Money, Banking, and Credit, Assignment #3 Answers

Assignment #3 Answers Question 1: IS/MP Model See graphs below. a) Exogenous change: εMP↓ Effects: Y↑, r↓, C↑, I↑, CF↑ 3. R e a l m o ne y de m a nd inc re a s e s be c a us e inc o m e inc re a s e s . r r M 1 /P M 2 /P MP1 1. F e d inc re a s e s the m o ne y s upply to lo we r re a l inte re s t ra te s . r1 * r2 * r' A MP2 A r1 *r2 B 2. R e a l inte re s t ra te s a re no w lo we r fo r a ny give n le ve l o f o utput. (εMP ↓) B r' L(r,Y2 ) IS1 L(r,Y1 ) M 1 /P Y1 * Y2 * M/P Y 1a) b) Exogenous changes: εMP↑ and G↓ Effects: Y↓, r ambiguous (depends on which policy is bigger), C↓, I and CF are ambiguous (depends on whether interest rates rise or fall). 2. F e d inc re a s e s εMP r M 2 /P M 1 /P MP2 r MP1 1. F e d c uts M to inc re a s e inte re s t ra te s A r1 * B r1 * B A 1. De c re a s e in G 3. R e a l m o ne y de m a nd de c re a s e s be c a us e Y de c re a s e s L(r,Y1 ) L(r,Y2 ) M 2 /P M 1 /P IS2 Y2 * M/P IS1 Y1 * Y 1b) c) Exogenous change: εMP↓ Effects: Y↑, r↓, C↑, I↑, CF↑ r M 2 /P M 1 /P r 1. P re fe re nc e fo r ho lding m o ne y fa lls r1 * r2 * r' 2. This is a de c re a s e in εMP (lo we r r fo r a give n Y) MP2 r2 * A r1 * r2 * r' B A B L(r,Y1 ) L(r,Y2 ) L(r,Y1 ) M 1 /P 3. R e a l m o ne y de m a nd inc re a s e s be c a us e Y inc re a s e s MP1 IS2 M/P 1c) Y1 * Y2 * IS1 Y d) This implies that any time output in the economy rises, the government offsets part of this increase by reducing government spending. This affects the slope of the IS curve, because now, G is a function of Y (much like consumption is a function of income). Specifically, the slope of the IS curve will be steeper (changes in interest rate r will be associated with smaller changes in Y) e) This implies that the MP curve is steeper. Changes in output (Y) will be associated with larger changes in r (the Fed adjusts r by more when Y changes). Question 2: IS/MP Model – Monetary Policy Strategy a) The MP curve is flat. In other words, when output Y changes, the central bank does not change r. Changes in inflation will shift the MP curve up or down; changes in output will not affect interest rates. r r1 * M 1 /P F e d s till s hifts m o ne y s upply to a ffe c t inte re s t ra te s . The F e d o nly do e s this whe n infla tio n c ha nge s . A r Inte re s t ra te s do no t va ry with o utput, o nly infla tio n r1 * A MP1 L(r,Y1 ) M 1 /P IS1 Y1 * M/P Y 2a) b) The MP curve is vertical. The MP curve shifts only in response to output movements (it is determined strictly by where output is). r M 1 /P r1 * A F e d s till s hifts m o ne y s upply to a ffe c t inte re s t ra te s . The F e d o nly do e s this whe n o utput c ha nge s . r r1 * MP1 A L(r,Y1 ) M 1 /P M/P 2b) Inte re s t ra te s do no t va ry with infla tio n, o nly o utput. IS1 Y1 * Y c) This will lead to an upward shift in the MP curve. The central bank achieves this by decreasing the money supply. 2. F e d inc re a s e s εMP M 2 /P M 1 /P r r' r2 * r1 * B MP2 r 1. F e d c uts M to inc re a s e inte re s t ra te s MP1 r' r2 * r1 * A B A 3. R e a l m o ne y de m a nd de c re a s e s be c a us e Y de c re a s e s L(r,Y1 ) L(r,Y2 ) M 2 /P M 1 /P IS1 IS2 Y2 * Y1 * M/P Y 2c) Question 3: IS/MP/IA Model a) Exogenous change: εIS↑ Effects: Y↑, r ↑, π↑, C↑, I↓ and CF↓. b) Exogenous change: εIA↑ Effects: Y↓, r ↑, π↑, C↓, I↓ and CF↓. 1. C o ns um e r c o nfide nc e inc re a s e s , εIS inc re a s e s . MP2 r r2 * r' r1 * 3. π inc re a s e s , c a us ing the F e d to inc re a s e r (M P s hifts up). A MP2 r MP1 B 2. π inc re a s e s , c a us ing the F e d to inc re a s e r (M P s hifts up). B r2 * A r1 * MP1 IS2 IS1 IS1 Y1 * Y2 * Y' π Y2 * Y Y1 * IA 2 π IA 1 B π 2* π 1* π 2* π 1* 1. εIA inc re a s e s , infla tio n inc re a s e s fo r a give n Y. B A AD2 AD1 Y1 * Y' Y2 * 3a) IA 1 2. Inc o m e is highe r, fo r a give n ra te o f π. A Y Y AD1 Y2 * Y1 * 3b) Y c) Exogenous change: εMP↑ Effects: Y↓, r ↑, π↓, C↓, I↓ and CF↓. d) This makes the IS curve flatter, but does not necessarily affect the endogenous variables. What this change means is that exogenous shocks to the economy will affect interest rates, output, and inflation differently. 