{[ promptMessage ]}

Bookmark it

{[ promptMessage ]}

202 Fall 10, PS 4 Discuss

# 202 Fall 10, PS 4 Discuss - ECO 202 Lyons Fall 2010 PROBLEM...

This preview shows pages 1–3. Sign up to view the full content.

ECO 202, Lyons Fall 2010 PROBLEM SET IV DISCUSSION SHEET CHAPTER 12 Problem 1: Begin, as usual, by finding PAE, given the information in the problem, remembering to plug in the interest rate as a decimal fraction (0.10, rather than 10%). PAE = C + Ip + G + NX = [2,600 + 0.8(Y - 3,000) - 10,000•0.10] + [2,000 - 10,000•0.10] + [1,800] + [0] = [2,600 + 0.8Y -2,400 - 1,000] + [2,000 - 1,000] + [1,800] = 2,000 + 0.8Y Solve for equilibrium (i.e., where PAE = Y): PAE = Y = 2,000 + 0.8Y => 0.2Y = 2,000, so PAE = Y = 10,000 . Graphically, you will observe that a plot of the expenditure line PAE = 2,000 + 0.8Y, crosses the equilibrium line (PAE = Y) where Y = 10,000. Problem 2 (a & b): a) Given the results of problem 1, if potential output, Y*, is equal to 12,000, then the economy is suffering a recessionary gap, and monetary policy should be expansionary, which means acting to lower the real (and nominal) interest rate. There are two ways to proceed: i) The recessionary gap is 2,000, so the Fed must lower the interest rate by enough to increase autonomous expenditures by 400 (that is, given the expenditure multiplier of 5 derived from the mpc of 0.8). Two components of expenditure are interest-rate-sensitive -- autonomous consumption and investment. The interest-sensitive components are -10,000• r in each case, so together the impact of r is –20,000• r . We want PAE = 400 = -20,000• r , so r = –0.02. That is, the interest rate must be reduced by two percentage points from 10% to 8% . ii) Solve the equation in problem 6 for r after substituting Y* = 12,000 for Y: Y*= 12,000 = PAE = [2,600 + 0.8(12,000 -3,000) -10,000• r ] + [2,000 - 10,000• r ] + [1,800] + [0] 12,000 = [2,600 + 7,200 - 10,000• r ] + [2,000- 10,000• r ] + [1,800] 20,000• r = 2,600 + 7,200 + 2,000 + 1,800 - 12,000 = 13,600 - 12,000 = 1,600 Thus, r = 1,600/20,000 = 0.08, or 8%. * Lowering the real interest rate by 2% is correct policy. b) If Y* = 9,000, the Fed should raise the interest rate to eliminate the expansionary gap. Using the method of a) i) above: Since the gap is 1,000 and the multiplier is 5, autonomous expenditures must fall by 200. A 1% increase in the interest rate will accomplish this end, since –20,000•0.01 = –200.

This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document
ECO 202, Lyons Problem Set IV Discussion, page 2 10th December, 2010 CHAPTER 13 Problem 1: Refer to Figure 13.12 on page 401 in the textbook for parts a), b), c), and e). Figure 13.13 on page 404 can be used for part d). Notice that each response assumes (for convenience) that the economy begins at long-run equilibrium, and that there is no change in monetary or fiscal policy.
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}

### Page1 / 3

202 Fall 10, PS 4 Discuss - ECO 202 Lyons Fall 2010 PROBLEM...

This preview shows document pages 1 - 3. Sign up to view the full document.

View Full Document
Ask a homework question - tutors are online