Macroeconomics

Page 1 of 15 5/23/2018

*Quotes from The Lord of the Rings, or The Hobbit by JRR Tolkien. Nothing written in italics applies to the questions—it’s there just for Tolkien fun. Go forth and read!!!

Welcome to Macroeconomics in Middle Earth! Part 2*

Section 8 The market for loanable funds in Middle Earth finances investment in capital goods like new sawmills in the Shire, new bridges in Moria and Gimli’s development of the Glittering Caves of Aglarond located behind the Deeping Wall of Helm's Deep.

"Immeasurable halls, filled with an everlasting music of water that tinkles into pools, as fair as Kheled- Zaram in the starlight"

Page 2 of 15 5/23/2018

*Quotes from The Lord of the Rings, or The Hobbit by JRR Tolkien. Nothing written in italics applies to the questions—it’s there just for Tolkien fun. Go forth and read!!!

a) Sam Gamgee, who bought the old mill from Ted

Sandyman, is spending $500 on new equipment this year. The old equipment worth $400 had been just torn down by a mob of hobbits. What is the Shire’s net investment? Show your work.

b) Draw a graph of the Middle Earth loanable funds market in equilibrium. Be sure to label correctly.

c) Gorthmog is planning to invest in developing Mount Doom as a source of energy for Middle Earth. He is informed by the Orc Union that they will not work in the future without being paid so his expected costs will increase. What happens to his expected profit? Draw what happens in the loanable funds market. What happens to the real interest rate? Explain the dynamics of exactly how the change in expected future costs feeds through to the loanable funds market.

d) With the return of the king, Osgiliath is being restored to its former glory. Such a level of spending causes a budget deficit in Gondor. Draw what happens in the loanable funds market.

e) Moria’s exports increase so that net exports are positive. What will happen to the demand and supply for loanable funds and the real interest rate in Moria? Draw and explain precisely how this works.

Section 9 Treebeard runs the MENB (Middle Earth National Bank) with “branches” all over the Shire. Merry Brandybuck makes a deposit in the Shire’s MENB of $100 from the loot he brought back from his travels in Wilderland.

Page 3 of 15 5/23/2018

*Quotes from The Lord of the Rings, or The Hobbit by JRR Tolkien. Nothing written in italics applies to the questions—it’s there just for Tolkien fun. Go forth and read!!!

'One felt as if there was an enormous well behind them, filled up with ages of memory and long, slow steady thinking; but their surface was sparkling with the present: like sun shimmering on the outer leaves of a vast tree, or on the ripples of a very deep lake. I don't know, but it felt as if something that grew in the ground -- asleep, you might say, or just feeling itself as something between root-tip and leaf-tip, between deep earth and sky -- had suddenly waked up, and was considering you with the same slow care that it had given to its own inside affairs for endless years.'

a) If the reserve rate is set at 15%, how much of Merry’s deposit must the bank keep? How much can the bank loan out to Pippin Took?

b) What would be the maximum change to the money supply from a)? Where does the change come from and by what formula? Show reserve and loan amounts for the first 6 levels.

c) Suppose Bilbo took $500 out of an old box he had hidden

under his bed at Bag End (Bilbo’s house in the shire) and put it in MENB. What would be the maximum change to the money supply if the reserve rate was now 20%? Note: this is not related to the problem in a).

d) What three assumptions are included in calculating the maximum change in the money supply in a)? Explain the difference between a) and c) (not the difference in reserve ratios).

'Of course we understand,' said Merry firmly. 'That is why we have decided to come. We know the Ring is no laughing

matter; but we are going to do our best to help you against the Enemy.'

Page 4 of 15 5/23/2018

*Quotes from The Lord of the Rings, or The Hobbit by JRR Tolkien. Nothing written in italics applies to the questions—it’s there just for Tolkien fun. Go forth and read!!!

Section 10 The Federal Council of Elrond (Fed) controls the banking system in Middle Earth. The Council is responsible for controlling the money supply and implementing monetary policy.

a) The Council wishes to expand the money supply. Describe precisely how this would work through open market operations and effects on reserves.

b) The Council wishes to decrease the money supply. Describe precisely how this would work through the required reserve ratio and effects on reserves.

c) The Council wishes to decrease the money supply. Describe precisely how this would work through the discount rate and effects on reserves.

