Review feedback from your instructor (in Grades) on your final draft of Writing Project 1 and/or the half draft of this project, from your peers (in M05 Peer Response–Writing Project….

## 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.