Problem 1: Loanable Funds Market
Consider the initial condition is one where the government is running a deficit of $100. Now consider what would happen in the market for loanable funds if the government decides to raise net taxes by $150 to eliminate the deficit - and start running a surplus. Draw the market for loanable funds and show graphically how investment and savings will change in response to the change in taxes. Explain about "crowding" out...is it occurring now? Why or why not?
Problem 2: Unexpected Inflation
Suppose that Nick lends Suzanne $1000 for a year. They both expect the inflation rate to be 3%, and therefore decide on a nominal interest rate of 7%. The inflation rate is actually only 1%.
a. At the end of the year, how much money does Suzanne owe Nick?
b. Who does the unexpectedly low inflation benefit?
c. Explain how wealth has been redistributed due to the unexpected inflation.
Problem 3: Fiscal Policy
The government proposes a tax cut to stimulate the economy. They are not going to reduce spending to compensate for the tax cut.
a. Consider the tax cut is $200 billion and assume the MPC = .8. What would all the effects be under the classical model.
b. Now consider how this tax cut (of $200 billion) would affect GDP (MPC = .8). What is the increase in GDP? What assumptions must be made?
c. Evaluate - is the tax cut good in the short run? When would it be good and when would it be bad. Evaluate based on different possible initial conditions for the economy and include what happens to GDP and inflation.
Problem 4: Fiscal vs. Monetary Policy
The FED wants to keep inflation low and therefore will attempt to follow that goal. If there is a recession and the government attempts to stimulate the economy through fiscal policy, but the FED is following a policy of keeping inflation at a low level...what will be the result. Be specific and include graphs as needed.
Problem 5: Inflation Again.
You own a hammer store and make a contract to supply a box of hammers every year for 5 years to a construction company at $100 each year (i.e. you make hammers and give the hammers to Joe's construction company in exchange for a $100 bill). However, the actual rate of inflation is less than you anticipated. Is this contract really good or really bad for you? Why?
Problem 6: Loanable Funds Market
Consider the market for loanable funds. The government starts off running a deficit of $500 billion. A change in government takes place and the new administration decides that it is best for the people to reduce the government spending. Thus the administration reduces the government purchases by $400 billion. (Assume the net taxes are unchanged.)
Draw the market for loanable funds. Clearly label the demand and supply. Label the initial equilibrium - including what the initial level of investment and the initial level of savings are (note: these will not be numbers - rather label them I0 and S0). Then explain what shifts and why. Label the new equilibrium. What is the new level of Investment and Savings? What has happened to the interest rate?