest rate increases. As the income increases, the demand for money also increases and
now the demand of money is also greater than the supply of money.
As a result, the output would be at Y2 and the real interest rate at r2. Compared to
initial, output is greater (Y2>Y0) and the real interest rate is greater also. (r2>r0).
Problem Set #3
7/13
g.
After these fiscal policy changes have been fully implemented, the Federal Reserve uses monetary
policy to keep economic at output its full-employment output level. On your diagram above,
clearly and accurately show the effects on economic output and the real interest rate from these
monetary policy actions. These changes should be drawn in GREEN for the Feds response to
higher income taxes and in BROWN for the Feds response to higher government purchases.
h. Provide a brief economic explanation for the results you have shown in your diagram above. Be
sure to discuss what happens to economic output and the real interest rate for each of these
monetary policy actions and to explain why these changes take place.
First, as a response to increase in income taxes, the Fed increases money supply by
buying financial assets from the public with newly created money in order to keep
economic output at its full-employment output level. As the money supply increases, real
interest rate decreases and, thus, the LM curve shift to right from LM0 to LM3 until it
reaches general equilibrium. If Fed is successful in keeping economic output at its fullemployment output level, Y1 would increases to Y3 and r1 would decreases to r3.
As a result, the output would be at Y3 and the real interest rate at r3 and it is at
general equilibrium at point B where LM3, IS1 and FE intersect. So the output of
economy equals to initial output of economy and greater than Y1 (Y0=Y3>Y1). The real
interest rate would be much lower than the initial real interest rate (r3<r1<r0).
Second, as a response to increase in government purchases, the Fed would decrease
money supply by selling financial assets to the public. As public pays for the assets,
money moves from publics checking account to the Fed. By doing so, money is removed
from the public sector and the money supply decreases.
The decrease in money supply would shift LM curve to left from LM0 to LM4. It
further leads to increase in interest rate. As real interest rate increases, the desired
national saving increases and desired investment decreases. The desired consumption
also decreases. If Fed is successful in keeping economic output at its full-employment
output level, Y2 would decreases to Y4 and r2 would increases to r4.
As a result, the output would be at Y4 and the real interest rate at r4 and it is at
general equilibrium at point C where LM4, IS2 and FE intersect. So the output of
economy equals to initial output of economy and smaller than Y2 (Y0=Y4<Y2). The real
interest rate would be much higher than the initial real interest rate (r0<r2<r4).
Problem Set #3
8/13
i.
After both the fiscal and monetary policy effects have fully taken effect, indicate whether the
following variables are higher with increased income taxes (Scenario #1), with increased
government spending (Scenario #2), or whether they are the same.
1.
Economic output or income: they are same
2.
The real interest rate: Scenario #2 has higher real interest rate than scenario #1
3.
Consumption: scenario #1 has higher consumption
4.
Investment: scenario #1 has higher investment
5.
Government purchases: scenario #2 has higher government purchases
6.
Tax revenues: scenario #1 has higher tax revenue
7.
Private saving: scenario #2 has higher private saving
8.
Government saving: scenario #1 has higher government saving
9.
Employment: they are the same
10. The unemployment rate: they are the same
11. The demand for money: scenario #1 has higher demand for money
12. The supply of money: scenario #1 has higher supply for money
Problem Set #3
9/13
2.
IS LM Model (35 points). Suppose that the economy is initially in short-term equilibrium with an
unemployment rate well above the natural rate of unemployment.
a. Based only on this information, use an IS-LM diagram to clearly and accurately show the
economys initial equilibrium situation. This diagram should be drawn in BLACK.
Problem Set #3
10/13
b.
Provide a brief economic explanation of what you have shown in your diagram above.
It is given that the economy is initially in short term equilibrium with an unemployment rate
well above the natural rate of unemployment. Therefore, at the short term equilibrium point A, IS
curve (IS0) and LM curve (LM0) intersect at the economy output well below the economy output
of the full-employment, where FE line lies.
As a result, the output of economy is initially lower than the output at the general equilibrium
where FE, IS and LM curves intersect. Below from FE line, employment level is not equal to fullemployment level initially. Since the unemployment level is higher than the natural
unemployment level, the employment level is lower than the full employment level while output
is lower than output of full-employment.
As a result, initially, it would be at point A with output Y0 and the real interest rate r0.
Problem Set #3
11/13
c.
Now suppose that there is a sharp drop in the liquidity of non-money financial assets. On your diagram
above, clearly and accurately show the effect on economic output and the real interest rate. This
change should be shown in RED.
d. Provide a brief economic explanation for the results you have shown in your diagram above. Be sure
to discuss what happens to economic output, the real interest rate, and the unemployment rate and to
explain why these changes take place.
As there is a sharp drop in the liquidity of non-money financial assets, the demand
for money increases. As the demand for money increases, the real interest rate increases
also. So, the LM curve shifts to left from LM0 to LM1.
Since the real interest rate becomes higher from r0 to r1, the desired saving increases
while desired consumption and desired investment decreases. Further, the output of
economy decreases also from Y0 to Y1.
As a result, the output would be at Y1 and the real interest rate at r1 at point B where
LM1 and IS0 intersect. At its new short-term equilibrium, the output of economy is less
than initial (Y0>Y1). The real interest rate would be higher than the initial real interest
rate (r1>r0).
Problem Set #3
12/13
e.
Now suppose that after the drop in the liquidity of non-money financial assets, there is a significant
decline in household and business expectations about their future incomes. On your diagram above,
clearly and accurately show the effect on economic output and the real interest rate. This change
should be shown in BLUE.
f.
Provide a brief economic explanation for the results you have shown in your diagram above. Be sure
to discuss what happens to economic output, the real interest rate, and the unemployment rate and to
explain why these changes take place.
Now, there is a significant decline in household and business expectations about their
future incomes. So, the IS curve shifts to left from IS0 to IS2. The decrease in future
expected income leads to a decrease in desired consumption and increase in desired
saving. Further, these also lead to decrease in output of economy from Y1 to Y2. And the
real interest rate becomes lower from r1 to r2.
As a result, the output would be at Y2 and the real interest rate at r2 at point C where
LM1 and IS2 intersect. At its new short-term equilibrium, the output of economy is much
less than initial (Y0>Y1>Y2). The real interest would be lower than right before the
decline of expected future income (r2<r1). However, the final real interest rate would be
depends on the magnitude of effects of sharp drop in liquidity of non-money financial
assets and decline in future income. Depends on the strength of the effects of these two
events, final real interest rate r2 can be higher, lower or equal to initial real interest rate
r0. As shown in the diagram, if the effect of decline in future income is less than that of
decrease in liquidity of NM, r2 would be still bigger than r0.
Problem Set #3
13/13