Norman

1. Assume that the U.S economy is in long-run equilibrium with an expected inflation rate of 6% and an unemployment rate of 5%. The nominal interest rate is 8%. (a) Using a correctly labeled graph with both the short-run and long-run Phillips curves and the relevant numbers from above, show the current long-run equilibrium as point A.

SRPC LRPC
Inflation

6%

5%

Unemployment

(b) Calculate the real interest rate in the long-run equilibrium.

Answer to 1. (b) The real interest rate = the nominal interest rate anticipated (expected) inflation. NIR [8%] - expected inflation [6%] = RIR [2%]

(c) Assume now that the Federal Reserve decides to target an inflation rate of 3%. What open-market operation should the Federal Reserve undertake? Answer to 1. (c) The open market operation to decrease inflation from 6% to 3% would be for the Fed to sell bonds to the banks. (d) Using a correctly labeled graph of the money market, show how the Federal Reserves action you identified in part c will affect the nominal interest rate.
Nominal Interest Rate

DmMS2 MS1
ir2
ir1 0
[Sell bonds]

Money Market

Answer to 1. (d) The Feds selling of bonds would decrease MS from MS1 to MS2 and increase nominal interest rates.

Dm

MS2 MS1

DI

AD1 AD2

AS

NIR

ir2

ir2

PL3 PL2
QID2 QID1 QID

ir1 0

ir1 0

Money Market

Investment Demand

RGDP Y* YI

(e) How will the interest rate change you identified in part d affect aggregate demand in the short run?
Answer to 1. (d) The Feds selling of bonds would decrease MS from MS1 to MS2 and increase nominal interest rates, decreasing QID, which decreases AD in the short run.

(f) Assume that the Federal Reserve action is successful. What will happen to each of the following as the economy approaches a new long-run equilibrium. (i) The short-run Phillips Curve. Explain (ii) The natural rate of unemployment

SRPC
Inflation

6% 3%

Y1

Unemployment

Answer to 1. (f) (i) As can be seen on the graph, the decrease in AD would result in a movement down and to the right on the SRPC, but as the economy approaches long-run equilibrium, the SRPC would shift left. Answer to 1. (f) (ii) The natural rate of unemployment would not increase in the long run, but stay the same.

2. Assume that as a result of increased political instability, investors move their funds out of the country of Tara. (a) How will this decision by investors affect the international value of Taras currency on the foreign exchange market? Explain. Answer to 2. (a) As foreign investors pull their money out of Tara, there would be a decrease in demand for their currency, which would depreciate their currency. (b) Using a correctly labeled graph of the loanable funds market in Tara, show the impact of this decision by investors on the real interest rates in Tara. S2
Real Interest Rate, (%)

LFM
E2

S1
Answer to 2. (b) As can be seen on the graph, as investors pull their money out of Tara, there is a decrease in supply in their LF market which increases the RIR.
Quantity of Loanable Funds

r2 r1

E1

(c) Given your answer in part b, what will happen to Taras rate of economic growth? Explain.

F2 F1

Answer to 2. (c) As the RIR increases, it becomes less profitable for firms to invest in capital equipment, which decreases economic growth.

3. Assume that the reserve requirement is 20% and banks hold no excess reserves. (a) Assume that Kim deposits $100 of cash from her pocket into her checking account. Calculate each of the following. (i) The maximum dollar amount the commercial bank can initially lend (ii) The maximum total change in demand deposits in the banking system (iii) The maximum change in the money supply. Answer to 3. (a) (i) The $100 in DD will result in $80 new ER that the banks can initially lend. (ii) Maximum total DD could be as high as $500. MM [5] x DD [$100] = DD of $500. (iii) The MS was already $100 as the $100 in cash was part of MS, so this results in an increase in money supply of $400. (b) Assume that the Federal Reserve buys $5 million in government bonds on the open market. As a result of the open market purchase, calculate the maximum increase in the money supply in the banking system. Answer to 3. (b) Once this $5 million is deposited by the public, $1 million has to be kept in RR and $4 million becomes ER. MM [5] x ER [$4 M] = $20 million increase in the MS in the banking system. The total MS is now $25 million [DD of $5 & PMC of $20] (c) Given the increase in the money supply in part b, what happens to real wages in the short run? Explain. Answer to 3. (c) The increase in MS results in a decrease in the NIR, resulting in a increase in QID, and an increase in AD, which pushes prices up, therefore a decrease in real wages.

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