eco121_fb0604_hw03_thaontfb00142

8/3/2019 ECO121_FB0604_HW03_ThaontFB00142

1/8

Name: Nguyen Thu Thao

ID: FB00142

Class: FB604


2/8

QUESTION 1

In 2011:

Money supply = M2011 = $250 billion

Nominal GDP = YN2011 = $10 trillion = $10000 billion

Real GDP = YR2011 = $7,5 trillion = $7500 billion

a. What is the price level? What is the velocity of money?Price level

P2011 x YR2011 = YN2011

P2011 =YN2011YR2011

P2011 =10000

7500

P2011 = $4

3 $1,33

Thus, the price level in 2011 equals $

4

3 , approximately $1,33.

Velocity of Money

V2011 x M2011 = P2011 x YR2011

V2011 =P2011 x YR2011

M2011=

YN2011M2011

V2011 =10000

250

V2011 = 40

Thus, the velocity of money in 2011 equals 40.


3/8

Suppose the velocity is constant and real GDP grows by 5 percent each year.b.What will happen to nominal GDP and the price level in 2012 if money supply

stays constant?

Because the velocity is constant and real GDP grows by 5 percent each year:In 2012:

V2012 = V2011 = 40

YR2012 = YR2011 + YR2011 x 5% = 1,05 x YR2011 = 1,05 x 7500 = $7875 billion

In 2012 money supply stays constant, so M2012 = M2011 = $250 billion

YN2012 = V2012 x M2012 = V2011 x M2011 = YN2011 = $10000 billion

Thus, nominal GDP in 2012 equals $10000 billion, the same as that in 2011.

P2012 = YN

2012YR2012

= 100007875

= $8063

$1,27

Thus, the price level in 2012 is $80

63, approximately $1,27.

c. What money supply should the Fed set in 2012 if it wants to keep the price levelstable?

In 2012:

P2012 = P2011 = $4

3

V2012 = V2011 = 40

YR2012 = $7875 billion

M2012 = YR2012 x P2012V2012 =7875 x 4/3

40= $262,5 billion

Thus, to keep the price level in 2012 stable, the money supply must be $262,5 billion.


4/8

d. What money supply should the Fed set in 2012 if it wants the inflation rate to be10 percent?

The inflation rate reflects the increase in the price level. Therefore, when the

inflation rate is 10%:

In 2012: P2012 = P2011 + P2011 x 10% = 1,1 x P2011 = 1,1 x4

3= $

22

15 $1,47

V2012 = V2011 = 40

YR2012 = $7875 billion

M2012 = YR2012 x P2012V2012

=7875 x 22/15

40

= $288,75 billion

Thus, the Fed should set the money supply of $288,75 billion if it wants the inflation rate

to be 10%.


5/8

QUESTION 2

Suppose the US government removes subsidies on US exports, and keep all other fiscal

policies the same. Using a three-panel diagram and supporting explanations in words,

show what happens to national saving, domestic investment, net capital outflow, theinterest rate, the exchange rate, imports, exports, and the trade balance.

Real

Interest

Rate

Supply

Demand

Quantity of

Loanable funds

Net Capita

Outflow

Real

Interest

Rate

Real

Exchange

Rate

Quantity of Dollar

NCO

Supply

D1

D2

r1 r1

E1

E2

1. Subsidies removed

decrease the

demand for dollars

2. and causes the

real exchange rate

to depreciate

3. Net

export,

however,

remain

the same.

a. The market for Loanable b. Net Capital Outflow

c. The market for Foreign-CurrencyFigure 1


6/8

Explanation:

When US Government removes subsidies on US exports, and keeps all other

fiscal policies the same, it directly affects export (trade policy). Removing subsidies

makes the export decrease. Because net exports equal exports minus imports, this policy

also affect net export. The decline in exports makes the net exports go down for any

given real exchange rate. And because net exports are the source of demand for dollar

in the market for foreign-currency exchange, this policy affects the demand curve in this

market. In this case, the demand curve in the market for foreign-currency exchange

shifts to the left. This shift has been shown graphically in figure 1 as the shift from D1 to

D2.

Now consider the comparison between the old and new equilibriums.

