macroeconomics problem set

1. (25 pts) Suppose an economy currently under a Recessionary Gap. The Potential Output of the economy is $850 billion. Please use the following information to answer the questions below:

Assumptions:

1. a)Government revenues come from total income taxes.
2. b)Consumers only react to changes in taxes, and there is no autonomous consumptionc) Investment only reacts to changes in the interest rate
3. d)The golden assumption of Neoclassical Economics: Investment = Savings

1. Define Potential Output, a recessionary GDP gap, and an inflationary GDP gap
2. Calculate the recessionary gap of the economy
3. What are the current levels of Consumption and government Revenues?
4. Now suppose the government wants to implement an expansionary Fiscal Policy that leads the economy to the level of full employment.
5.      What is the value of the current government deficit? What is the correct policy under these circumstances?
6.      What should be the value of the effect of the government’s fiscal policy, given the value of the multiplier? Calculate the value of the government’s policy and show graphically the effects.
7. The Central Bank offers to implement an expansionary Monetary Policy before the government sacrifices its good standing. It then decides to bring the down the interest rate to 1.75%. Explain what happens to the economy under this Monetary Policy. Show each of your steps. What happens not to the recessionary gap? Explain your assumptions.
8. What would you recommend the president of this economy to do, should she go for the fiscal policy or the monetary policy? Explain and justify your answer.

2. (10 pts) Following the description of the Aggregate Supply and the long-run growth theory,
3. Describe what determines the short-run Aggregate Supply curve to be upward sloping, and describe under what conditions does the supply curve shift.
4. Describe the five main sources of growth and define according to the new growth theory, what is the primary source of growth?
5. Define the Law of Diminishing Marginal Productivity. Explain why Classical growth economists who applied the law of diminishing marginal productivity to capital concluded that output could grow indefinitely but per capita output could not.

3. (5 pts) Can an increase in equilibrium income eliminate a cyclical deficit and eliminate the structural deficit? Why or why not? Explain and analyze graphically.

4. (10 pts) Do you think the United States can continue its expansionary fiscal policies without causing a new financial crisis? Explain why or why not and what are the implications in terms of the interest rates and bonds. Explain the effects on the short run AS/AD model and then in the long-run AS/AD model.

5. (10pts) Governments  issue debt mainly as bonds. Explain:

1. Why do people hold money rather than bonds when bonds pay higher interest than money? Why are interest rates important to the economy?
2. What are the names of the bonds of the following governments: United States, Brazil, United Kingdom, Japan, China. Which of these countries has a higher debt to GDP ratio? Show in a graph.

6. (5pts) If the reserve requirement is 20 percent, and banks keep no excess reserves, by how much will an increase in an initial inflow of $100 into the banking system increase the money supply? Show your procedure.

Part II – Deficit, austerity, and Fiscal Policy (20 points)

7. (10pts) Think of an economy that has established a marginal tax rate of 15%. In this economy the government expenditures do not change with output and in the year 2015, the economy was operating at its potential output with a deficit of $120 billion.

1. What is the size of the cyclical deficit?
2. What is the size of the structural deficit?
3. How would your answers to a and b change if the deficit were still $120 billion but output were $100 billion below potential?
4. How would your answers to a and b change if the deficit were still $120 billion but output were $100 billion above potential?
5. Which is likely of more concern to policy makers: a cyclical or a structural deficit?

8. (5pts) Calculate the real deficit or surplus in the following cases.
9. Inflation is 10 percent. Debt is $5 trillion. Nominal deficit is $570 billion.
10. Inflation is -4 percent. Debt is $500 billiion. Nominal deficit is $30 billion.

9. (5pts) Based on the definitions of the Reservation Wage:
10. What is the definitions of the Reservations Wage and how does it affect the participation rate?
11. What happens when there is a reservation wage that is higher than the equilibrium wage?
12. What is the relation of the reservation wage to structural unemployment?

Part III – Financial Sector and the Economy – Money creation (10 points)

10. (10pts) Use the following data:
11. Describe the three functions of money and give an example for each.
12. How large is the money supply (M1)?
13. How much excess reserves are there?
14. What is the money multiplier?
15. What is the available lending capacity?

11. (5pts) The money supply is described as endogenously determined by the monetary system. Explain how this statement relates to the function of the interest rate as the main instrument of policy and level of reserves. Describe the different instruments the Central Bank has to target the Money Supply and how such instruments relate to private banks and finally with the level of Savings and Investment in the economy.

12. (5pts) Describe the difference between an offensive and a defensive action from a Central Bank. Define:

1. Each type of action: Offensive and defensive
2. Under what circumstances should the bank adopt one policy or the other?
3. What is the relation of each policy with the federal funds rate, the discount rate, government securities, and the reserve requirement.

Part IV – Monetary policy and Inflation (20 points)

13. (10pts) If the European Central Bank wants to carry out the following Monetary Policies, define what they are and describe what the effect of each would be:

1. Reduce the discount rate
2. Increase the reserve requirement
3. Reduce the money multiplier
4. Limit open market operations

14. (5pts) Explain the relation between the Long Run and Short Run Phillips Curve. Explain how each relates to inflation expectations, unemployment and graph each to show their slope. Enumerate the three tools of Monetary Policy and define them.

15. (5pts) Following the Quantitative Theory of Money:
16. Explain what happens if the velocity of money is increasing, but the money supply is not. What kind of Monetary Policy should be carried out in that situation?
17. Now suppose velocity is constant but real GDP is not independent of the money supply. If this is the case, what will happen if there is a 10 percent increase in the money supply.

16. (5pts) Money and inflation:
17. Calculate the inflation level if the monetary authorities allow the money supply to grow at a rate of 6 percent in an economy that is growing by 2 percent in real terms. Show your procedure.
18. If inflation is 1 percent, the Fed wants 2 percent inflation, and output is 2 percent below potential, what would the Taylor rule predict for a Fed funds rate target?