FINAL_sample_ANS

# Alone hint substitute out mp lm y 1000 r 2000 c 2

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alone [Hint: Substitute out M/P ] LM : Y = 1000 r + 2000 (c) [2 points] What are the short-run equilibrium values of Y , r , and national saving ( S )? Y = 4000, r = 2, S = 1000 2

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(d) [2 points] Assume that G increases by 1,500 (i.e., G = 3 , 000). By how much will Y increase in short-run equilibrium? Y increases by 2000 (e) [3 points] You are the chief economic adviser in this hypothetical economy. Do you believe that fiscal policy is more potent than monetary policy? Briefly discuss [Hint: Use the slope of IS and LM curve in (a) and (b)] Since the IS curve is steeper than the LM curve, fiscal policy is relatively more effective than monetary policy (f) [3 points] Write the numerical aggregate demand ( AD ) curve for this economy, expressing Y as a function of P Y = (10 , 000 / 3) + (2000 / 3 P ) or Y = 3333 + 667 /P (2) [10 points] Classical models in the Long Run During early 1980s, President Reagan proposed to increase defense spending and decrease taxes. Table 1 shows how the policies affected the U.S. economy. Use the Classical Model to answer the following questions (a) [3 points] Use the closed economy model and illustrate graphically how the model predicts national saving ( S ), investment ( I ), real interest rate ( r ), net export( NX ), and real exchange rate ( ε ) in the long run See Figure 1 (b) [2 points] Are the data in the table consistent with model predictions that you found in part (a)? Briefly discuss The closed economy model correctly predicted that national saving would fall and the interest rate would rise. But, the closed economy model predicted that investment would fall as much as saving; actually, investment fell by much less than saving. Also, the closed economy model by definition could not have predicted the effects on the trade balance or exchange rate (c) [3 points] Now use the small open economy model and illustrate graphically how the model predicts national saving ( S ), investment ( I ), real interest rate ( r ), net export ( NX ), and real exchange rate ( ε ) in the long run See Figure 2 (d) [2 points] Are the data in the table consistent with model predictions that you found in part (c)? Briefly discuss The small open economy model correctly predicted what would happen to NX and the real exchange rate, but incorrectly predicted that the interest rate and investment would not change. In order to explain the U.S. experience, we need to combine the insights of the closed and small open economy models 3
Table 1: The Reagan Deficits variable 1970s 1980s actual change S 19.6 17.4 I 19.9 19.4 no change r 1.1 6.3 NX -0.3 -2.0 ε 115.1 129.4 Data: decade averages; all except r and ε are expressed as a percent of GDP (3) [6 points] Open Economy in the Short Run Economic expansion throughout the rest of the world raises the world interest rate. Use the Mundell-Fleming ( IS * - LM * ) model to illustrate graphically the impact of an increase in the world interest rate ( r * ) on the nominal exchange rate ( e ) and level of output ( Y ) in a small open economy with a floating-exchange-rate system The fiscal expansion in the rest of the world would raise the world interest rate and lower domestic investment. As a result, an increase in world interest rate will raise national income

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