Economics Assignment: Long-run classical model, IS-LM model and AS-AD model

Instructions:

1. You can submit an individual or group assignment. If you submit a group assignment, there must be no more than FIVE students in your group and you just have to submit One copy.
2. Label your graph(s); otherwise, marks will be subtracted.
3. No credit will be given if you do not show your work (i.e., don’t simply say the answer is 3 write down enough of the steps you used to arrive at this answer).
4. Your answer should be structured in a way such that those that know little about economics will have no difficulty understanding your argument/answer.
5. Do Not Use any notations that are not used in lectures. If you use your own notations and/orabbreviations that are not being used in lectures, you will receive a grade of zero for that question. 

A small open economy with perfect financial capital mobility is currently in its long-run equilibrium with a trade deficit. With the increase in vaccination rates and the reopening of the economy, the government reduces its subsidy to households. As the same time, local businesses become more optimistic as they expect future sales will grow faster than previously anticipated.

Use the long-run classical model of a small open economy, discuss the long-run impacts of these changes on the levels of output, trade balance, price level, and both nominal and real FC/DC exchange rates.

Explain and support your answer with one loanable fund market diagram and foreign exchange market diagram. Be sure to explain in words why the variables of interest change or remain unchanged.

 

Home is a small open economy with perfect financial capital mobility and no risk premium, that can bedescribed by the following set of equations:

 

Note: Real interest rates, r, is expressed in percentage points. For example, if r = 5, then r = 5%. Keep your answer to 3 decimal points if necessary.

(a). Derive the net foreign investment function for Home in terms of the exogenous variables. (2 points)

(b). Find the long-run equilibrium levels of national savings, real exchange rate, net exports, and price in Home if the government of Home runs a budget surplus of 500 and the world interest rate is 5%. (6 points)

Home is initially in its long-run equilibrium as described in part (b). Due to political and economic uncertainty a large foreign economy, businesses in the foreign country reduce desire to acquire new machinery and equipment. In addition, studies show that this change in large foreign economy will cause the world interest rate to change by 1 percentage point.

(c). Redo part (b). (6 points)

(d). Suppose the government of Home wants to balance the trade account via a change in government spending; and at the same time, the central bank wants to achieve price stability (i.e., keeping the price level fixed at the initial level) via a change in money supply, find the level of government spending and money supply that will achieve these goals simultaneously. (6 points)

The Policy makers of a closed economy are seeking proposals on how monetary policy should be conducted. Currently, two proposals have been submitted, and they are:
Proposal 1: Use the policy to target (real) investment

Proposal 2: Use the policy to target level of employment

Suppose the economy experiences an improvement in payment technology such that most households move to making transactions using mobile payment apps. You are asked to do the followings: 

1.  Evaluate the effect of this change on the short-run equilibrium level of consumption under these two different proposals.
2.  Rank the change in consumption in ascending order (i.e., from smallest change to largest change) in the above proposals. 

Explain and support your answer using ONE IS-LM diagram (only the first diagram will be graded)

Macroland is a closed economy that can be described by the IS-LM model. 

 

         

Note: Interest rate, r, is expressed in percentage points, i.e., if r = 7.5, then r = 7.5%. Keep your answers to 3 decimal points if necessary. 

 

(a). Derive the IS and LM equations in terms of the exogenous variables. (4 points)

(b). In the initial (long-run) equilibrium, the central bank sets the level of nominal money to 40600. Find the resulting long-run equilibrium values of real interest rate, investment, and price level. (3 points)

(c). The economy is initially in its long-run equilibrium as shown in part (b). Now, with the rolling out of COVID-19 vaccine, businesses become more optimistic about the future economic outlook. As a result, autonomous investment changes by 3%. Find the new short-run equilibrium values of real output, real interest rate, and investment. Compute the new long-run equilibrium values of real interest rate, investment, and price level. (10 points)

(d). (Continued from part c) Suppose the central bank wants to increase the short-run level of output in part (c) by 1000 via a change in the level of money supply. Find the level of money supply that would achieve the goal. What will be the new (short-run) equilibrium level of real interest rate? (8 points)

The economy is a closed economy and is currently producing at its full potential. Suppose that people finally realize that they must save a larger portion of their income in order to be able to retire and live with a reasonable level of comfort and that they simultaneously begin to use a new payment technology, which allows them to reduce their holdings of real cash balances as a proportion of their income.

In thecontext of the AS-AD model, explain the effects of these changes on the short-run equilibrium levels of output and real money balance. Also, support your answer by One AS-AD diagram.