Assignment #4 Answers ECON 100A: Intermediate Macroeconomic Theory. DUE DATE: Monday, July 7 th Prof. Van Gaasbeck Summer 2008

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1 alifonia State Univesity Sacamento ssignment #4 nswes EON 100: Intemediate Macoeconomic Theoy DUE DTE: Monday, Jly 7 th Pof. Van Gaasbeck Smme IS/MP/I in the Open Economy a) MP shifts downwad & D shifts ight.,,,, I, F, $ depeciates. b) If the Fed loweed inteest ates by the same amont in a closed economy, then the effect on otpt wold be smalle. In the open economy, when the Fed lowes inteest ates, this boost OTH investment (I) ND net expots (F). In the closed economy, the decease in inteest ates affects only investment. In the open economy, we have an additional channel thogh which monetay policy affects spending. c) IS shifts leftwad & D shifts leftwad. The coesponding decease inflation cases the MP cve to shift down.,,,, I, F, $ depeciates. d) Notice that in the closed economy, the tax incease edces inteest ates which boost investment patially offsetting the negative effects on otpt (). Hee, in the open economy, the decease in inteest ates boosts OTH investment and net expots, fthe offsetting the effects on otpt. MP 3 1 * 2 * ' ' 1 * 2 * ' ' 1 * 2 * ' ' 2 * 1 * IS 2 I 1 I 1 2 * 1 * ' 1 * 2 * ' D 2 D 1 D 1 D 2 1 * 2 * ' ' 2 * 1 * 1a) 1c) 2. Phillips ve a) In the long n, expected inflation mst eqal actal inflation (othewise, podces wold adjst thei pices to eflect the diffeence). Recall, this is the mechanism thogh which the economy moves fom shot n to long n in the IS/MP/I model. We can see fom the Phillips cve above, that this

2 alifonia State Univesity Sacamento ssignment #4 nswes EON 100: Intemediate Macoeconomic Theoy DUE DTE: Monday, Jly 7 th Pof. Van Gaasbeck Smme 2008 implies the cent level of nemployment is eqal to the natal ate (e.g., the ate that coesponds to fll employment). If t = e t then 0.5( t n ) = 0 and t = n = 5%. See diagam below (to the left) 1. Fed implements an incease inteest ates (withot an annoncement), shifting D to the left I 1 2. e does not decease becase the policy is not expected. I % = 1 2 3% = 3 P 1 ( e 1 = 7%) D 1 D 2 P 2 ( e 3 = 3%) 2 * 1 * n = 5% 2 = 5% b) See diagam above to the ight. The long n eqilibim is defined as the level of otpt whee = P. c) Since the policy change is nexpected, the Fed will implement an incease in inteest ates that is not expected, theefoe expected inflation emains nchanged. Theefoe, aggegate demand shifts to the left, otpt declines, inflation falls, and the nemployment ate inceases. This is illstated as a movement along the Phillips ve becase expected inflation is nchanged. d) t point, otpt is below fll employment. Eventally, expected inflation will decease, shifting the I line to the ight, ntil the gap between actal and fll employment otpt is closed. Notice, this decease in expected inflation is illstated as a downwad shift in the Phillips cve (the intecept deceases), ntil the economy etns to the natal ate of nemployment. e) It implies that the speed of adjstment will be apid. In othe wods, if expected inflation changes in the shot n, the economy moves diectly fom point to point. 3. Theoies of siness ycles Fo answes, eview the eading. o shold be able to identify the answes based on the aticle. 4. ompehensive Macoeconomic Model a) The Fedeal Reseve deceases the money spply. SR (-):,,,, I, F, $ appeciates. LR(-): No change, except.

3 alifonia State Univesity Sacamento ssignment #4 nswes EON 100: Intemediate Macoeconomic Theoy DUE DTE: Monday, Jly 7 th Pof. Van Gaasbeck Smme I 1 I P 3 n 2 2 P 3 D 1 1 D b) onsme confidence deceases. SR (-):,,,, I, F, $ depeciates. LR(-): No change in, (dop in consme confidence),,, I, F, $ depeciates.

4 alifonia State Univesity Sacamento ssignment #4 nswes EON 100: Intemediate Macoeconomic Theoy DUE DTE: Monday, Jly 7 th Pof. Van Gaasbeck Smme 2008 MP IS 2 I 1 I n 2 P 3 P D 1 1 D c) The govenment deceases taxes. Revese of pat b). d) Oil pices incease. SR (-):,,,, I, F, $ appeciates. LR(-): No change in any vaiables.

5 alifonia State Univesity Sacamento ssignment #4 nswes EON 100: Intemediate Macoeconomic Theoy DUE DTE: Monday, Jly 7 th Pof. Van Gaasbeck Smme 2008 MP I 2 I 1 I n P 2 2 P 1 P 3 D 1 e) In geneal, ational expectations wold mean the adjstment fom Point to Point wold be moe apid. The adjstment fom shot n to long n opeates thogh the adjstment of inflation expectations. If people ae ational, they evise thei expectations qickly, shifting the I and P lines moe qickly Soces of siness ycles onside data on the following ecessions. ased on the data, identify one potential soce of the ecession (in tems of the exogenos shocks fom the IS/MP/I model). Use IS/MP/I analysis to sppot yo answe. Ding all of these ecessions, otpt declines. a) 2001: Inteest ates decease and inflation declines. IS cve shifts to the left, casing D to shift to the left. b) : Inteest ates incease and inflation deceases. MP shifts p, casing D to shift to the left. c) : Inteest ates ise and inflation inceases. I shifts p (coesponding to an pwad shift in MP).