# Suppose that an economy can be described by the following three equations

Suppose that an economy can be described by the following three equations:

PART A answer only ONE question

1. Suppose that an economy can be described by the following three equations:
1. Okun’s law ; gyt  = growth rate of the real GDP
1. πt πt-1 = -(ut – 3.5%)        Phillips curve
1. gyt = gmt – πt                  Aggregate demand; gmt = growth rate of money supply (nominal money)
• What is the natural rate of unemployment for this economy?
• Suppose that the unemployment rate is equal to the natural rate. What is the growth rate of output?
• Assume further that the growth rate of the money supply equals 5.5%. What is the rate of inflation?
• Why are the increases in the price level not the same as the growth rate of money?
• Suppose now that the growth rate of nominal money is reduced from 5.5% to 3%, starting in year t. Calculate the value of the unemployment rate, the inflation rate and the rate of growth of the GDP at time t and compare these values to your answer from parts (a-c).
• An economy can be represented by the following relationships (where C is consumption, Y income, T tax revenue, i the interest rate, I investment, G government spending, X exports, IM imports, Md  money demand, Ms money supply)

𝐶 = 1000 + 0.75(𝑌 − 𝑇)

𝐼 = 2000 − 30,000𝑖

𝐺 = 2000

𝑇 = 0.2𝑌

X= 1000

IM = 0.1Y

TR  i =  5%  (Taylor rule, monetary policy curve, this is the new LM curve)

𝑀𝑑 = 2𝑌 − 100,000𝑖 = 𝑀𝑠

Real exchange rate =1 (PPP)

• Derive expressions for the IS, solve and illustrate the equilibrium output and interest rate.
• What are the equilibrium values of consumption, investment, trade balance and the fiscal balance?
• What is the effect on Y, fiscal balance, and trade balance of increasing government spending by 1500? Would this fiscal intervention crowd out private investment?
• Represent the changes made in (c) in IS-TR and NX diagrams.
• Explain how the conclusions of your analysis in (d) are different when prices are variable, aggregate supply is taken into account, expected inflation is fixed and the CB is targeting the inflation rate.

PART B answer all THREE questions

• (AOL linked question). Consider an open economy and use the IS/TR or the IS/LM models together with uncovered interest parity condition (i.e. the Mundell Fleming Model) to answer the following questions:
1. Discuss and illustrate how globalization and interdependence of financial markets can affect the propagation of international shocks.
• Discuss the effects on the domestic economy of a contractionary monetary policy conducted by a big foreign economy which is able to affect the level of the international interest rate.  Assume that the domestic economy is adopting perfect capital mobility and a flexible exchange rate regime.
• Why might a rise in international interest rates lead to hyperinflation in some highly-indebted countries? Why would this be less likely to happen in a country with a government that has the capacity to effectively raise taxes?
• A risk neutral investor in London has two investment opportunities. They can invest in one year UK government bonds with an annual nominal interest rate of 4.5%. Or they can invest in one year US government bonds with an annual nominal interest rate of 2.6%. Currently the spot exchange rate is 1.36 US dollar/UK pound (i.e., the price of one UK pound= 1.36 US dollars) and the one year expected exchange rate is 1.32 US dollar/UK pound. Should the investor hold their money in UK or US government bonds? (In replying to the question, use the exact and not the approximate version of the relevant interest rate formula, and show your work).
• The same London investor now looks to Europe and notices that the annual nominal interest rate on one-year German government bonds is 2.7%. Remember that one-year UK government bonds give an annual nominal interest rate of 4.5%. The spot exchange rate is 0.85 UK pound/European euro (i.e, the price of one European euro is 85 UK cents). Do financial markets expect the pound to appreciate or depreciate against the euro? By how much? (In replying to the question, use the exact and not the approximate version of the relevant interest rate formula, and show your work).
• Consider an economy with a fixed exchange rate Ē (Ē = fixed exchange rate parity). The exchange rate is defined as the price of the domestic currency in terms of the foreign currency. Suppose that at time (t-1) financial market participants believe that the central bank is committed to the fixed exchange rate. At time t, however, financial market participants become fearful that the central bank will devalue or allow the exchange rate to float (which would, everyone believes, lead to a currency depreciation).
1. At time t, what happens to the expected exchange rate, Ee(t+1)? Draw an IS-UIP diagram with UIP curves for time (t-1) and time t and explain why the UIP curve change at time t.
• Suppose that the central bank decides to maintain Et= Ē.  What must happen to the interest rate in order to achieve this? What happens to output?
• Suppose that instead the central bank decides to devalue the currency, Et= Ee(t+1). What does this imply for the interest rate and output?
• How might expectations of a devaluation, even if they are unfounded, force a government to devalue? Why do we call such a devaluation a self-fulfilling exchange rate crisis?
• Consider the wage-setting and price-setting model of the labour market developed in class.