If the money supply in Middle Earth is $10,000, velocity of money is a constant 3, the price level is 2.0, and output is constant at 15,000,

d) What is aggregate demand? What is nominal GDP? How did you get your answer?

e) The Council increases the money supply by $1,000. What is the net effect on the economy of the increase in the money supply in this case? Graph the impact on the Middle Earth economy with a constant level of real GDP and velocity (simple AD/AS model). Use actual numbers.

f) Explain exactly and draw how the change in e) affects the money market in the short run. What

are the dynamics that make the nominal interest rate adjust in the long run? (don’t use numbers—answer in general terms)

g) Now suppose that the Council implements a technological innovation with ATM’s in Middle Earth.

Graph the change in the money market and explain how the change comes about. (don’t use numbers—answer in general terms)

Page 5 of 15 5/23/2018

*Quotes from The Lord of the Rings, or The Hobbit by JRR Tolkien. Nothing written in italics applies to the questions—it’s there just for Tolkien fun. Go forth and read!!!

Section 11 Bilbo Baggins loved to have parties and give gifts. Since he came back from his adventures with Thorin Oakenshield and the dwarves with lots of gold, he could afford to import magical toys and other special presents from the foreign country of Dale where they are made. The Shire (where Bilbo lives) and Dale have different currencies.

a) Draw the foreign exchange market for the Shire dollar. Be sure to show the equilibrium exchange rate and quantity traded.

b) Real income in the Shire increases. Draw what

happens in the exchange rate market. What happens to the exchange rate and quantity traded? (Remember both sides of market can be affected)

c) The Shire’s interest rates fall compared to the rest of the world. Draw what happens in the exchange rate market. What happens to the exchange rate and quantity traded? (Remember both sides of market can be affected)

d) The exchange rate for the Shire dollar is expected to rise in

the future. Draw what happens in the exchange rate market. What happens to the exchange rate and quantity traded? (Remember both sides of market can be affected)

Page 6 of 15 5/23/2018

*Quotes from The Lord of the Rings, or The Hobbit by JRR Tolkien. Nothing written in italics applies to the questions—it’s there just for Tolkien fun. Go forth and read!!!

Section 12 Denethor, son of Echthelion II, is Steward of Gondor in the absence of the rightful king. He is a firm believer in Say’s Law and the laissez-faire approach to the economy of Gondor.

He is not as other men of this time, Pippin, and whatever be his descent from father to son, by some chance the blood of Westernesse runs nearly true in him; as it does in his other son, Faramir, and yet did not in Boromir whom he loved best. He has long sight. He can perceive, if he bends his will thither, much of what is passing in the minds of men, even of those that dwell far of. It is difficult to deceive him, and dangerous to try.

a) Draw aggregate demand, aggregate short run supply

and aggregate long run supply for Gondor’s economy in long run equilibrium. What is the unemployment level?

b) Consumers in Minas Tirith believe there will be an acute shortage developing in the supply of rings and anticipate higher future price levels in the economy. Draw and explain what happens to aggregate demand in the Gondorian economy in the short run. Identify any change in determinant(s) and explain why and how the change occurs. What happens to the price level, unemployment and real GDP in the short run? Is there an inflationary or recessionary gap?

c) Draw and explain what happens to the Gondorian economy in the long run as a result of b). What happens to the price level, unemployment and real GDP in the long run? Include all the dynamics in your explanation and graph.

Page 7 of 15 5/23/2018

*Quotes from The Lord of the Rings, or The Hobbit by JRR Tolkien. Nothing written in italics applies to the questions—it’s there just for Tolkien fun. Go forth and read!!!

d) The Gondorian dollar appreciates. Draw and explain what happens to aggregate demand in the Gondorian economy in the short run. Identify any change in determinant(s) and explain why and how the change occurs. What happens to the price level, unemployment and real GDP in the short run? Is there an inflationary or recessionary gap?

e) Draw and explain what happens to the Gondorian economy in the long run as a result of d). What happens to the price level, unemployment and real GDP in the long run? Include all the dynamics in your explanation and graph.

f) A new discovery of mithril (a valuable metal

resource) is located in the White Mountains of Gondor. Draw and explain what happens to the kingdom’s economy. What happens to the price level and real GDP in the long run?

The Dwarves delved deep at that time, seeking beneath Barazinbar for mithril, the metal beyond price that was becoming yearly ever harder to win.

Section 13

The (returned) king, Aragorn the King Elessar, is a Keynesian advocate, as is his chief Steward, Faramir, younger son of Denethor.

