# ps3 - Department of Economics University of California...

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1 Department of Economics 3/2/06 University of California, Berkeley Economics 182 Problem Set 3 Due in class on Thursday, March 16 . To be handed at the beginning of lecture to your GSI. Please write your name, GSI name , and section time in your problem set. Question 1 – Fiscal policy under balanced budget in AA/DD framework Imagine that Congress passes a constitutional amendment requiring the U.S. government to maintain a balanced budget at all times. Thus, if the government wishes to change government spending, it must change taxes by the same amount, that is, G = T always. (a) Suppose that the government has a balanced budget and decides to cut government expenditures and simultaneously cut taxes by the same amount. (i) Using the model of determination of output in the short run, explain whether aggregate demand increased or decreased. (ii) Using the AA - DD diagram, discuss what happens to the exchange rate and output. (b) Suppose instead that the government decides to finance a tax cut by printing extra money while keeping government expenditures unchanged. What will happen to the exchange rate and the output level in this case? Question 2 – Modification of AA/DD d iagram How would you draw the DD-AA diagram when the current account’s response to the exchange rate follows a J-curve? Use this modified diagram to examine the effects of both temporary and permanent (i) monetary expansion and (ii) fiscal expansion. Question 3 – Fixed e xchange r ates and c entral b ank i ntervention Oil prices have recently reached \$60 a barrel. Suppose you are a member of the monetary policy committee of a small open economy, dependent on oil imports, which also wants to maintain a currency peg to the dollar. (a) Describe the pressures that the currency would face due to the increase in oil prices? (Hint: think about the effects of the higher oil prices on the domestic price level as well as the current account). How would the central bank have to respond

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2 in order to maintain the currency peg? Will this response by the central bank increase or decrease foreign reserves? (b) Describe the impact of the Central Bank actions on the money supply, output,
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## This note was uploaded on 08/01/2008 for the course ECON 182 taught by Professor Kasa during the Spring '08 term at Berkeley.

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ps3 - Department of Economics University of California...

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