Advanced seminar in Economics

Week 12 - AD-AS & Policy Implications

Part a

1. Consider the example from the previous module:

C = 116+0.8(Y −T)−1000r I = 140−2000r,G = 165,T = 30+0.25Y

EX = 100,IM = 110+0.2Y

L = 5Y −100000r M = 60000,P = 100,rrr = 0.2

Recall that the equations for IS and LM curves for this example were:

IS : Y = 1

0.6 (387−3000r)

LM : Y = 1

5 (600+100000r)

Suppose the government is considering an expansionary fiscal policy of increasing G by 18.

(a) Was the budget balanced before this policy? How can you say so? (b) If Fed does not do anything, how much is the crowding out effect of this policy? (c) Is the budget balanced after this policy? How can you say so? (d) What is “monetizing budget deficit”? (e) If Fed monetizes the additional budget deficit to eliminate crowding out, do they need to buy bonds, or sell bonds?

Worth how much?

2. Role of interest sentivity in the effectiveness of fiscal and monetary policies:

(a) “Fiscal policy has more strength when the interest sensitivity of investment and consumption is lower.”True or false? Explain why.

(b) “Monetary policy has more strength when the interest sensitivity of demand for real balances of money is lower.” True or false? Explain why.

Part b

3. What is liquidity trap?

“Expansionary monetary policy increases bond prices in the liquidity trap.”True or false? Explain why.

4. What is described by Aggregate Demand (AD) curve and Aggregate Supply (AS) curve? Draw the diagram.

5. What is the difference between Keynesian and Classical AS? Which one is right and which one is wrong? Explain your answer.

6. Describe the role and effect of an expansionary fiscal policy and an expansionary monetary policy using IS-LM and AD-AS models.

7. Consider the example given in Question 1 (before changing G). Suppose the general price level P is not fixed. Find out the equation for AD curve.

(a) Suppose the AS curve is given by: P = 120.

i. Is it Keynesian, or classical? How much are the equilibrium price and output? ii. If G increases by 18, then by how much do AD and AS shift? How much are the new equilibrium price and output?

(b) Suppose instead the AS curve is given by: Y = 556.

i. Is it Keynesian, or classical? How much are the equilibrium price and output? ii. If G increases by 18, then by how much do AD and AS shift? How much are the new equilibrium price and output?