Real Exchange Rate: the decrease in the demand for dollars causes the realexchange rate to depreciate from E1 to E2(shown in panel c).

Real Interest Rate: Because nothing has happen to the market for loanable funds,there is no change in the real interest rate, national saving (the supply in

loanable funds) and the domestic investment (the demand in loanable funds)

(shown in panel a).

Net Capital Outflow: Because there is no change in the real interest rate, there isno change in net capital outflow (shown in panel b).

Imports: At first, the policy of removing subsidies on USs exports does notaffect the imports. Thus, imports remain stable. However, the dollars depreciatein the market for foreign-currency exchange makes domestic goods cheaper in

comparison with foreign goods, which discourage imports. In the end, the

imports fall.

Exports: Removing subsidies on export causes the decline in exports. Trade balance (net exports): Because there is no change in net capital outflow,

there is no change in net exports, even though the exports have reduced. When

the dollar depreciates in value in the market for foreign-currency exchange,

domestic goods become cheaper relative to foreign goods. This depreciate

encourages exports and discourage imports, both of these changes work to offsetthe direct decrease in trade balance due to the policy of removing subsidies on

exports. Trade policy does not alter the trade balance because they do not alter

national saving or domestic investment (NX=NCO=S I). For given levels of

national saving and domestic investment, the real exchange rate adjusts to keep

the trade balance the same, regardless of the trade policy the government puts

in place.


7/8

QUESTION 3

The government reduces taxes by $20 billion. T = $20 billion

No crowding out.

MPC =4

5

a. What is initial effect of the tax reduction on aggregate demand?When the government cuts the taxes, it increases households take-home pay.

The decrease in the level of taxation boosts consumer spending and shifts the

aggregate demand to the right. When a tax decrease occurs, consumers will

spend part of the money and save part of it.Thus, the initial effect of the tax reduction on aggregate demand is:

AD =4

5x 20 = $16 billion.

b. What additional effects follow this initial effect? What is the total effect of the taxcut on aggregate demand?

When the government cuts taxes and stimulates consumer spending, earnings

and profits rise, which further stimulates consumer spending. When consumers

have more disposable income, they spend some and save some. The money that

they spend goes back into the economy and is saved and spent by somebody

else. This process continues, and eventually the final change in output created by

a tax cut is significantly larger than the initial tax cut itself.

Total change in demand: AD =MPC

1 - MPCx 20 = $80 billion.

A decline in tax of $20 billion initially increases the aggregate demand by $16

billion, but the multiplier effect can amplify the shift in aggregate demand and

raise the aggregate demand by $80 billion, 5 times as much as the initial impact

of reducing level of taxation.

Thus, multiplier effect is the additional one follow the initial effect.

The total effect of the tax cut is the increasing in the aggregate demand by $80

billion.


8/8

c. How does total effect of this $20 billion tax cut compare to the total effect of a $20billion increase in government purchases? Why?

When the government purchases increase by $20 billion and there is no

crowding-out effect:

Multiplier = 5

Total change in demand: AD = 5 x 20 = $100 billion.

This multiplier is derived in a different way. When the government increases

purchases , it directly increases output, or national income. When the

government spends more, the populace receives more.

It is obvious that the total effect of a $20 billion tax cut is smaller than the totaleffect of a $20 billion increase in government purchases.

d. Based on your answer to part c, can you think of a way in which the governmentcan increase aggregate demand without changing budget deficit?

From part c, it is obvious that both increase in government purchases and

decrease in level of taxation can increase the aggregate demand.

But we note that: Budget deficit = Taxes Government Purchases

Thus, either increasing government purchases or cutting taxes can lead to thechange in budget deficit.

When the fiscal policies cannot be used in order to raise aggregate demand

without changing budget deficit, we think of using monetary policies to

stimulate aggregate demand.

One of the best ways we should think of is monetary injection. The Fed can

increase the money supply by buying government bonds in open market

operations. When the Fed increases the money supply, it lower the interest rate

and increases the quantity of goods and services demanded for any given pricelevel, shifting the aggregate demand curve to the right.

eco121_fb0604_hw03_thaontfb00142

Documents