MGEB05 Assignment 2 (Fall 2020) 2
Question 1 (20 points) – Topics 3 & 5
Home is a small open economy with perfect capital mobility. Initially, it is in its long-run equilibrium
and domestic assets and foreign assets are prefect substitutes. Recently, residents in Home have
undertaken many protest (non-violent so far) demanding more freedom and greater say in future
decisions. Many believe that this kind of the political unrest might have negative impacts on the economy
and people worry that the negative impacts include the following:
• Making domestic assets become more risky and the risk premium (on domestic assets) becomes
positive. (Hint: think about what happens to domestic real interest rate)
• Lower business confidence.
a) Use the long-run classical model of an open economy to evaluate the people’s concerns mentioned
above on the country’s output, consumption, investment, net exports, real exchange rate, and price
level. Explain and support your answer by ONE loanable funds market diagram and ONE foreign
exchange market diagram. (15 points).
b) Based on your answer in part (a), is there anything the central bank can to if it wants to offset the
effect of the change in risk premium on the country’s real interest rate? Explain. (5 points).
Question 2 (30 points) – Topics 3, 4 & 5
Suppose the world consists of only one pair of open economies, country A and country B, and these
countries only trade with each other. Country A only produces food whose output is measured in standard
units, where one unit of YA is equal to 250 kilograms of food. Country B only produces clothing in
standard units, where one unit of YB is equal to 10 kilograms of clothing. The table below provides some
selected information about the economies of these countries. Keep your answers to at least 4 decimal
places.
Country A Country B
Production function: YA = 3xK0.50L0.50
Capital stock: K = 500
Labour supply: L = 500
Production function: YB = K0.50L0.50
Capital stock: K = 850
Labour supply: L = 850
Consumption function: C = 150 + 0.5(Y – T) Consumption function: C = 110 + 0.65(Y – T)
Investment function: I = 804 – 80r Investment function: I = 150 – 90r
Gov’t sector: G = 100 & T = 100 Gov’t sector: G = 110 & T = 110
Net export function: NX = 841 – 975ε Net export function: NX = 748 – 614(1/ε)
Monetary sector:
Real money demand = L(r, Y) = 0.8Y – 100r
Nominal price level = 1
Monetary sector:
Real money demand = L(r, Y) = 0.9Y – 200r
Nominal price level = 1
Use the long-run classical model of an open economy to answer the following questions. Both countries
have perfect financial capital mobility and no risk premium. Also, expected inflation is zero in both
countries.
Note:
• Interest rates, i and r, are expressed in percentage points, i.e., if r = 7.5, then r = 7.5%.
• Since there are only two open economies, both are large open economies.
• Think about what holds true when we add up all countries’ net exports together.
a) Determine the long-run equilibrium level of food and clothing production. (4 points)
MGEB05 Assignment 2 (Fall 2020) 3
b) Suppose absolute purchasing power parity holds for these countries. For each country, determine the
long-run equilibrium levels of:
• The trade balance;
• The domestic nominal money supply;
• The real exchange rate (in the usual orientation # of foreign per domestic, εFC/DC);
• The nominal exchange rate (in the usual orientation of # of foreign currency per domestic
currency);
• The domestic real rate of interest;
• The real wage rate of labour and real rental rate of capital;
• The unemployment rate; and
• Output per worker.
Support your answer with one set of diagrams, one for the (Country A) loanable funds market and
one for the (Country A) foreign exchange market. Which country has a better standard of living? (11
points)
c) Suppose the government of country A decides to implement a new law that imposes a minimum real
wage of 1.75. Redo parts (a) and (b). Explain in words which country has a better standard of living
& why. (15 points)
Support your answer with one NEW set of diagrams, one for the (Country A) loanable funds market
and one for the (Country A) foreign exchange market. Be sure to label the initial and new long-run
equilibrium points and provide an explanation on whether the values of variables of interest change
or remain unchanged.
Note: There is no need to do any calculation. Written explanation will be sufficient.
Question 3 (25 points) – Topics 6 & 7
The following question’s sub-parts are completely separate questions.
a) Some economists claim that the government should always use monetary policy to stabilize (or
target) the real interest rate in the short-run if they also wish to keep the resulting impact on (changes
to) the government budgetary balance to a minimum. Is this claim true, false or uncertain? Explain
by using words and one IS/LM diagram. (5 points)
b) The government should always use monetary policy to combat the effect of business cycle
fluctuations coming from COVID-19 induced changes in autonomous consumption if it wishes to
keep movements in unemployment & investment to a minimum. Is this claim true, false or uncertain?
Explain by using words and a single IS/LM diagram. (10 points)
c) The government should never use fiscal policy to combat business cycle fluctuations coming from
COVID-19 induced changes in money demand if it also wishes to keep longer term movements in
the price level to a minimum. Is this claim true, false or uncertain? Explain by using words and a
single AS/AD diagram. (10 points)
MGEB05 Assignment 2 (Fall 2020) 4
Question 4 (25 points) – Topics 6 & 7
Utopia is a closed economy and is characterized by the following equations:
Consumption: C = 1510 + 0.95(Y – T) – 510r
Investment: I = 2000 – 900r
Government spending: G = 2400
Taxes: T = 2200
Real money demand: (Md/P) = L(i = r + πe, Y) = 0.5Y – 200i
Expected inflation: e = 0
Production function: Y = 5K1/3L2/3
Note: Interest rates, i and r, are expressed in percentage points, i.e., if r = 7.5, then r = 7.5%.
Suppose the IS-LM model can used be to describe Utopia, and answer the following questions. Keep
your answers to a minimum of THREE decimal points (for fractions) if needed.
a) Derive the IS and LM equations for this economy. (4 points)
b) The supply of capital and labour in this economy are both equal to 4000; and the level of the nominal
money supply is 9600. Calculate the long-run or full-employment values of real output, consumption,
investment, real interest rate, public saving, private saving, national saving, and price level. (8 points)
c) Now suppose the government of Utopia is deciding on a new monetary policy regime. They are
considering targeting the real interest rate. It is considering either setting it real interest rate target at
1.75% or 2.20%. Assuming that the economy was initially at full-employment, for each real interest
rate target what are the new values of real output, consumption, investment, real interest rate, public
saving, private saving, national saving, and price level in the short-run? (8 points)
d) The central bank cares about both the rate of inflation and the unemployment rate and would prefer
neither to be large. Given these considerations explain in words whether they prefer one of these
interest rate targets mentioned in part (c) over the other and why. (5 points)