1. Inc re a s e in re a l m o ne y de m a nd le a ds to a n inc re a s e in r. εMP inc re a s e s , M P s hifts MP' r MP2 MP1 r 1. If inve s tm e nt is le s s s e ns itive to inte re s t ra te s , the n a n inc re a s e in r will re duc e Y by a s m a lle r a m o unt (a lo ng the IS c urve ). MP1 r' B r2 * r1 * 3. π inc re a s e s , c a us ing the F e d to inc re a s e r (M P s hifts up). A r1 * A IS2 IS1 IS1 Y' Y2 * Y1 * π Y2 * Y1 * Y π IA 1 π 1* π 2* A Y IA 2 IA 1 2. Y de c re a s e s fo r a ny give n π, AD s hifts le ft. π 1* A B AD1 AD2 Y' Y1 * AD1 Y Y1 * Y2 * 3c) 3d) Y e) Exogenous changes: εIA↑ and εIS↓ Effects: Y↓, r and π ambiguous, C↓, I and CF ambiguous. Question 4: IS/MP/IA Model – Fiscal and Monetary Policy Preview a) IS curve shifts to the right. This causes an upward shift in the MP curve (when inflation rises) Exogenous change: T↓ Short Run Effects: Y↑, r ↑, π↑, C↑, I↓ and CF↓. Long Run Effects: Y no change, r ↑, π↑, C↑, I↓ and CF↓. 4. As infla tio n a djus ts upwa rd, the F e d furthe r ra is e s r. r r3 * r2 * r' r1 * r r1 * 1. εIS de c re a s e s B A IS2 IS1 Y1 * Y2 * MP2 MP1 B Y IA π 3. π inc re a s e s , c a us ing the F e d to inc re a s e r (M P s hifts up). A MP1 2. πIA inc re a s e s , s o the F e d inc re a s e s r (M P s hifts up) MP3 C MP2 2 IA 1 π 1* 1. εIA inc re a s e s B A IS2 IS1 Y1 * Y2 * Y' π π 3* IA 3 IA Y 1 C B π 2* π 1* 1. T de c re a s e s , s o IS s hifts right. AD2 Y2 * Y1 * AD1 Y 3e) 2. Inc o m e is highe r, fo r a give n ra te o f π. A AD1 Y1 * Y' Y2 * 4a) b) IS curve shifts to the left. This causes a downward shift in the MP curve (when inflation falls). This is simply the reverse of the diagram 4a) above. Exogenous change: G↓ Short Run Effects: Y↓, r ↓, π↓, C↓, I↑ and CF↑. Long Run Effects: Y no change, r ↓, π↓, C no change, I↑ and CF↑. c) IS curve shifts to the left. This is because the effects of the government spending cut are larger than those of the tax cut. Households only consume a fraction of the tax cut (marginal propensity to consume is less than one). This causes a downward shift in the MP curve (when inflation falls). The diagram is the same as 4a), except that the shifts would be smaller in magnitude. Short Run Effects: Y↓, r ↓, π↓, C↓, I↑ and CF↑. Long Run Effects: Y no change, r ↓, π↓, C↓ (this is because Y is unchanged and I and CF increase), I↑ and CF↑. d) A balanced budget amendment would force the government to decrease spending each time it cut taxes. However, the effects of these two policies are not the same in terms of output. This policy would actually reduce output in the short run. The policy is beneficial because it would reduce interest rates in the long run, leading to higher investment (and net exports). e) MP curve shifts to the right. This causes an upward shift in the MP curve (when inflation rises) Exogenous change: εMP↑ Short Run Effects: Y↓, r ↑, π↓, C↓, I↓ and CF↓. Long Run Effects: Y no change, r no change, π↓, C no change, I no change and CF no change. f) The central bank would implement this policy to reduce inflation. Notice, there are no effects on real economic variables in the long run. 1. F e d inc re a s e s inte re s t ra te s fo r a give n va lue o f Y a nd π. εMP inc re a s e s , M P s hifts up. MP' r MP2 MP1= MP3 5. As π de c re a s e s , the F e d to de c re a s e s r (M P s hifts do wn). r' B r2 * r1 * A= C 3. π inc re a s e s , c a us ing the F e d to inc re a s e r (M P s hifts up). IS1 Y' Y2 * Y1 * π Y IA 1 IA 3 π 1* π 2* A B π 3* C 4. π, de c re a s e s a s IA s hifts do wn to bring the e c o no m y to full e m plo ym e nt. 2. Y de c re a s e s fo r a ny give n π, AD s hifts le ft. AD1 AD2 Y' Y1 * Y2 * 4f) Y