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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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 Winter '08
 Staff
 Inflation, Civil War, real wage

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