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381 Econ 381 Winter 2011 Midterm Answers

381 Econ 381 Winter 2011 Midterm Answers - Econ 381...

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Page 1 of 4 Econ 381: Sections 4 and 5, Winter 2011, Midterm: Classical Model Answer Key 1. (30 Points) A classical economist wears a t- shirt printed with the slogan ―Fast Money Raises My Interest!‖ Explain the meaning of the slogan. Be as specific as you can. Hint: if you haven’t used at least one equation you aren’t done. Answer: From the Quantity Equation: Y P V M therefore using the growth rate rules Y V M Y P V M % % % % % % % . If either M % or V % increased holding all else constant (both could be interpreted as fast money either money is moving more quickly or money is growing at a faster rate) then inflation would increase. From the Fisher equation: e r i . If M % or V % then e which would then increase the interest rate i (―Raise My Interest‖). 2. (30 Points) In the classical model, compare the outcome when the domestic government increases government spending in an open economy without perfect financial capital mobility when A: consumption does not depend upon the domestic real interest rate to B: when consumption does depend upon the domestic real interest rate. Explain. Use graphs. Answer: The difference between scenario A and B is seen in the slope of the Savings curve (S). If the scenario is A, S is a vertical curve that is exogenous and does not vary with r. If instead, as in scenario B, consumption changes with r then consumption will fall as r rises (r is the opportunity cost of current consumption) which means that savings, the complement to consumption, rises.
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