Name ______IAS 107 Fall 2013
Instructor: Mario Muzzi
Problem Set #5 – Due 12/5/13
1)(7pts) Supply Side Economics:
(a) (4pts) Identify twotax based policies supply-side economists advocate and describe their rationale in support.
(b) (3pts) Describe two separate criticisms of supply-side policies.
2)(12pts) Monetary Policy Debates:
a) (6pts) Monetary Transmission Mechanism: According to the Keynesian school, show what happens, step by step, when the Federal Reserve sells US treasury bills to US banks.
i) (1.5 pts) Show the impact in the Money Market
ii) (1.5 pts) Show the impact in the Keynesian Cross Diagram
iii) (1.5 pts) Show the impact in the IS-LM graph
iv) (1.5 pts) Show the impact in the AD/ASgraph
b) (4pts) Quantity Theory of Money: According to the Monetarists and Rational Expectations, explain what happens, step by step, when the Federal Reserve sells US treasury bills to US banks. Describe the impact in words and:
i) (2pts) Show the impact in the AD/AS graph
ii) (2pts) Show the impact in the Phillips curve. (Include Short-run and Long-run)
c) (2pts) What is the difference between the Keynesian view and Monetarist/Rational Expectations view on the short run and long run effects of discretionary monetary policy?
3)(5pts) Rule Based Monetary Policy: Below draw an AD/AS graph and a money market graph side-by-side. For the money market, use an upward sloping money supply curve and assume that the equilibrium interest rate in the money market is 5%. Also, assume that actual GDP is at full employment and that the equilibrium price level in the AD/AS graph is 100. Now shift AD to the right based on an increase in animal spirits. Show how the money market graph will adjust to a new equilibrium. Then explain and show what happens if the Fed acts to keep the equilibrium quantity of money constant. Is this rule based policy pro-cyclical or countercyclical? (explain)
4)(10pts)Debts and Deficits:
a) (2pts) (True or False) An increase in income tax rates will always result in an increase in government tax revenues. (Explain)
b) (2 pts) (True or False) Recessions will often result in a government budget deficit. (Explain)
c) (6pts) Compare the traditional view versus the view of Ricardian equivalence of the effects of a debt-financed tax cut on:
i) Current Consumption
ii) Current National Savings
iii) Current Interest rates
5)(6pts) Open Economy: Assume that in a small open economy where full employment always prevails, national saving is 300.
a) (2pts) If domestic investment is given by I = 400 – 20r, where r is the real interest rate in percent, what would the equilibrium interest rate be if the economy were closed?
b) (2pts) If the economy is open and the world interest rate is 10 percent, what will investment be?
c) (2pts) What will the current account surplus or deficit be? What will net capital outflow be?
6)(6pts)Exchange Rates and Purchase Power Parity:
Country / Nominal ERfx/$ / Price of Basket / Price of US Basket ($190) in local currency terms / Real Exchange Rate / According to PPP, will currency appreciate or depreciate against $Brazil (real) / 2.1893/$1 / 520
reals
India (rupee) / 46.6672/$1 / 12,000 rupees
Mexico (pesos) / 11.0131/$1 / 1,800
Pesos
South Africa (rand) / 6.9294/$1 / 800
rands
7)(4pts) Determining the ER in Open Economy Model:
(a)(2pts)Suppose that governments around the world (not including the US) begin to increase taxes and cut government spending in order to reduce their budget deficits. Illustrate graphically the impact of this contractionaryfiscal policy by foreigners on the U.S. exchange rate and the trade balance. Assume that the country starts from a position of trade balance, i.e., exports equal imports. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curves shift; and v. the new long-run equilibrium values.
(b)(2pts) Based on your graphical analysis, explain the predicted impact of the foreign expansionary fiscal policy on the U.S. exchange rate and the U.S. trade balance.