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Economics W3213 Spring 2010
Bruce Preston
Problem Set 6 Solutions
Review Questions
1. Chapter 14: Exercises 1 and 2; Chapter 16: 4, 5 and 7; and Chapter 17: 4, 5 and 8
Short Answer Questions
Indicate whether you think the following statements are true, false or uncertain. Support
your answer by giving all necessary reasoning and calculations.
1.
In its most recent monetary policy decision, the European Central Bank lowered interest
rates for the Euro area. In the open economy IS/AS/MP model, this policy action will
reduce aggregate demand in the U.S.
Solution: True
A fall in interest rates in the Euro area leads to higher demand for US assets as the
relative return is now higher. To purchase those assets, foreigners have to convert Euros
into Dollars which leads to an appreciation in the US dollar, as the supply of currency
now more expensive for Europeans, and European goods cheaper for Americans. This
leads to a fall in net exports. This serves to weaken demand in the US. In terms of our
shortrun model, aggregate demand is determined by
~
Y
t
a
b
(
R
t
r
)
where
a
a
c
a
i
a
g
a
nx
1 +
b
nx
R
w
r
±
b
=
b
i
+
b
nx
:
Hence, a fall in
R
w
is equivalent to a fall in
a
.
2.
G
t
Y
t
a
g
+
~
Y
t
1
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View Full Documentis consistent with an exogenous change in government expenditures having an impact on
the output gap that is greater than oneforone. That is
@
~
Y
t
@
a
g
>
1
.
Solution: True/Uncertain
To answer this, consider rederiving the IS curve given this assumption in the case
of a closed economy for simplicity. Output equals the sum of consumption, investment
and government expenditures which is:
Y
t
=
C
t
+
I
t
+
G
t
a
c
Y
t
a
i
Y
t
b
(
R
t
r
)
Y
t
a
g
Y
t
+
~
Y
t
Y
t
:
Hence
~
Y
t
=
Y
t
Y
t
a
c
a
i
b
(
R
t
r
a
g
+
~
Y
t
1
=
1
1
h
a
c
a
i
b
(
R
t
r
a
g
+
~
Y
t
1
i
=
1
1
a
b
(
R
t
r
)
±
:
For
0
1
changes in
a
g
will have an e/ect equal to
1
1
for constant real interest
rates. Of course, Problem Set 5, shortanswer question 3, showed that the more activist
is monetary policy the smaller will be the multiplier. (This is because the endogenous
increase somewhat.) What is interesting here, in contrast to that earlier problem, is
that at least in principle the multiplier can be greater than one.
Long Answer Question
1.
Consider the following version of the BarroGordon model based on the AD/AS model
developed in class. The Phillips curve is given by
±
t
=
±
e
t
+
v
~
Y
t
o
t
(1)
where
v >
0
and
±
t
±
e
t
~
Y
t
the output gap and
o
t
a
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 Spring '11
 P
 Economics, Macroeconomics

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