Then Frodo came forward and took the crown from Faramir and bore it to Gandalf; and Aragorn knelt, and Gandalf set the White Crown upon his head, and said: 'Now come the days of the King, and may they be blessed while the thrones of the Valar endure!'

Page 8 of 15 5/23/2018

*Quotes from The Lord of the Rings, or The Hobbit by JRR Tolkien. Nothing written in italics applies to the questions—it’s there just for Tolkien fun. Go forth and read!!!

a) Draw the total expenditures and total production model for the Gondor economy. Show the equilibrium level of real GDP being produced. What are the slopes of the TE and TP curves? Put all the labels!

b) Draw the Gondor economy in a recessionary gap, using the Keynesian total expenditures and total production model. What can you say about unemployment and real GDP?

c) Draw the Gondor economy in an inflationary gap, using the Keynesian total expenditures and total production model. What can you say about unemployment and real GDP?

The King has set the income tax rate at 20% for Gondorian citizens.

Faramir has provided the following information to King Elessar:

Personal Income Consumption

$1375 $1000

$1625 $1120

$1875 $1240

$2125 $1360

$2375 $1480

d) What are the marginal propensity to consume (MPC) and the marginal propensity to save (MPS) in Gondor?

e) What is the Gondorian economy’s expenditure multiplier? What is the tax multiplier?

We are truth-speakers, we men of Gondor. We boast seldom, and then perform, or die in the attempt. Not if I found it on the highway would I take it, I said. Even if I were such a man as to desire this thing, and even though I knew not clearly what this thing was when I spoke, still I should take those words as a vow, and be held by them.

f) The economy of Gondor is in an inflationary gap of $1,000. What type of fiscal policy can King Elessar undertake to bring the economy to back to the natural unemployment rate? By what 2 methods? Graph one method using the total expenditures and total production model and explain how the policy would work. Be numerically precise, using the information in d) and e). Include unemployment.

g) The economy of Gondor is in a recessionary gap of $500. What type of fiscal policy can King Elessar undertake to bring the economy to back to the natural unemployment rate? By what 2 methods? Faramir suggests a different type and method of fiscal policy from f) to King Elessar. Graph this second method using the total expenditures and total production model and explain how the policy would work. Be numerically precise, using the information in d) and e). Include unemployment.

Page 9 of 15 5/23/2018

*Quotes from The Lord of the Rings, or The Hobbit by JRR Tolkien. Nothing written in italics applies to the questions—it’s there just for Tolkien fun. Go forth and read!!!

h) Draw and explain the effect of a change in the price level, using the TE/TP model and the AD/AS

model in combination. Section 14 Gandalf wishes the economy of Middle Earth to operate smoothly after he sails from the Grey Havens to the never-ending lands in the West. He gathers King Elessar of Gondor, King Eomer of Rohan, Thain Pippin Took of the Shire, King Thorin III Stonehelm of the Lonely Mountain, King Bard II of Dale, King Thranduil of Mirkwood, Gimli son of Gloin of Aglarond, Prince Faramir of Ithilien, Prince Imrahil of Dol Amroth, Treebeard of Fangorn Forest and other councilors and leaders of the various countries of Middle Earth to instruct them on fiscal policies designed to smooth out the business cycle.

Even as the first shadows were felt in Mirkwood there appeared in the west of Middle-earth the Istari, whom Men called the Wizards....[A]terwards it was said among the Elves that they were messengers sent by the Lords of the West to contest the power of Sauron, if he should rise again, and to move Elves and Men and all living things of good will to valiant deeds. In the likeness of Men they appeared, old but vigorous, and they changed little with the years, and aged but slowly, though great cares lay on them; great wisdom they had, and many powers of mind and hand.

a) Describe a budget deficit, a budget surplus and a balanced budget. Include relationship of tax revenues and government spending. What impact will each have on the market for loanable funds?

b) Describe and graph how an income tax affects potential GDP and aggregate supply. Indicate the income tax wedge. (2 graphs) How do taxes on expenditures affect the income tax wedge?

c) Draw the Laffer curve. Show where the maximum tax revenues would be. From this point does an increase in tax rates increase or decrease tax revenues?

d) Describe the three multipliers for government fiscal policy and describe the differences in size of impact. How does each work to affect the economy?

