ANALYTICAL PROBLEMS

PROBLEM 1

Suppose that in 2012 the economy could be described by the Keynesian model, that it was in general equilibrium with an inflation rate of 3%. Assume that the adjustment process to long-term equilibrium takes 4 years, that demand shocks have a larger effect on output than any inflation or supply shocks, and that any long-run supply shock effect on full-employment output is larger than any short-run inflation shock effect on output.

In 2013, oil prices doubled, which added 2 percentage points to the inflation rate. As a result, consumers' expected future income declined substantially.

In 2014, oil prices fell in half, which subtracted 2 percentage points from the inflation rate. As a result, consumers' expected future income returned to its 2012 level.

a) Based only on this information, use a AD - AS model diagram to clearly and accurately show:

• The economy's output level and inflation rate in 2012 (in black),
• The economy's output level and inflation rate in 2013 (in red),
• The economy's output level and inflation rate in 2014 (in blue),
• The economy's output level and inflation in 2015 (in green), and
• The economy's output level and inflation rate once general equilibrium is re-established (in black).

b) Provide a brief economic explanation of the economy's initial equilibrium, of EACH of the changes that you have made, and of the final equilibrium that you have shown in your diagram above. Be sure to discuss the adjustment process that the economy undergoes with respect to economic output and inflation for EACH year

PROBLEM 2

Argentina and Brazil are major trading partners. Assume that both economies are in general equilibrium, can be described by the Keynesian model, and that changes in economic output from domestic events are greater than from international events.

Now suppose that Brazil experiences a sharp decline in the expected future marginal product of capital at the same time that Argentina reduced its tax rates significantly. In reaction to these events, the Brazilian central bank immediately responds to keep Brazilian economic output at its full-employment level.

a) Based only on this information, use a 2-country, open economy IS - LM diagram to clearly and accurately show:

I. The initial general equilibrium situation in both countries (in black),
II. The short-run effects on economic output (in red and blue as needed).

b) Provide a brief economic explanation of the changes you have shown in your diagrams above. Be sure to compare the level of economic output, the real interest rate, and the exchange rate between the initial equilibrium and the new short-term equilibrium that exists in each country after Brazil's monetary contraction.