Assignment:
This assignment is due in hard copy at the beginning of class on Thursday February 21. Remember that the process of how you arrive at an answer is as important as the answer itself. Therefore, full credit will require you to show all steps and work, clearly label all graphs, and fully explain any answers that ask for an explanation.
Question 1: Analyzing fiscal policy options after a recession
Consider an economy that behaves according to the following behavioral equations (this is the simplest version of the economy that we've set up in class):
C= co + c1 Yd
Yd = Y - T
and taxes (T), investment (I), and government spending (G) are all exogenous.
GDP in 2009 was roughly $15,000 billion. During the 2009 crisis, GDP fell approximately 3 percentage points.
a. How many billion dollars is 3 percentage points of $15,000 billion?
b. What is the government spending multiplier in this economy?
c. If the propensity to consume is 0.5, by how much would government spending have increased to prevent a decrease in output?
d. What is the tax multiplier?
e. If the propensity to consume is 0.5, by how much would taxes have to have been cut to prevent any decrease in output?
Question 2: Comparative statics in the money market model
Does the interest rate increase or decrease in each of the following scenarios? In each case, set up a graph to support your answer.
a. An increase in the money supply set by the central bank.
b. An decrease in nominal GDP.
c. An increase in real GDP.
Question 3: Monetary policy and open market operations.
Suppose that money demand is given by:
Md = $Y(0.25 - i)
Where $Y is $100. Also suppose the supply of money is $20.
a. What is the equilibrium interest rate?
b. If the Federal Reserve wants to increase i by 10 percentage points, at what level should it set the money supply?
c. Show graphically how a change in the money supply leads to an increase in the interest rate.
Question 4: Bond prices and interest rates
Consider a bond that promises to pay $100 in one year.
a. What is the equilibrium interest rate on the bond if its price today is $75? $85?
b. Explain why there is an inverse relationship between bond prices and interest rates. (Explain the economic logic, not only the mechanics of the formula).
c. If the interest rate is 8%, what is the price of the bond today?