Name: Nguyen Thu Thao ID: FB00142 Class: FB604

QUESTION 1
In 2011: Money supply = M2011 = $250 billion Nominal GDP = Y N2011 = $10 trillion = $10000 billion Real GDP = Y R2011 = $7,5 trillion = $7500 billion

a. What is the price level? What is the velocity of money? Price level P2011 x YR2011 = YN2011 YN2011 P2011 = R Y 2011 10000 P2011 = 7500 4 P2011 = $ $1,33 3 4 Thus, the price level in 2011 equals $ , approximately $1,33. 3 Velocity of Money V2011 x M2011 = P2011 x YR2011 P2011 x YR2011 YN2011 = M2011 M2011 10000 V2011 = 250 V2011 = 40 Thus, the velocity of money in 2011 equals 40. V2011 =

b. Suppose the velocity is constant and real GDP grows by 5 percent each year. 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: V 2012 = V2011 = 40 YR2012 = YR2011 + YR2011 x 5% = 1,05 x YR2011 = 1,05 x 7500 = $7875 billion In 2012 money supply stays constant, so M 2012 = M2011 = $250 billion YN2012 = V 2012 x M2012 = V 2011 x M2011 = YN2011 = $10000 billion Thus, nominal GDP in 2012 equals $10000 billion, the same as that in 2011. YN2012 10000 80 R2012 = 7875 = $63 $1,27 Y 80 Thus, the price level in 2012 is $ , approximately $1,27. 63 P2012 =

c. What money supply should the Fed set in 2012 if it wants to keep the price level stable? In 2012: 4 3 V 2012 = V 2011 = 40 YR2012 = $7875 billion P2012 = P2011 = $ YR2012 x P2012 7875 x 4/3 = = $262,5 billion V2012 40 Thus, to keep the price level in 2012 stable, the money supply must be $262,5 billion. M2012 =

d. What money supply should the Fed set in 2012 if it wants the inflation rate to be 10 percent? The inflation rate reflects the increase in the price level. Therefore, when the inflation rate is 10%: 4 22 In 2012: P2012 = P2011 + P2011 x 10% = 1,1 x P2011 = 1,1 x = $ $1,47 3 15 V2012 = V2011 = 40 YR2012 = $7875 billion YR2012 x P2012 7875 x 22/15 = = $288,75 billion V2012 40 Thus, the Fed should set the money supply of $288,75 billion if it wants the inflation rate to be 10%. M2012 =

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, the interest rate, the exchange rate, imports, exports, and the trade balance.

Real Interest Rate

a. The market for Loanable Funds

b. Net Capital Outflow Real Interest Rate

Supply

r1

r1

3. Net export, however, remain the same. NCO

Demand

Quantity of Loanable funds Real Exchange Rate

Net Capital Outflow

Supply

E1 2. and causes the real exchange rate to depreciate

1. Subsidies removed decrease the demand for dollars

E2
D1

D2 Quantity of Dollars

Figure 1

c. The market for Foreign-Currency Exchange

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 real exchange 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 is no change in net capital outflow (shown in panel b). Imports: At first, the policy of removing subsidies on USs exports does not affect the imports. Thus, imports remain stable. However, the dollars depreciate in 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 offset the 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.

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: 4 AD = x 20 = $16 billion. 5 b. What additional effects follow this initial effect? What is the total effect of the tax cut 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. MPC x 20 = $80 billion. 1 - MPC 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. Total change in demand: AD =

c. How does total effect of this $20 billion tax cut compare to the total effect of a $20 billion 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 total effect 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 government can 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 the change 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 price level, shifting the aggregate demand curve to the right.