Problem Set #4

Due December 6th

(Late problem sets will NOT be accepted)
In these problems it is permissible (although not necessary) for the answers to be fractional numbers. For all
problems show your work. Please include the names of your group members on your write-up.

Question 1
Assume two countries have the same nominal GDP (measured in the same currency using the same accounting
rules). Give at least three reasons why you cannot assume that citizens in each country enjoy approximately the
same level of economic well-being. Explain.

Question 2
Explain which expenditure category of GDP changes and the direction of the change that results for each
transaction described.
a. A domestic business purchases a domestically produced computer to use in a business office.

b. A domestic business produces a computer that is sold to a foreign company.

c. The federal government purchases a domestically produced computer to use in a courthouse.

d. A domestic household purchases a domestically produced computer to use in a home.

e. A domestic household purchases a computer produced in a foreign country to use in a home.

Question 3
a. Use diagrams to illustrate the following effects in the Solow growth model on the steady-state capital levels.
Label your graphs and axes clearly. Describe the effects in 1-2 sentences.
i.
ii.
iii.

Population growth rate decreases.

Savings rate decreases.
Productivity increases.

b. Using the Solow model, explain the short-run versus long-run consumption per capita tradeoff of the
following situations, if any.
i.
ii.

A government policy that raises the savings rate.

An invention that raises productivity (assume no additional R&D expenditure was necessary the
inventor just got lucky).

Question 4
Use simple diagrams/graphs to illustrate the effects of the following government policies on the market for
loanable funds. Label your graphs and axes clearly. Describe the effects in 1-2 sentences.
a. The government introduces a tax on interest income.
b. The government introduces an investment tax credit.

Question 5
a. Use simple diagrams/graphs to illustrate the effects of the following government policies on the trade
balance. Label your graphs and axes clearly. Describe the effects in 1-2 sentences. Assume a small
open economy and zero net exports at the initial conditions.
i.
ii.

Domestic fiscal contraction (decrease in government spending or increase in taxes).

An decrease in government spending by a large foreign economy.

b. Describe how the effects above would be different if we assumed a large open economy instead.

Question 6
a. Use simple diagrams/graphs to illustrate the effects of the following government policies on the
exchange rate. Label your graphs and axes clearly. Describe the effects in 1-2 sentences. Assume a
small open economy.
i.
ii.

The domestic government decreases spending or increases taxes.

A large foreign government decreases spending or increases taxes.

Question 7
a. Find a particular price from at least 10 years ago and no more than 50 years ago (something that still
exists today so no typewriters or Chia Pets, please!). It may be easiest to ask one of your parents for this
or you can look it up online (as I did). Be sure to get the year of this transaction. (This will be easiest if
you can get the price or wage from the United States. If that is not possible, try to get some idea of what
the price would have been, at the time, in U.S. dollars.)

b. Calculate what this price would be today if it had risen at the same rate as U.S. consumer prices. For this
you will need to look up the CPI by going to the Bureau of Labor Statistics website. Write down exactly
what version of the CPI you use and how you calculate your answer (I suggest using the CPI for All
Urban Consumers).

c. What is the actual price of your item/service today?

d. Why might your answers to parts (b) and (c) be different?

Question 8
The Federal Reserves tools to control the money supply include: open-market operations, the discount rate, and
interest payments on reserves.
a. How should each instrument be changed if the Fed wishes to decrease the money supply?
b. Will the change affect the monetary base and/or the money multiplier?

Question 9
Assume that the monetary base (B) is $100 billion, the reserve-deposit ratio (rr) is 0.1 and the currency-deposit
ratio (cr) is 0.1.
a. What is the money supply?
b. If rr changes to 0.2, but cr is 0.1 and B is unchanged, what is the money supply?
c. If rr is 0.1 and cr is 0.2, but B is unchanged, what is the money supply?

Question 10
In the standard Keynesian Cross model we assumed that investment did not depend on income. To make the
model somewhat more realistic, lets consider the possibility that investment depends positively on Y. That is,
when the economy is doing well, firms are more likely to spend more money on building equipment and
factories. This is summarized by the following set of equations.
C=c 0 +c 1 (Y T )

G=G
I =I + kY

NX= NX

Assume that

c 1+ k <1

and k >0 .

a. Solve this model for the equilibrium level of output, Y .

b. What is the fiscal multiplier in this economy? How does it compare to the regular multiplier of
1
1c 1 ?
In addition to the assumptions above, assume that net exports also depend on income (when incomes are higher,

people demand more imports). Specifically, suppose that NX = NX mY , where m>0 .

c. Solve for the equilibrium level of output with this new assumption.
d. How does the fiscal multiplier compare to the regular multiplier of

1
1c 1

and to the multiplier you

derived in part (b)?

Question 11
Use the Aggregate Demand/Aggregate Supply model to illustrate the following situations (be sure to label
your axes/lines/equilibria carefully). Explain whats going on in a few sentences.
a. There is a recessionary gap in the economy due to a negative supply shock. Show what happens in the
very short run assuming no government action. What happens to the unemployment rate?
b. There is a recessionary gap in the economy due to a negative supply shock. Show what happens in the
long run assuming no government action (include the short-run shifts as well). What happens to the
unemployment rate?
c. Illustrate how the government can address the recessionary gap in the economy through fiscal policy in
the short run. Explain. What happens to the unemployment rate?

d. Show what happens in the long run when the government addresses the recessionary gap in the economy
through fiscal policy. Explain and compare to the long run in part (b), including the unemployment rate.