Inflation in the Economy 1 Consider a closed economy whose aggregate demand is described by the NIPA equation: Y=C+I+G where the individual components of the NIPA equation are given by CIG=C+mpc(YT)=Iv(r+)=G Note that in this economy, consumption and investment spending respond to the nominal interest rate (i r+). In this economy, short-run aggregate supply is given by =(YYN)+ Long-run aggregate supply is fixed at Y=YN. a (20 points) Plot the short-run aggregate supply, long-run aggregate supply, and aggregate demand curves and show the dynamics of (i) a negative permanent supply shock (YN); (ii) a negative temporary supply shock () and a positive demand shock (C) that occur simultaneously. Do this in two separate graphs that show the dynamics of aggregate supply and demand. (this requires no math and does not involve the equations above). What happens to inflation in each case? b (10 points) Derive the aggregate demand equation using the NIPA equation as well as the consumption function, investment function and the level of government spending. c (20 points) Suppose the following values: C=120,I=50,T=50,G=50,mpc=0.6,v=50. If C decreases to 110 , by how much will output decrease in the short-run? d (30 points) Now suppose that consumption decisions depend on the rate of inflation. Consumers do not like to consume when prices go up, meaning that the consumption function is given by C=C+mpc (YT)h. This yields the following system of equations that determine aggregate demand: CIG=C+mpc(YT)h=Iv(r+)=G Do the following (parts e and f) : e (10 points) Derive the new aggregate demand equation. f (20 points) Suppose that supply is always at its long-run level, Y=YN and =. Starting from =0, show graphically what would happen if increases and supply does not adjust (ie Y stays at YN ). Be sure to show or describe how much total private consumption (C) changes as inflation () changes. inancial Markets and Other Markets 2 There is an economy with a central bank, a Bank A and a firm B. The Bank's T-Account is given by a (10 points) If the central bank sets the required reserve ratio for commercial banks 10%, how many of this bank's reserves are required and how many are excess reserves? For parts b and c, assume the following: Firm B has a plan to invest in a new project that costs $30B. To finance this, it issued one-year bonds with $100 face values. Bank A purchased all of them. b (10 points) Suppose that bonds sold by Firm B are one-year zero-coupon bonds and has a face value of $100 and that the market interest rate is 3% annually. How many bonds does Firm B need to sell to finance a $30B expansion? Assume that bonds are priced at the market interest rate. c (20 points) Suppose that Bank A purchases $30 B in bonds from firm B. Show Bank A's new T-Account. For parts d through f, consider the following scenario: Suppose that the required reserve ratio was set at 10% and shortly after the economy enters a downturn. Depositors worry that they will be unable to withdraw their money. All the bank's depositors show up and demand the bank return their deposits. If the bank is unable to cover all their deposits with its cash on hand, it can sell its Mortgage-Backed Securities (MBS) at 85\% value and its Corporate Bonds at 90% value. d (20 points) Suppose that Bank A had not made a loan in part (c). Show their value under the situation described above and argue whether or not they would be able to repay their depositors. e (30 points) Now assume that Bank A has executed its loan in part (c). Is the bank still solvent? Can the bank repay its depositors? f (10 point) How would this affect the aggregate economy