Question

This problem has four parts: (a), (b), (c), and (d). Suppose that the following sets of equations describe ALL the relevant information about a country's money market and goods market. The Money Market is described as follows: · Money Demand function: Md=Y +2P - 250r • Money Supply: Mº = 4800 · Price Level: P = 152 • Required reserve ratio (rrr) = 18% . Total reserves = required reserves; Excess reserves = 0 The Goods Market is described as follows: • Consumption function: C = 400+ 0.9Y. · Planned Investment function: Id = 410 - 190r . Government expenditures: G = 200 • Taxes: T = 80 • Exports: EX = 40 • Imports: IM = 50+ 0.1Y (a) Derive the equations for the IS and LM curves and solve for equilibrium Y* and r* (6 pts + 5 pts) (b) The country's Parliament wants to increase spending on social safety nets, and therefore increases taxes by S40 and increases government spending by $40. What is the new equilibrium national income, Y' and the equilibrium interest rate r'? (4 pts + 4 pts) (c) Calculate the effective balanced-budget multiplier. (4 pts) (d) After fiscal action by the Parliament in (b), the country's central bank announces that given the good shape of the economy, it wants to target a lower interest rate of 8% to create future monetary space for itself. To do so, it takes the route of Open Market Operations (OMO). Under OMO, will the central bank buy or sell bonds to get to a lower interest rate? What value of bonds will the central bank buy or sell to get to an interest rate of 8%? (5 pts)

Answer 1

Auswen a ) In the goode market, we get the Is cowe i < (Aggregate Demand or, Y C + I + 9 +(EX-JM) (Yd) + I + G +(Ex- (M) Oh, Y + 200 t org 700 40.9 (4-80) + 910 – 1904 40 – 50 -0.19) 400 + 0.9ř - 72 + 110 9 or + 200 -100.14 y org O. q Y 190r 928 is the Is t cwere ego a In the market, we the LM get money wore 9 MO ile P org Y + q P-250r - P on, Y + 301 7800 Р 429600-4800 350r Org y 350r = 72 9 29.6 org ly-25or = 4196 is the Scanned by TapScanner

qu brium, 3 M ly 1526 0011 112 % 2 by Fan equilib 15 - LM le thus solving equations le is, we get 261 0.12 25 (A) increased b) If the taxes, are Ano) Encreases by & 90 e gout. spending en then the IS equation will beo Y = 900 +0.914 – 120) + 910–1901 + 240 + (90–50 - 0.17) 400 t 0.94 108 + 4 10 - 190r + 240 - 10 - 70 - 0. Y 9321 new Y or 0.2 y + 190r lucis me get new 91 - 41 300 = 0.136 6 Solving for (100) & (re get the Y' & r 4', Y' - 27181 - 9530.17 (4m) 13.67% For effective balanced budget (Aus) multiplier , we see that it is equal to 1 breause the increase in aggregate the increase u government offset by a decrease in a aggiugate production by the increase production by the increase i spending a Scanned by TapScanner

d. If the Central Bank wants to lower the interest rate then it has to buy bonds because when everyone expects a lowering of the interest rate then the bond prices rise and thus people buy bonds.

The calculation is shown below.

d) The value of bond reate s to maintain a 8% interest 0 face value bond v F- time. (1481) Bond value of f = 1000 1000 60 t = 2 years, then v a1000 85 7.33 ( + 0.08) At this price of 88 bonde. 7.33 it should buy Scanned by TapScanner