Homework 5-
1. Use the AD/AS model for this question. For each given scenario complete the following four steps:
Step 1: Draw the AD/AS model in long-run equilibrium. Label Yfe and the initial price level in this graph. Label all curves and both axes.
Step 2: In a second graph model the given event and identify clearly the new short-run equilibrium. This graph should include everything from the first graph as well as the short-run effect of the new event.
Step 3: Analyze verbally the short-run status of the economy: 1) is the economy in a boom or a recession?; 2) is unemployment relatively high or relatively low?; and 3) what is happening to the aggregate price level as this economy moves from the long-run position (step 1) to the short-run position (step 2)?
Step 4: Draw a third graph indicating how this economy will reach long-run equilibrium. Describe verbally this adjustment process.
a. Holding everything else constant, the real estate market collapses due to a housing bubble.
b. Holding everything else constant, the stock market declines and this causes a reduction in people's wealth.
c. Holding everything else constant, uncertainty in European markets results in a loss of consumer confidence.
d. Holding everything else constant, the government embarks on an austerity campaign and reduces government spending.
2. Suppose there is only one bank in Finlandia, the National Bank of Finlandia. Furthermore, suppose that in Finlandia there are no currency drains: that is, no one holds currency and all financial transactions are done via checks drawn on the National Bank of Finlandia. I n Finlandia the initial level of demand deposits in $1,000,000 and the initial level of reserves in the banking system is $100,000. Assume that the National Bank of Finlandia is not holding any excess reserves initially. You also know that in Finlandia the Central Bank of Finlandia has assets of $100,000 in Finlandia Treasury bills and reserve liabilities of $100,000. To simplify this problem, assume that the net worth of the National Bank of Finlandia is equal to zero.
a. Using the above information fill in the t-accounts for the Central Bank of Finlandia and the National Bank of Finlandia.
b. Given the above information, what is the required reserve ratio in Finlandia?
c. Given the above information, what is the value of the money multiplier in Finlandia?
d. Given the above information, what is the value of the money supply?
e. Suppose the Central Bank sells $50,000 worth of T-bills. Provide a t-account that illustrates the immediate impact of this transaction on the Central Bank as well as on the National Bank of Finlandia. Assume that the Central Bank sells the T-bills to the National Bank of Finlandia.
f. The t-account you drew in (e) should have assets equal to liabilities for the two institutions. If this is not true, you have an error and you need to go back and revise the t-account so that this is true. The t-account that you drew in (e) for National Bank of Finlandia no longer has the required amount of reserves. Describe the state of current reserves for the National Bank of Finlandia as represented in your answer to (e).
g. Now, provide a t-account that illustrates the impact of this transaction on both institutions once full adjustment to this purchase has occurred. Explain verbally this adjustment process.
h. Given the transaction in (e), calculate the change in the money supply. Show any formulas you are using to find your answer.
i. Instead of the scenario described in (e), suppose that the Central Bank purchases $80,000 worth of T-bills from the National Bank of Finlandia. Provide a t-account that illustrates the immediate impact of this transaction on the Central Bank as well as on the National Bank of Finlandia. Assume that the Central Bank sells the T-bills to the National Bank of Finlandia.
j. Now, provide a t-account that illustrates the impact of the transaction described in (h) on both institutions once full adjustment to this purchase has occurred. Explain verbally this adjustment process.
k. Given the transaction in (h), calculate the change in the money supply. Show any formulas you are using to find your answer.
3. You are given the following information about an economy.
Money supply = Ms = 1000
Money demand = Md = 2000 - 200r where r is the interest rate expressed as a percentage and not a decimal (hence, 2% would be 2 in the equation and not .2)
Required reserve ratio = rr = 10%
There are no currency drains in this economy.
There are no excess reserves in this economy.
Labor demand = Ld: W/P = 5 - (1/1000)Ld where W/P is the real wage and Ld is the quantity of labor demanded
Labor supply = Ls: W/P = (1/1000)Ls where W/P is the real wage and Ls is the quantity of labor supplied
P = aggregate price level = 1 initially
Y = AKαL1-α is the aggregate production function for the economy
A = 10
K = 400
Α = .5
C = 12,000 + .5(Y - T) - 10,000P
TR = 0
G = 100
T = 100
X = 500
M = 500
I = 15,000 - 100r
SRAS: Ys = 17,050P
AD: Y = C + I + G + (X - M) where Y is aggregate demand
a. Start by finding the equilibrium in the money market. Use the above information to determine the equilibrium interest rate.
b. Now that you have the equilibrium interest rate calculate the level of investment in this economy when the money market is in equilibrium.
c. What is the full employment level of labor? Find the real wage, W/P, and the nominal wage, W.
d. Find the full employment level of output for this economy.
e. If this economy produces at its full employment level of output, what will labor productivity equal?
f. Given the above information, calculate the aggregate price level for this economy when it is in long run equilibrium.
g. Suppose the Fed purchases $50 worth of T-bills in the open market. First, predict what will happen in the short run to the new interest rate (r'), the new short run level of Y (Y'), the new aggregate price level (P'), and the new real wage ((W/P)') because of this monetary policy. Then, find the new short-run interest rate (r'), the new short run level of Y(Y'), the new aggregate price level (P"), and the new real wage ((W/P)') because of this new monetary policy.
h. Discuss the long run adjustment process that will occur as this economy moves from the short-run equilibrium you found in (g) to the long run equilibrium.