Page 10 of 15 5/23/2018

*Quotes from The Lord of the Rings, or The Hobbit by JRR Tolkien. Nothing written in italics applies to the questions—it’s there just for Tolkien fun. Go forth and read!!!

e) Draw expansionary fiscal policy that

is applied when the economy is in a recessionary gap using the AD/AS model. What are the two fiscal actions that the government could take to implement this policy?

f) Draw contractionary fiscal policy that is applied when the economy is in an inflationary gap using the AD/ AS model? What are the two fiscal actions that the government could take to implement this policy?

g) List and briefly describe the five lags that cause problems in implementing fiscal policy. Section 15

Thorin III Stonehelm, son of Dain, became King of the Lonely Mountain after his father’s fall in the War of the Ring. The dwarves of his kingdom were busy and prosperous producing the weapons, armor and jewelry for which they were famous and which the inhabitants of Middle Earth were demanding now that there was peace. But Thorin III Stonehelm began to notice that prices were rising in his kingdom and he went to consult with King Bard II of Dale (son of Brand) to see why this was happening.

The lands opened wide about him, filled with the waters of the river which broke up and wandered in a hundred winding courses, or halted in marshes and pools dotted with isles on every side; but still a strong water flowed on steadily through the mist. And far away, its dark head in a torn cloud, there loomed the Mountain! Its nearest neighbours to the North-East and the tumbled land that joined it to them could not be seen. All alone it rose and looked across the marshes to the forest. The Lonely Mountain!

a) Draw (in the AD/AS model) and explain what happens to aggregate demand in the short run. What happens to the price level, unemployment and real GDP in the short run? Is there an inflationary or recessionary gap?

Page 11 of 15 5/23/2018

*Quotes from The Lord of the Rings, or The Hobbit by JRR Tolkien. Nothing written in italics applies to the questions—it’s there just for Tolkien fun. Go forth and read!!!

b) Draw (in the AD/AS model) and explain what happens to the Lonely Mountain economy on its own in the long run as a result of a) if no policy response occurs. What happens to the price level, unemployment and real GDP in the long run? Include all the dynamics. Is this inflation? Explain why or why not. If so, what is it called?

c) Draw (in the AD/AS model) and explain what happens to the Lonely Mountain economy in the long run as a result of a) if the Council (Fed) immediately applies monetary policy and contracts the money supply rather than wait for the economy to self-correct like in b). What happens to the price level, unemployment and real GDP in the long run? What is the final difference in the result of the monetary policy and the results in b)?

d) The Federal Council of Elrond (Fed) gets on a roll and increases the money supply each year for 3 years. Draw (in the AD/AS model) and explain the long-run effect of these increases on the economy of the Lonely Mountain. What happens to the price level, unemployment and real GDP in the short run and in the long run? What is the end result of these continued increases? Is there inflation? Explain why or why not. If so, what is it called?

The economy of the Lonely Mountain is dependent on iron for its armor and weapon manufacturing. A pack of Orcs fleeing the destruction before the gates of Barad-Dur make their way to the Iron Hills where the dwarves mine ore and force battle. The attack on the Dwarves’ mines causes a temporary supply shock to the economy of Middle Earth due to the reduction of raw materials.

e) Draw (in the AD/AS model) and explain the short-run effect of the supply shock on economy of

the Lonely Mountain. What happens to the price level, unemployment and real GDP in the short run? Is there an inflationary or recessionary gap?

f) Draw (in the AD/AS model) and explain what happens to the Lonely Mountain economy on its own in the long run as a result of e) if no policy response occurs. What happens to the price level, unemployment and real GDP in the long run? Include all the dynamics. Is there inflation? Explain why or why not. If so, what is it called?

Page 12 of 15 5/23/2018

*Quotes from The Lord of the Rings, or The Hobbit by JRR Tolkien. Nothing written in italics applies to the questions—it’s there just for Tolkien fun. Go forth and read!!!

g) Draw (in the AD/AS model) and explain what happens to the Lonely Mountain economy in the long run as a result of e) if the attacks continually re-occur and the Council (Fed) applies expansionary monetary policy and increases the money supply one time rather than wait for the economy to self-correct like in f). What happens to the price level, unemployment and real GDP in the long run? Is there inflation? Explain why or why not. If so, what is it called? What is the final difference in the result of the monetary policy and the results in f)?

h) Draw what happens in the AD/AS model when an increase in the money supply is correctly anticipated. Is there an increase in output or change in unemployment? Explain why or why not. What are two methods by which people form expectations?

i) If inflation was actually higher than anticipated, what would be the short-run result for output and

unemployment? If inflation was actually lower than anticipated, what would be the short-run result for output and unemployment? Graph both and indicate any gaps.

