1. According to classical macroeconomic theory, money supply shocks...

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1. According to classical macroeconomic theory, money supply shocks are “neutral.” a. Explain what this means. Hint: see 5.7 of the textbook. b. Based on that theory, how would a 5% increase in a nation’s money supply affect its real wage rate (W/P), all else equal (up, down, or no change, and by how much)? c. According to the quantity theory of money, how would a 5% increase in the money supply affect the price of goods and services (P), all else equal (up, down, or no change, and by how much)? d. To be consistent with both theories, what would have to happen to the nominal wage rate (W)? Explain. 2. Describe the difference between the “real” interest rate and the “nominal” interest rate. How is the “ex-post” real interest rate calculated? 3. Suppose that in the U.S., the income velocity of money (V) is constant. Suppose, too, that every year real GDP (Y) grows by 2 percent and the supply of money (M) grows by 6 percent. a. According to the quantity theory of money, what will be the growth rate of nominal GDP = P×Y? b. What will be the inflation rate? c. If the central bank wants the inflation rate to be 0%, what money supply growth rate (i.e. - %∆M per year) should it set? 4. Use the classical model of a closed economy (chapter 3) and the quantity theory of money (chapter 5, section 1) to predict how each of the following shocks would affect real aggregate income (Y), the real interest rate (r), and the price of goods and services (P) in a closed economy in the long run, all else equal. For each shock, be sure to clearly state a prediction for all three variables (up, down, or no change) and illustrate your predictions with supply/demand diagrams for the goods market and the loanable funds market. a. An increase in total factor productivity (A up). b. An increase in the money supply (Ms up). 5. Consider the following model of a closed economy:  𝑌 = 𝐴𝐾1/2𝐿1/2  𝑌𝑑=𝐶+𝐼+𝐺  𝑌=𝑌𝑑  𝐶=250+0.7(𝑌−𝑇)  𝐼 = 2000 − 20,000𝑟  𝐴=25; 𝐾=144;𝐿=100  𝐺=600;𝑇=500  𝑀=1500;𝑉=8 a. What values of aggregate income (Y) and national saving (S) result from full employment of labor and capital? b. What must the interest rate (r) be in order to establish long run equilibrium in the market for loanable funds? c. According to the quantity theory of money, what is the equilibrium price of goods (P) for this economy? d. If the money supply increases by 20% (from 1500 to 1800), what will the new equilibrium price of goods be, all else equal? 6. Chapter 6 presents a model of a small, open economy with perfectly mobile capital. How is interest rate determination in such a nation different from interest rate determination in a closed economy? What sort of shocks would increase interest rates in a small, open economy with perfectly mobile capital? 7. Consider the following model of a small, open economy:  𝑌=4000  𝑌𝑑 =𝐶+𝐼+𝐺+𝑁𝑋  𝑌=𝑌𝑑  𝐶=400+0.8(𝑌−𝑇)  𝐼=800−5000𝑟  𝑁𝑋=800−400𝜀  𝐺=300  𝑇=1000 a. Assuming that the world’s real interest rate is 8% (rw* = .08), what will national saving (S) and investment (I) be for this economy? b. What are the equilibrium values of net exports (NX) and the real exchange rate ()? c. What are the equilibrium values of net exports and the real exchange rate if the world’s real interest falls to 6%, all else equal? d. What are the equilibrium values of net exports and the real exchange rate if the world’s real interest rate is 8%, but domestic government purchases (G) are reduced to 100, all else equal? 8. Define the terms “trade balance” and “net capital outflow,” and explain why the two will always be equal. 9. Use the textbook’s model of a small, open economy with perfectly mobile capital to predict how each of the following shocks will affect a nation’s national saving (S), investment (I), trade balance (NX), and real exchange rate (), all else equal. For each shock, be sure to clearly state a prediction for all four variables and illustrate your predictions with the relevant supply/demand diagrams. a. The domestic labor force expands (LS up) b. Domestic income taxes are reduced (T down) c. Forecasts of a recession cause an exogenous decrease in autonomous investment (i0 down) d. An increase in the world’s supply of loanable funds, pushes world interest rates down (rw* down) 10. Suppose that last year, the nominal exchange rate between the Japanese yen and the British pound was ¥225.0 per £1.0, one unit of Japanese output cost ¥2000, and one unit of British output cost £8.0. a. What was the real exchange rate between the U.K. and Japan last year, expressed as the cost of British output (i.e. – the quantity of Japanese output that exchanges for 1 unit of British output)? In which country were goods more expensive last year? b. Suppose that between last year and this year the British pound appreciated by 20% against the Japanese yen (a 20% increase in the number of yen required to buy 1 pound). If the price of goods in the U.K and Japan are unchanged from last year, what is this year’s new real exchange rate? In which country are goods more expensive this year? c. Now suppose, instead, that between last year and this year, the pound appreciated by 20% against the yen and Japan experienced a 30% increase in its price level (a 30% increase in the number of yen required to purchase one unit of Japanese output). All else equal, what is this year’s real exchange rate in that case? In which country are goods more expensive this year? 11. What is arbitrage (in goods)? Why don’t arbitrage opportunities last? 12. Suppose that a Toyota Camry costs $25,000 in the U.S. and €20,000 in Europe, while the nominal dollar-euro exchange rate is 0.9€/$. a. Describe how an arbitrageur could profit from this situation (What would they buy? What would they sell?) b. Based on the Law of One Price, what is the equilibrium nominal exchange rate between the U.S. dollar and the euro? What is the equilibrium real exchange rate between the U.S. and Europe? c. Suppose the price of everything in the U.S. (including a Toyota Camry) increased by 5%. All else equal, how would that affect the equilibrium euro price of the U.S. dollar (i.e. – e*(€/$)) in the long run (up or down, and by how much)? Explain. 13. According to the theory of Purchasing Power Parity, what determines a nation’s nominal exchange rate in the long run? Based on that theory, how would you expect an increase in a nation’s money supply to affect the exchange value of its currency? In particular, would you expect that nation’s currency to appreciate or depreciate against other currencies as a consequence, all else equal? Explain. 14. According to the Keynesian Cross model, how would each of the following shocks affect real aggregate income (Y) in the short run, all else equal? For each shock, be sure to clearly state a predicted direction of change for income, illustrate your prediction with a Keynesian Cross Diagram, and explain your predictions intuitively in words. a. Government purchases decline b. Congress cuts household income taxes c. Autonomous consumption increases d. Total factor productivity increases 15. Consider a closed economy with demand for goods as follows:  𝑌𝑑=𝐶+𝐼+𝐺  𝐶=200+0.80(𝑌−𝑇)  𝐼=600  𝐺=1000  𝑇=1000 a. What is “autonomous expenditure” for this economy? b. Graph this economy’s (planned) aggregate expenditure function. Be sure to give the coordinates of at least 2 distinct points in your graph. c. According to the Keynesian Cross model of income determination, what would be the short run equilibrium value of real aggregate income (Y) for this economy? d. If government purchases (G) were to increase to 1,200, what would the new short run equilibrium value of income be?

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1. a) According to the classical macroeconomic theory, money supply shocks are neutral, and this means that any change in the money supply by the central bank will not affect the real variables of the economy like the real GDP and the real wage rate and real interest rate. In the situation of money supply changing it would affect the nominal variables such as the price level inflation rate and the dollar wage earned by people. This is referred to as Monetary neutrality....

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