Macroeconomics

Remarks: Write clearly and concisely. Denote some time to give the graphs. plots and tables a format
easy to understand. Also the way you present your answers matter for the final grade. Even if a question is
mainly analytical, briefly explain what you are doing. stressing the economic meaning of the various steps.
Being able to convey your thoughts efl’ectively is an invaluable asset in life.

Question 1: IS-LM & AD-AS (20 Marks)
(a) Draw a diagram representing a business cycle. Why are they important to economists and policy
makers? W’hich component of output expenditure is the most volatile? How are the real wage and the real
rate of interest affected during a contraction (recession)? W’hat about nominal interest rates?
(b) Suppose that the policy goal is to maintain output at its full employment (long-run) level. How would
a Keynesian economist respond to a recession caused by an aggregate demand shock (decrease)? How
would a nee-classical economist respond to the same demand shock? Use AD-AS diagrams to explain.
Question 2: IS-LM & AD-AS – The Keynesian short-run (40 Marks)
Consider the following closed economy “Aberdeen”.

C?” = .75(Y – T) – 2. 0oor

G = 60

T = 50
Md/P = .5(Y) – 2. 000(r + n‘)

1″ = 300(Af) – 3000r

n‘ = 0
where (I is aggregate consumption. l” is output. T is the lmnp sum tax. Aid/P is real money demand, P is
the price level, a” is expected inflation, 1“ is investment demand and r is the real rate of interest. There
exists a government with expenditures equal to G and a central bank that_ sets the money supply equal to
Ill. The price level takes time to adjust and is fixed in the short-run at (P). In the short-run. firms are
willing to produce any given level of output. You may assume that the economy starts at a long-rim
equilibrium. Expected future productivity is A’.
(a) Find an equation for the investment-savings curve (r1 5) and the money-demand. money-supply curve
(rm!) and the aggregate demand curve (PAD) as fimctions of (Y. M. A! ). To simplify, replace T and G
with the corresponding values above.
(b) Using A’ = 1. 4″, = 1.005 and Y = 550, solve for the equilibrium values of LS. P. r
(c) Suppose that expected future productivity (A! ) increases to 1.1. With the fixed price level, find the
short-run level of output YSR that firms produce. Then find the the short-run real rate of interest (r).
Illustrate your result on both an IS-LM and AD-AS diagram.

((1) Suppose now that the economy is at a new long-run equilibrium where expected future productivity
(AI ) is still 1.1 but now output (Y) is 600. The central bank is concerned that the price level will fall
below its current level. By what amount must the central bank set the money supply in order to achieve a
price level of 5.25 in the long run? By what. percentage rate must the money supply be increased? By what
percentage rate did real money demand increase? Hint (i): first calculate the new long-run rate of interest.
Hint (ii) recall from chapter 7: it = gp = 9M.
Question 3: IS-LM & AD-AS in an open and closed economy (40 Marks)
For parts a to c, amume the economy is closed and be sure to differentiate the short-run and long-run
eifects on the economy. For all parts, assume that the price level is fixed in the short-run and firms will
produce any given level of output when the price level is fixed.
(a) Suppose that the government of “Collingwood” imposes new regulatory requirements on the ability of
firms to hire and fire workers. Interpret this policy as a negative labour demand shock. Draw a diagram of
the Labour Market and IS-LM model illustrating the effect on output (Y) and the real rate of interest (1′).
“fill the price level increase or decrease? Explain your conclusions.
(b) Suppose that during the Great Moderation, the consumers of “Bagot” became much more optimistic
about future income and increase consumption for any given level of income and the real rate of interest.
Vhat affect will this have on output (Y), the real rate of interest (1′) and the price level (P). For a closed
economy. draw a diagram of the Goods Marlnet and the IS-LM model.
(c) Suppose that the government of “Bader” increases fiscal spending (G) and the central bank increases
the money supply (A!) \Vhat happens to output (Y) and the real rate of interest (7′)? \Vhat happens to
the price level (P) in the long-run?
((1) Consider the following open economy of “Earl”. Derive an expression for the open economy IS curve
and AD curve. Then find an exprmsion for YSR by re-arranging the AD curve equation so that Y is
isolated on the left-hand side. Use your equation to determine if an increase in the real exchange rate
increases or decreases shortprun output.

C“ = ao+ai(Y-T) -a,r

Id = 70 – 7r,-
5“ = v – Cd – G
N: = 60 – 6UY – 6ce
1“ _ OiY – 4‘! | P

L1″ – or
where e is the real exchange rate and r L M is the ???? curve and the remaining variables are the usual
suspects (see question 2 for a complete list). Note that the real rate of intermt is always equal to the world
real rate of interest and that “Earl” has a floating exchange rate. Assume all coefficients (the Greek
letters) are positive.

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