Section 16 After the War of the Rings, Legolas returns to Mirkwood, where his father rules the Woodland Elves. Due to new ideas gained in his wide travels, Legolas convinces King Thranduil to implement continuing expansionary monetary and fiscal policy to reduce unemployment in Mirkwood. (Actually, a reduction in the consumption of barrels of wine would work better.)

There was also a strange Elf, clad in green and brown, Legolas, a messenger from his father, Thranduil, the King of the Elves of Northern Mirkwood.

a) Draw and explain the short-run Phillips curve for the economy of Mirkwood on which Legolas

is basing his ideas. What is held constant along the short-run Phillips curve? What is the tradeoff in the short-run?

Page 13 of 15 5/23/2018

*Quotes from The Lord of the Rings, or The Hobbit by JRR Tolkien. Nothing written in italics applies to the questions—it’s there just for Tolkien fun. Go forth and read!!!

b) Draw the combined short-run and long-run Phillips curves for the Mirkwood economy. Explain what happens to the price level and unemployment in the long run? Is there any tradeoff in the long-run?

c) Explain and show by graph the

connection through unemployment and changes in the price level between the business cycle as shown by the AD/AS model and the long run Phillips curve (show 3 points on the graph and include unemployment at each).

d) Suppose job search time in Mirkwood

suddenly becomes easier. Draw and explain what happens to the Phillips curve in Mirkwood.

Section 17

Elrond, Chairman of the Council, is a monetarist and believes that prices and wages are flexible so that the economy is self-regulating. But unlike Denethor, he feels that money is the key to the economy.

The face of Elrond was ageless, neither old nor young, though in it was written the memory of many things both glad and sorrowful. His hair was dark as the shadows of twilight, and upon it was set a circlet of silver; his eyes were grey as a clear evening, and in them was a light like the light of stars. Venerable he seemed as a king crowned with many winters, and yet hale as a tried warrior in the fulness of his strength. –

a) What are the 3 monetary policy objectives and goals of the Federal Council of Elrond (Fed)? What

tradeoff does the council face for its goals? Explain.

Page 14 of 15 5/23/2018

*Quotes from The Lord of the Rings, or The Hobbit by JRR Tolkien. Nothing written in italics applies to the questions—it’s there just for Tolkien fun. Go forth and read!!!

b) Graph the implementation of expansionary monetary policy on the economy of Middle Earth when there is a recessionary gap (in both money market and AD/AS model). What happens to the price level, unemployment and real GDP? Specify 3 different actions the Council (Fed) could do to accomplish this policy.

c) Graph the implementation of contractionary monetary policy on the economy of Middle Earth when there is an inflationary gap (in both money market and AD/AS model). What happens to the price level, unemployment and real GDP? Specify 3 different actions the Council (Fed) could do to accomplish this policy.

d) Draw the effect on the federal funds rate if the Council (Fed) performs an open market purchase. Graphs the ripple effects of this action. Be sure to include the end result in each market and how those results affect the components of aggregate demand.

e) Draw the effect on the federal funds rate if the Council

(Fed) performs an open market sale. Graphs the ripple effects of this action. Be sure to include the end result in each market and how those results affect the components of aggregate demand.

Then Círdan led them to the Havens, and there was a white ship lying, and upon the quay beside a great grey horse stood a figure robed all in white awaiting them. As he turned and came towards them Frodo saw that Gandalf now wore openly on his hand the Third Ring, Narya the Great, and the stone upon it was red as fire. Then those who were to go were glad, for they knew that Gandalf would also take ship with them.... Then Frodo kissed Merry and Pippin, and last of all Sam, and went aboard; and

Page 15 of 15 5/23/2018

*Quotes from The Lord of the Rings, or The Hobbit by JRR Tolkien. Nothing written in italics applies to the questions—it’s there just for Tolkien fun. Go forth and read!!!

the sails were drawn up, and the wind blew, and slowly the ship slipped away down the long grey firth; and the light of the glass of Galadriel that Frodo bore glimmered and was lost. And the ship went out into the High Sea and passed on into the West, until at last on a night of rain Frodo smelled a sweet fragrance on the air and heard the sound of singing that came over the water. And then it seemed to him that as in his dream in the house of Bombadil, the grey rain-curtain turned all to silver glass and was rolled back, and he beheld white shores and beyond them a far green country under a swift sunrise.