ECMC61 – International Economic: Finance
Assignment 2 Answer Key – Fall 2011
Question 1 (15 points)
Suppose the policy makers run expansionary monetary policy and contractionary fiscal policy at
the same time:
•
G
↓
⇒
AD
↓⇒
DD shifts to the left to DD(G
1
)
(1 pt)
⇒
A leftward shift in DD alone will decrease Y and cause DC to depreciate.
•
MS
↑
⇒
AA shifts up to AA(MS
1
)
(1 pt)
⇒
An upward shift in AA alone will increase Y and cause DC to depreciate.
•
Shortrun equilibrium:
⇒
DC depreciates unambiguously.
(3 pts)
⇒
The overall effect on Y is ambiguous:
If the shift in DD > the shift in AA, then point B is the equilibrium – DC depreciates
(say to E
1
) & Y
↓
to Y
1
.
If the shift in DD < the shift in AA, then point C is the equilibrium – DC depreciates
(say to E
2
) & Y
↑
to Y
2
.
If the shift in DD = the shift in AA, then point D is the equilibrium – DC depreciates
(say to E
3
FE
.
E
DD(G
1
)
DD(G
1
)
DD(G
1
)
DD(G
0
)
E
1
B
D
E
3
E
2
C
Graph: 5 pts
– must show
show all possible outcomes.
E
0
A
AA(MS
1
)
AA(MS
0
)
Y
Y
1
Y
FE
Y
2
Question 2 (25 points)
Part (a) (4 points)
•
Output, Y: Y = Y
FE
= 2(40000)
1/2
(14400)
1/2
= 48000
(1 pt)
•
DD function:
Y = 30000 – 250P + 500E
•
Solving P first:
⇒
From DD equation:
E = 36 + 0.5P
(1)
⇒
From AA equation:
E = 1750/P – 134
(2)
1
ECMC61 Assignment 2 Answer Key (Fall 2011)
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Equate (1) and (2):
36 + 0.5P = 1750/P – 134
P
2
+ 340P – 3500 = 0
P = 10
(1 pt)
or
P = – 350 (reject)
⇒
Sub P = 10 into either (1) or (2)
E = 36 + 0.5(10) = 41
(1 pt)
Or,
E = 1750/10 – 134= 41
•
Solving E first:
⇒
From DD equation:
P = 2E – 72
(1)
⇒
From AA equation:
P = 1750/(134 + E)
(2)
⇒
Equate (1) and (2):
1750/(134 + E) = 2E – 72
E
2
+ 98E – 5699= 0
E = 41
or
E = – 139 (reject)
⇒
Sub E = 41 into either (1) or (2)
P = 2(41) – 72 = 10
Or,
P = 1750/(134 + 41) = 10
Part (b) (6 points)
(1 pt for showing work)
Short run:
•
P = 10
(1 pt)
•
Exchange rate, E:
(1 pt)
26400 + 6000 – 250(10) + 500E = 17500 + 10(35000/10) + 150(40) – 200E
29900 + 500E = 58500 – 200E
E = 40.8571
•
Output, Y:
(1 pt)
Y = 29900 + 500(40.8571) = 50328.55
Or, Y = 58500 – 200(40.8571) = 50328.58
Long run:
•
Given the changes a temporary, both DD and AA curves will reverse back to its initial
position before the long run arrives.
•
Thus, the initial longrun equilibrium will the new longrun equilibrium:
Output, Y:
Y = Y
FE
= 48000
(1 pt)
Exchange rate, E = 41
(1 pt)
Part (c) (4 points)
(1 pt for showing work)
Suppose the central bank wants to keep Y at 49000 in the short run:
•
To keep Y at 49000, the central bank should run contractionary monetary policy.
•
Level of E that will keep Y = 49000 in the short run:
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 Fall '11
 Dr.IrisAu
 International Economics, Fiscal Policy, Monetary Policy, YFE

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