Economics 442: Macroeconomic Policy - Midterm Exam 1

Q1. Use the AD-AS model, assuming the economy begins in a liquidity trap, and output is less than Y_n, natural output, or potential GDP.

1. Show what the IS-LM and AD-AS graphs look initially.

2. Show what happens if the central bank increases the money supply and the interest rate remains at zero, in the period the money supply is increased. Use a graph to explain your answer. You can assume adaptive (price) expectations.

3. Continuing on 1.2, show what happens over time, assuming no further action, and assuming adaptive price expectations. Be sure to use graph(s).

4. Return to 1, and assume consumption takes the following form.

C = c_o + c₁Y_D + c₂(B+MB/P)

Where MB is money base (reserves and currency).

Show what happens in the IS-LM and AD-AS graphs over time in the absence of either monetary or fiscal policy.

Q2. Suppose the economy is described by the following equations, where P is fixed:

-Real Sector

-Real Sector

(1) Y = Z                          Output equals aggregate demand, an equilibrium condition

(2) Z = C + I + G             Definition of aggregate demand

(3)  C = c_o + c₁Y_D           Consumption fn, c₁ is the marginal propensity to consume

(4) Y_D ≡ Y - T + T_r           Definition of disposable income

(5) T = t₁Y                      Tax function; 1t is marginal tax rate.

(6) T_r = TR₀                    Transfer payments; TR0 is lump sum transfers.

(7) I = b₀ + b₁Y - b₂i        Investment function

(8) G = GO₀                    Government spending on goods and services, exogenous

-Asset Sector

(9) M^d/P = M^s/P               Equilibrium condition

(10) M^s/P = M₀/P              Real money supply

(11) M^d/P = μ₀ + Y - hi     Real money demand

The IS and LM equations are given by:

Y = γ^-[Λ₀ - b₂i] let γ^- = 1/[1-c₁(1-t₁)-b₁]

1. Assume G increases by ΔGO, and is completely bond financed. Calculate the government spending multiplier.

2. Suppose that the central bank targets the interest rate so that interest rate does not change from its original value. What is the change in income resulting from the increase in government spending? Show using a graph and/or equations. Explain why this occurs.

3. Suppose money demand rises by j real dollars when real wealth, (MB+B)/P rises by one real dollar, and the central bank targets the interest rate (as in 2.2). What is the impact on income resulting from the increase in government spending? Show using a graph.

4. Returning to the model used in 2.1, now assume the government does not change spending on goods and services, but the central bank drops the target interest rate by 1%. Show graphically the effect. Using algebra, show the impact on investment and GDP.