Question

Hi, Please find some solution for this question below. I need your answer for this question very  quickly.Br/H

Consider the AS-AD model . Assume, initially, that the real interest
rate only affects domestic investment.

a. Write down the expressions for the AS and AD curves and interpret the expressions. What must be true of the model parameters and variables in the long-run equilibrium, i.e. in the steady state?

b. Analyse the effects of a supply shock that causes a decrease in inflation, preferably using a diagram. Assume that the shock lasts for one period and then assumes the value zero. Describe the mechanisms that brings the economy back to long-run equilibrium. What happens to aggregate demand?

c. Now assume that net exports, ??_t , as a fraction of potential GDP, ?^-? , are determined by the following equation:

??_t^/ ?^-_t = ??? − ???(?_t − ?*_t ),

where ?_t is the real interest rate and * denotes foreign. Explain the intuition behind this expression.

d. Derive the IS-curve when net exports are determined as in question c above.

Answer 1

income elasticity of the demand for money in this case is ηY = 0.5 and is
obtained as follows:
ηY = [dMd(Y)/dY](Y/M) = [d(PY0.5)/dY]/(Y/PY0.5)
= P(0.5Y-05)(Y/PY-0.5) = 0.5
Part b) (7 Marks)
First find equilibrium in the money market, namely:
Md = Ms
= M
PY0.5 = M
With P=1 we get:
(1) Y = (M)2
This shows the relationship between output and money supply in our simple
economy. Next we use the definition of velocity, in order to get values of both Ms and
Y. First:
V = PY/M = 2, or
(2) Y = 2M
We now have two relationships between output and money. Setting one equal to the
other we get:
2M = (M)2 or
(3) M2 – 2M = 0
We have to solve a simple quadratic equation, which is:
M1, M2 = {2 ± √4 - 0}/2 = (2 ± 2)/2
The two roots are M1 = 0 and M2 = 2. We will focus on the second case, which is the
more sensible one. Thus a level of Ms
= 2 and Y = 4 (from either 1 or 2 above) would
be consistent with velocity of 2 and a price level of 1.
Note that some students may just factor expression (3) – M(M – 1) = 0 – and get
M = 2 directly as a root. This is fine as an answer.We have to rely on the following equation, linking predicted or expected inflation,
πe
, to money growth ∆M/M and output growth ∆Y/Y:
(1) πe
= ∆M/M – ηy∆Y/Y = 0.04 – 0.5(0.05) = 0.015
In our case, expected inflation is going to be 1.5%. Money is growing too fast
compared with the increase in transactions needs: this will induce inflation in the
economy.
Part d) (7 Marks)
Only equation (ii) is consistent with the quantity theory. The theory makes the
strong assumption that the velocity of money (the rate at which it turns over in the
economy) is constant. The two other equations imply that velocity will change with
interest rates and real income.
Question 2: Deriving and solving the IS-LM-AD model – closed economy
version (25 Marks)
Part a) (4 Marks)
For the IS curve, start with the desired saving-investment equilibrium condition. In
particular:
(1) S
d = Y – Cd – G = Y – 0.6(Y – T) + 50r – G
(2) I
D = 310 – 150r
Setting the two equal and solving for r in terms of Y and factors that would shift the
curve, we get:
(3) r = 1.55 – 0.002Y – 0.003T + 0.005G (IS Curve)
Movements along the IS curve show the combinations of r and Y that are consistent
with goods market equilibrium. For instance, an increase in Y implies an increase in
S
d (from (1) above). The shift outward in the Sd curve will lower interest rates and in
the process raising investment, bring it into equilibrium with the higher level of
saving. As well, saving being equal to investment is consistent with goods market
equilibrium.
The LM curve is straightforward and is simply the money demand function
rewritten as r related to Y, M and πe
.
(4) r = 0.00125Y – 0.0025(M/P) – πe
(LM curve)
The LM curve shows combinations of r and Y that are consistent with money market
equilibrium, given an unchanged money supply, M, and constant inflation
expectations, πe
. A rise in income will raise the demand for money and in order this paper, we analyze a number of monetary and FX policy alternatives using the model of a small open oil-exporting economy hit by severe balance-of-payment shocks, such as those that simultaneously affected the Russian economy in 2014–2015. For our purposes, we modify Romer's (2013) IS-MP general equilibrium model by adding a structure similar to the Russian economy (tradables and oil vs. non-tradables). In the model, we consider an optimal policy mix that includes a floating exchange rate, FX liquidity provision by a central bank and temporary tightening of monetary policy. The flexible exchange rate works as a shock absorber, helping restore aggregate demand and domestic production. If inflation expectations are not anchored, contractionary monetary policy helps to stabilize them. Financial stability risks are addressed by lending FX liquidity to the banking sector.

Over the past 2 to 2.5 years, the Russian economy has experienced several balance of payment shocks. These are related to the onset of the Fed monetary policy normalization, geopolitical tension followed by the sanctions which led to capital outflow, as well as the decline in oil prices and increased volatility.

This drastically different external environment has brought about substantial changes in the Russian economy that have been dubbed “new reality”. There are still heated discussions underway regarding the most appropriate macroeconomic policy that would enable the economy to adapt to the situation and to put it on the path of sustainable growth under the new conditions, as soon as possible.

The range of policy measures being proposed is quite broad, while theoretical justification for many of them is not quite clear. To narrow this gap in policy discussions, this paper attempts to deal with the issue from the standpoint of standard macroeconomic theory. We demonstrate how standard basic macroeconomic models should be adapted and used to find the most appropriate macroeconomic policy for Russia. This paper addresses both monetary and fiscal policies and relies upon basic macroeconomic models.

The first part defines the macroeconomic variables describing the long-run equilibriumin the model: potential GDP, the long-run real interest rate, and a central bank's inflation target. It also defines indicators that reflect the structure of the economy (tradable goods and commodities vs. non-tradable goods) and the variables responsible for structural shifts in the economy in the aftermath of changes in oil prices (the real exchange rate). In our description of a small open economy we follow the textbook by Vegh (2013).

In the second part of the paper, we look into the short-run equilibrium in the goods and money markets (IS-MP model), following Romer (2013), measuring the equilibrium real interest rate and the equilibrium GDP output, the values of which may differ in the short run and in the long run. In parallel, we analyze the foreign exchange market and define the equilibrium real and nominal foreign exchange rates, putting the balance of payments in equilibrium. To close the model, we define inflation and inflation expectationsand introduce a tight link between inflation and aggregate output. The model is helpful in explaining correlation between inflation and aggregate demand. Finally, we describe the core elements of the government budget and present the concept of a long-run (equilibrium) budget deficit and national debt.

With the modelling tool now at our disposal, in Part 3 we analyze how the Russian economy reacted to the 2014 balance of payment shocks and explore the most appropriate monetary policy response to the oil shock, taking into account the projected medium-term fiscal policy.