Macroeconomic Theory and Policy

Question 1 (20 points) – Topics 3 & 5
A small open economy with perfect capital mobility is currently in its long-run equilibrium with a trade
surplus. Recently, the economy experienced a drop in the level of total factor productivity.
In the context of the long-run classical model of a small open economy, discuss the effect of the drop in
the total factor productivity on the levels of output, (domestic) investment, trade balance, price level, and
both nominal and real FC/DC exchange rate. Explain and support your answer by the loanable fund
market and foreign exchange market diagrams. Be sure to explain why the variables of interest change
or remain unchanged.
Question 2 (25 points) – Topic 5
Suppose a small open economy can be described by the following set of equations:
Long-run output: YFE = 48000
Consumption: C = 11250 + 0.75(Y – T) – 2000r
Investment: I = 13500 – 1500r
Net exports: NX() = 9000 – 1000, where  = the real FC/DC exchange rate
Taxes: T = 15000
Government spending: G = 12000
Money supply: MS = 25200
Real money demand: L(r + 
e
, Y) = 0.2Y – 200(r + 
e
)
Expected inflation rate: 
e = 0%
Note: Real interest rates, r, is expressed in percentage points. For example, if r = 5, then r = 5%. Keep
your answer to at least 4 decimal points if necessary.
a) Derive the net foreign investment function in terms of the exogenous variables. (2 points)
b) Find the long-run equilibrium levels of real exchange rate, net exports and price if the world interest
rate is 6%. (5 points)
The economy is initially in its long-run equilibrium as described in part (b). The outbreak of COIVD-19
leads to economic uncertainty; as a result, the world demand for (loanable) funds drops. In addition,
studies show that this change in the world demand for funds will cause the world interest rate to change
by 3 percentage points.
c) Redo part (b). (6 points)
d) With the aid of a set of diagrams for the long-run classical model of a small open economy, explain
in words your findings in parts (b) and (c). (6 points)
e) Suppose the government wants to balance the trade account via a change in government spending;
and at the same time, the central bank wants to achieve price stability (i.e., keeping the price level
fixed at the initial level) via a change in money supply, find the level of government spending and
money supply that will achieve these goals simultaneously. (6 points)
MGEB05 Assignment 2 (Winter 2021) 3
Question 3 (20 points) – Topics 6 & 7
The government of a closed economy is seeking proposals on how income taxes should be conducted.
Currently, there are three proposals have been submitted, and they are:
Proposal 1: Use the policy to target real output
Proposal 2: Use the policy to target real interest rate
Proposal 3: Use the policy to target price level
Recently, the government has lowered the contribution limits of the registered retirement savings plan
(RRSP). The government asks you to do the followings:
• Evaluate the effect of this change in RRSP contribution limit on the short-run equilibrium level
of national savings under these three different proposals.
• Rank the change in national savings in ascending order (i.e., from smallest change to largest
change) in the above three proposals.
Explain and support your answer by ONE IS-LM diagram (only the first diagram will be graded).
Question 4 (20 points) – Topics 6 & 7
Macroland is a closed economy. It can be described by the IS-LM model.
Long-run level of output: YFE = 20000
Consumption: C = 4000 + 0.8(Y – T) – 150r
Investment: I = 2000 – 350r
Government spending: G = 4000
Real money demand: L(r, Y) = 0.5Y – 600r
Note: Interest rate, r, is expressed in percentage points, i.e., if r = 7.5, then r = 7.5%. Keep your answer
to 2 decimal places if needed.
a) In the initial (long-run) equilibrium, the government of Macroland runs a budget surplus of 250 and
the level of nominal money supply is set at 34400. Find the resulting long-run equilibrium values of
real interest rate, private savings, price level, and real money balance. (5 points)
b) The economy is initially in its long-run equilibrium as shown in part (a). Now, due to the outbreak
of the pandemic, there is an extensive use of online payment apps. As a result, the fraction of income
holds in the form of money drops from 0.5 to 0.4. Find equilibrium values of real output, private
savings, real interest rate, and real money balance in both short run and long run. (10 points)
c) (Continued from part b) Suppose the central bank wants to lower the short-run level of output in part
(b) by 1375 via a change in the level of money supply. Find the level of money supply that would
achieve the goal. What are the new short-run equilibrium levels of output and real interest rate? (5
points)
MGEB05 Assignment 2 (Winter 2021) 4
Question 5 (15 points) – Topic 8
Suppose a closed economy is currently producing below its full potential due to an adverse demand
side shock from the goods market. According to the AS-AD model, if the policy makers want to move
the economy more rapidly back to full employment output and, at the same time, wants to stabilize the
price level, which of the following policy (policies) would achieve the goals?
Policy 1 – An increase in transfer payments to households.
Policy 2 – A subsidy to business investment.
Policy 3 – An increase in open market purchases.
Explain and support your answer by ONE AS-AD diagram.

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