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EC 201 (O) MAJOR ASSIGNMENT

Due Date: Friday, 11th October, 2019 (end of week 13)

Value: 15% of total course marks

1. This assignment will be marked out of 50

2. Answer all questions

3. This assignment covers concepts and knowledge from Topics 8, 9, 10 and 11 (Chap 9, 10, 11)
of the text book and additional readings in Moodle.

Submission of assignments:

Moodle

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IS-LM Model (Closed Economy) [15 marks]

Question 1
The following equations describe a small open economy.

[Figures are in millions of dollars; interest rate (i) is in percent]. Assume that the price level is
fixed.

Goods Market Money Market

C = 250 + 0.8YD L = 0.25Y – 62.5i

YD = Y + TR – T Ms/P = 250

T = 100 + 0.25Y

I = 300 – 50i

G = 350; TR = 150

Y =250 + 0.8[Y + 150 - (100 + 0.25Y)] + 300 - 50i

Goods market equilibrium condition: Y = C + I + G + X-M

Money market equilibrium condition: L = Ms/P

a) What is the equation that describes the IS curve (YIS)? (2 mark)

b) What is the equation describing the LM curve (YLM)? (2 mark)

c) What are the equilibrium levels of income (Yo) and interest rate (io) (2 marks)

d) Suppose Government reduces the marginal tax rate (t) from 25%

(as given in the model) to 15%.

i) Calculate the change in the level of income (Y) and interest rate (i) that results from this fiscal
expansion whilst nominal money supply remains the same. (2 marks)
ii) Calculate the magnitude of crowding out that will result from the above fiscal
expansion. (2 mark)
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e) If you were your Reserve Bank advisor, what would you recommend the Reserve Bank to do
to keep the interest rate constant? (1 mark)

f) Show the impact of the above d) and e) on the IS-LM framework. Would the IS curve now
relatively flatter or steeper and why? (4 marks)

IS-LM-BP Model (Open Economy) [35 marks]

Question 2
Goods Market

C = Co + cYD

YD = Y- T +TR

T = To + tY

I = Io – bi

G = Go, TR = TRo

X = Xo + λθ + γYf

M = IMo + mY – ψθ

Money Market

L = kY - hi

Ms/P = Mo/P + ΔRE/P

Foreign Exchange Market

NX = NXo – mY + vθ + γYf

CF = CFo + f (i – if)

ΔRE/P = NX + CF
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Endogenous Variables: C, YD T, I, X, IM, L, Ms, CF, NX, Y, i and .RES/P

Exogenous Variables: Co, To, Io, Go, TRo, Xo, Yf, IMo, Mo, CFo, NXo, i, if and P

Parameters: c, t, b, λ, γ, ψ, m, f, k, h and v

Policy variables: Fiscal policy: (G, t and TR) Monetary policy: (Mo, P) and Exchange Rate: (θ)

1. Explain the general role of parameters λ, γ, ψ, m, f, k, h, v in the algebraic model (2 marks)

2. For the macroeconomic model given, identify the ER (exchange rate) system and the extent of
capital mobility (perfect or imperfect) in this economy. (2 marks)

3. Assume that the economy is initially in internal-external equilibrium, show the effects of a
devaluation of the real exchange rate (increase in θ), on interest rate i* and output Y*, in an
IS-LM-BP space. (3 marks)

4. Provide a brief written description of the adjustment process that occurs in no. 3 above.

(3 marks)

5. Use qualitative analysis (state direction of change, do not calculate any values) and clearly
describe in words, the ultimate impact of the above policy on the equilibrium level of the
following endogenous variables:

 Private Consumption
 Private Savings
 Net Exports
 Money Supply
 Government Revenue
 Investment- Savings balance (6 marks)
6. Explain the costs of devaluation and the ‘J Curve effect’ (3 marks)
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Question 3

1. Distinguish between internal and external balance. (2 marks)

Given each cases below, answer the questions that follow using the IS-LM-BP model to
graphically analysis and explain.

Case 1: The case of Argentina in 2001: Fixed ER, Limited Capital Mobility.

Case 2: The case of U.S.A and Canada: Flexible ER, Perfect Capital Mobility

2. Explain the effects of Expansionary Fiscal Policy and Expansionary Monetary Policy.

(6 marks)

3. Explain whether each of the policy above may enable the economy to achieve internal
balance. (2 marks)

4. Explain the repercussions of each policy to the external sector, therefore external balance.

(2 marks)

Question 4

External shocks affect the internal economy. Given the case below and using the IS-LM-BP
model to graphically analysis and explain how this comes about.

Case: The case of recovery after the worldwide recession in the early 1990’s led to a rise in
foreign income: Floating ER, Limited Capital Mobility. (4 marks)