14.02. — Fall 2001 — Q UIZ 1 A nsw ersQUESTION 1:1. FALSE. The car should not be counted (it was already counted whenBond first bought the car). The only services produced were the tuning andrepairing. Therefore GDP increases by £1000.2. FALSE. People k eep less cash. This implies that the money multipierincreases. Therefore the Central Bank needs to exchange fewer bonds in orderto have the same effect in the Money supply.3. TRUE. Both increase money supply. One directly increasing High-powered money and the other increasing the multiplier.4. TRUE. Money supply increases therefore interest rates decr ease. Asinterest rates decrease, investement increases, counteracting the effects of thedecrease in investors’ confidence.QUESTION 2:1. The demand for consumption depends positively on disposable income,that is, income after taxes, since this is the pool of resources from which con-sumers decide how much to consume or save. Only a fraction of additionalspending is actually consumed so c1< 1. There is also an autonomous compo-nen t of demand for consumption that could reflect necessities that consumerswill always want to satisfy or the level of consumers’ confidence (this is, howmuch they believe in the availability of future resources).The demand for investment also has an autononomous component that willdepend on investors’ confidence. Then, as production increases, there are moreinvestement opportunities, while high interest rates make it more costly to bor-row in order to undergo an investment proy ect (or, if you prefer this explanation,it is preferrable to save in bonds than to carry out the project).2. The result is:Y =11 − c1− d1(c0− c1T + d0− d1i + G)3. The multiplier is11−c1−d1and autonomous spending is c0+ d0− c1T +G − d1i.Yes,wehavetoassumec1+ d1< 1, so that this goods market has anequilibrium at a positive level of output and demand and supply do not diverge.Otherwise, an extra dollar of output would generate an increase in aggregatedemand of more than one dollar (in other words, the geometric series of themultiplicative effects would be exploding).4. The money demand depends positively on nominal income and negativelyon the interest rate. Nominal income is used as a proxy for the level of transac-tions in the economy —the higher nominal income is, the more transactions takeplace, so the more money is needed. The interest rate is the opportunity cost1of holding money as opposed to bonds —the higher the interest rate, the largerthe foregone earnings.5. It is:i =e$Y − Hf6. This is the usual IS-LM graph.7. A governement expands demand by demanding more goods. Hence,it increases G. In the IS-LM graph, the IS moves outwards, the interest rateincreases and so does output. As the demand impulses output to a new equi-librium, money demand increases, driving up the interest rate. Higher interestrates, on the other hand contract the demand for investment, hence partiallyoffsetting the initial impulse of fiscal policy.8. The cen tral bank expands money by open market operations, that is, bybuying bonds in the market. As the supply of bondscon tracts, their price in-creases and hence their return falls. Equivalently, as money expnads it becomescheaper and interest rates fall. In the IS-LM graph, the LM moves outw ards,interest rates fall. Lower interest rate expand the demand for investment, henceexpanding output. Higher output expands money demand, helping to close themoney market.QUESTION 3:1. If nothing changes in this economy, that is, if the economy is at a steadystate from period to period, GDP will be the same in two consecutive periods,and it will be:Yt=40 − 80 · 0.5 + 60 + 1001 − 0.5= 3202. At t=1, autonomous spending, and therefore aggregate demand, increasesby −c1· (−1) = c1= .5. Supply cannot react yet so there is an excess demandof c1. At t=2, supply reacts to accomodate previous demand and then increasesin c1, but demand reacts immediately increasing by c21= .25. At t=3, supplyreacts and increases now by c21....etc. Once an infinite number of periods havepassed, the total increase in output will be:∞Xj=1cj1=∞Xj=0cj1− 1 Ãj−→ ∞11 − c1− 1=c11 − c1=11 − c1· c1=2· .5=1So that the total effect is c1times the multiplier. The intuition is straight-forward. The multiplier continues to be the same, but the initial autonomousdemand impulse was only c1.3. If investment depends positively on output, then there will be a secondpositive effect on output in each period. Starting from period t=2, investmentwill also increase as a result of the increase in ouput, adding a second positiv eterm, say d1c1to the rise in aggregate demand. This effect reinforces that of2consumption, so as a result we should see output expand by more than in theprevious case where investment did not respond to changes in output.QUESTION 4:1. If consumers confidence goes up, autonomous spending expands, so nom-inal output will increase. Increased output leads to a higher demand for money,this is, to an outw a rd shift of the Mdcurve, which pushes interest rates up.(The increase in interest rates will contract investment and partially offset theexpansion in output, in a standard IS-LM framework. But we’re not consideringthe goods market here, only the financial market). Figures are standard.2. To restore the interest rate to its previous level, the Central Bank mustexpand money supply, thus shifting Msto the right and counteracting the effectof the increased Money Demand on the interest rate. In other words, if thereis an excess demand for money as a result of increased nominal income, thenit is necessary to increase supply if we want to maintain the same equilibriuminterest rate.In order to do so, the Central Bank will have to buy bonds in the market(Open Market Operation). In doing so, the Central Bank will be increasing thedemand for bonds, hence increasing the price of bonds —which is equivalent toreducing the interest rate on bonds.3. First assume that all money is paid this interest rate, this is, both checkingdeposits and pocket cash (currency). Then, the opportunity cost of holdingmoney is not i but i − im.Ifimgoes up, money demand will increase for anygiven interest rate on bonds, i,sotheMdcurve will shift to the right. In thenew equilibrium, and if money supply remains unchanged, the interest rate onbonds i will have to be
View Full Document
Unlocking...