Question

Question 2

Explain how the effectiveness of contractionary monetary policy (dM Fiscal policy (dg <0) depends on the magnitude of the response of NX to in r or dNX/dr. Make sure to provide your answer with the relevant mathematical equations, and economic interpretation. points) Question Two: Assume the following equations summarize the structure of an economy. с =C, +0.7(Y - T) са = 2,000 - 50 т * 150 + 0.15Y (M/P) 0.3Y - 10r M/P 3,000 2,000 -10r G 4,000 - 2y NX 1,500 - 0.18-58 A. Calculate the equilibrium real output (Y) and (r). B. If government spending increases by 100, compute by how much the fed must increase the money supply if it wants to avoid the crowding out of expansionary fiscal policy. Make sure to support your answer with the relevant graph (20 points) Question three Examine the spillover effect between the signaling and portfolio balance channel. (20 points) Question four Why are long-term interest rates so low? Do you agree with Ben S. Bernanke's explanation? (20 points) 30 B. Man

Answer 1

(2)

(A)

In goods market equilbrium, Y = C + i + G + NX

Y = 2,000 - 5r + 0.7[Y - 150 - 0.15Y] + 2,000 - 10r + 4,000 - 0.2Y + 1,500 - 0.1Y - 5r

Y = 9,500 - 20r + 0.7(0.85Y - 150) - 0.3Y

Y = 9,500 - 20r + 0.595Y - 105 - 0.3Y

Y = 9,395 - 20r + 0.295Y

0.705Y = 9,395 - 20r

Y = (9,395 - 20r) / 0.705................(IS equation)

In money market equilibrium, (M/P)d = Ms/P

0.3Y - 10r = 3,000

Y = (3,000 + 10r) / 0.3...................(LM equation)

Setting IS = LM,

(9,395 - 20r) / 0.705 = (3,000 + 10r) / 0.3

2,818.5 - 6r = 2,115 + 7.05r

13.05r = 703.5

r = 53.91

Y = [3,000 + (10 x 53.91)] / 0.3 = (3,000 + 539.1) / 0.3 = 3,539.1 / 0.3 = 11,797

(A)

When G increases by 100,

Using IS equation:

0.705Y = (9,395 - 20r) + 100

0.705Y = 9,495 - 20r

Y = (9,495 - 20r) / 0.705................(New IS equation)

Setting New IS = LM,

(9,495 - 20r) / 0.705 = (3,000 + 10r) / 0.3

2,848.5 - 6r = 2,115 + 7.05r

13.05r = 733.5

r = 56.21

Y = [3,000 + (10 x 56.21)] / 0.3 = (3,000 + 562.1) / 0.3 = 3,562.1 / 0.3 = 11,874

These (r, Y) values pertain to existence of crowding out effect.

To keep interest rate unchanged at higher output, money supply has to be increased.

Using new IS equation and keeping r unchanged,

Y = [9,495 - (20 x 53.91)] / 0.705 = (9,495 - 1,078.2) / 0.705 = 8,416.8 / 0.705 = 11,938.72

This is the maximum increase in Y, in absence of any crowding out effect.

Using LM equation:

Ms/P = (0.3 x 11,938.72) - (10 x 53.91) = 3,581.62 - 539.1 = 3,042.52

Increase in money supply = 3,042.52 - 3,000 = 42.52

In following graph, IS0 & LM0 are initial IS & LM curves intersecting at point A with initial interest rate r0 and output Y0. When government spending rises, IS0 shifts right to IS1, intersecting LM0 at point B with higher interest rate r1 and higher output Y0. To keep interest rate same, money supply is increased so that LM0 shifts right to LM1, intersecting IS1 at point C with further higher output Y2 but initial interest rate r1.

X 151 LMO 15. sy B LM А. ro Yo Yo Y2 Y