Question 1. Money Market and the Quantity Theory of Money:
Suppose that demand for money in the country of Zooland depends on the interest rate r. Money demand in Zooland is represented by the function Md = 700 + 10/r. The current supply of money in Zooland is M=1500. Note that the interest rate, r , is written as a decimal (e.g., an interest rate of 1% would be written as 0.01 in the equation).
a. Suppose the money market in Zooland is in equilibrium. What is the initial equilibrium level of interest rate in Zooland?
b. Suppose that the central bank in Zooland determines that the equilibrium interest rate should be equal to 2%. What is the level of the money supply required for the interest rate to be at this level? Assume that the demand for money remains unchanged.
c. Now, suppose that the current interest rate in Zooland is 10% and that the Fed has pursued monetary policy so that the supply of money is at the level that should result in an equilibrium interest rate of 2% (this is the level of money supply you determined in part (c) of this problem). At an interest rate of 10%, what is the amount of excess supply of money or excess demand for money? How will the market adjust back to the equilibrium? Describe this process.
d. Suppose that the government of Zooland wants to maintain an interest rate of 10%. What action would the government of Zooland need to take in order to ensure an interest rate of 10% in equilibrium?
e. Suppose that in Zooland the level of prices is 200 and real income is 120. Calculate the velocity in Zooland when the interest rate is equal to 10% and when the interest rate is equal to 2%. Assume that the money market is in equilibrium for each calculation.
Question 2. Short-run and Long-run effects using the aggregate demand and aggregate supply model:
Consider the following events:
i. OPEC (the organization of countries producing oil) will sign an agreement to maintain the price of oil below its normal value;
ii. The Stock Market falls dramatically
iii. The government (initially with balanced budget) decides to run a deficit
For each of these events, determine:
- if the event causes a shift in the short run aggregate supply (SRAS) curve or the long run aggregate supply (LRAS) curve for the United States
- if the event is followed by an inflationary gap or a recessionary gap
- the long run adjustment process that occurs as a result of the event
Question 3. Keynesian Model
The economy is populated by three people: Joe, Mary and Sue. The following table reports the level of expenditures for each of the people in this economy. Assume that there are no taxes or government spending, no foreign sector, and that the level of business spending on investment is equal to zero in this economy. Note that the first column specifies the level of individual income.
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Level of Individual Income (Aggregate Income in this economy would be 3*Individual Income for each level of income given in this table)
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Joe's Spending
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Mary's Spending
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Sue's Spending
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4000
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1000
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1500
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7000
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10000
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7000
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10500
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19000
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a. Calculate the aggregate consumption function for this economy. To do this you will first need to calculate the level of autonomous consumption spending for each of the three individuals in the economy and then sum these levels to get the total amount of autonomous consumption spending. Then, you will want to analyze the level of total consumption spending that occurs at a particular income level (for example, you might consider either the aggregate income level of $12,000 or $30,000 since you have data for these aggregate income levels). Drawing a graph may help you think about getting the aggregate consumption function, but be forewarned, this is a challenging question and you will need to be thoughtful in arriving at your answer. (Hint: do not worry if you get a negative number for autonomous consumption....)
b. What is the level of the income-expenditure equilibrium (assume that there is no government sector, no foreign sector, and that business spending on investment is equal to 0)?
Review Questions:
Question 4. Jin can spend her afternoon solving equations or preparing for class. In twenty minutes, Jin can either solve 14 equations while doing no class notes or prepare 20 pages of class notes for her discussion while not solving any equations. Today, Jin has 1 hour to dedicate to either solving equations or preparing for class, and she would like to solve 12 equations from her linear algebra textbook and 40 pages of class notes.
Is this combination feasible? Draw a graph where the y-axis shows the number of equations that Jin can solve in one hour and the x-axis shows the number of pages of class notes she can write. Explain your answer.
Question 5. Suppose you have the following Demand and Supply equations for a country in autarky (recall that this is a term that refers to the country being a closed economy):
P=10
Qs= P -6
Draw a graph of this market and determine the consumer surplus. Explain why the consumer surplus has this value.
Question 6. Use the classical long-run model developed in class to answer this question. Furthermore in this economy assume that consumption depends upon the level of disposable income (disposable income is equal to total income minus net taxes). Assume the economy described in this question is initially in long run equilibrium. Suppose the government decides to decrease taxes and government spending by the same amount in this economy.
Draw a graph and explain what the impact of this policy is if any on interest rates and the level of investment in the current period as well as the impact of this policy on long run production in this economy.
Question 7. Chang and Nate produce two goods: X and Y. and both have linear PPFs. Nate has the comparative advantage in the production of good X and his PPF is shown below.
Based on this information, which of the following is a possible equation for Chang's PPF? Explain your answer.
a.) 12Y = 24 - 2X
b.) Y = 24 - X
c.) 4Y = 20 - X