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PS3sol

# PS3sol - University of California Berkeley Department of...

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University of California Berkeley Spring 2006 Department of Economics Economics 182 Suggested Answers to Problem Set 3 Question 1 – Fiscal Policy under balanced budget in AA/DD framework (a) (i) To answer this question first we have to look at the aggregate demand function D = C(Y - T) + I + G + NX(q, Y - T, Y* - T*). A decrease in T will cause an increase in consumption spending C(Y - T) that is smaller than the increase in disposable income because part of the new income is saved. In addition, the increase in disposable income worsens the trade balance NX since imports increase. The increase in C(Y - T) shifts the AD curve upward but the decrease in G and NX shifts the curve downward. The net effect of a decrease in G and T of equal amount is contractionary. Hence the AD curve shifts down from AD1 to AD2. This is depicted in Figure 1. The diagram on the bottom in Figure 1 shows how the DD curve would shift in response to the above-mentioned shift of the AD curve.

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Figure 1 (ii) Now let’s turn to the AA - DD diagram. The DD curve has to shift to the left. We see this in Figure 1, where the equilibrium moving from point 1 to point 2. Also note that neither of these shocks has an effect on the AA curve (Note however that if you considered the case where these policies were permanent, there would be a shift of the AA curve). Since point 1 is below the DD 2 schedule, there is an excess supply of domestic output. As firms decrease production to avoid accumulating inventory, the economy travels along the AA curve to point 2 where aggregate demand and supply are equal. The exchange rate rises as the economy approaches point 2 along AA because decreasing national output causes money demand to decrease, pushing the interest rate steadily downward. (The currency must depreciate steadily to raise the expected rate of future domestic currency depreciation and maintain interest parity.) Once the economy has reached point 2 on DD 2 , aggregate demand equals output and producers no longer Y 2 Y 1 Y 2 Y 1 Y=AD Y E AD 2 AD 1 DD 2 DD 1
face the involuntary inventory accumulation. The economy therefore settles at point 2, the only point at which the output and asset markets clear. Figure 2 (b) A temporary tax cut shifts the DD curve to the right. Since the tax cut is financed by an increase in the money supply, it generates an outward shift of the AA curve. As a consequence the equilibrium moves from point 1 to point 2. The net effect on the exchange rate is ambiguous, but output certainly increases more than in the case of pure fiscal stimulus. [Can you think of what unfavorable implications such policy mix might have?] DD 2 1 2 DD 1

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Figure 3 Question 2 – Modification of AA/DD diagram The DD curve might be negatively sloped (though probably DD will be steeper than AA) in the very short run if a depreciation of the currency follows a J-curve effect on the CA.
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PS3sol - University of California Berkeley Department of...

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