Problem 1: Long-Term Growth in the AD-AS Model This will be a graph shifting question, which asks about the intuition of both the AD-AS figures and the I-NS figures, specifically relating them to long-term growth. Suppose that the economy uses (only) two major inputs in its production: capital (K) and labour (L). Suppose also that we are thinking about long-term growth, specifically through productivity growth. 1. Suppose that there is an increase in the productivity of input in this economy. What would we expect to happen to Y* in the long-run? Explain your answer. Now suppose that the Aggregate Demand (AD) remains fixed through this period, and that we begin in long-run equilibrium. 2. If AD remains fixed, and the growth in the economy's productivity occurs, then what would happen to (i) the price level (p), (ii) Real GDP (Y), and (iii) the price of inputs (L & K) in the economy? Explain your answer using the AD-AS model. Suppose that the government is concerned about stability in the price level and is concerned about the impact of this long-term growth on the long-run price level. 3. What can the Government do to maintain stability in the price level? Explain your answer using the AD-AS model. 4. What would be the impact of your answer to the previous question on the government budget deficit? What would need to be true for this to have a negative effect on the deficit? Assume that the budget deficit here increases. 5. What would be the impact of the change in Y* and the increase in the budget deficit on this economy's long-term interest rates? Explain your answer using the I-NS model.

2 Problem 2: Net-Present Values Consider the following contract, where you agree to pay somebody $200 per year, each year, for five years, beginning one year from now. On the final year of repayment (the fifth year), you are also expected to pay an additional $400 on top of the $200, making your full payment in the fifth year equal to $600. Assume that the interest rate is equal to 8%. Round all answers to two decimal places. 6. What is the Present Value (PV) of the total payments that you will need to make as part of this contract? 7. Suppose that somebody offers you $1,000 today to sign this contract. Would signing this contract yield a positive totally Net Present Value for you? Suppose that you could buy these contracts from people. You could pay a certain amount of money, and in return, you would own this contract which would make these payments to you. 8. What would we expect the be the market price for these contracts under efficient financial markets? Suppose finally that there is a large increase in the Government Budget Deficit due to an increase in Government Spending. 9. What would you expect to happen to long-term interest rates as a result of this increase in the Budget Deficit? Explain your answer using our I-NS figure from class. 10. How would this change in the interest rate affect the market price for these contracts? Explain your answer.

3 Problem 3: Bank Balances and Deposits Suppose that we exist in a banking system with a mandated reserve ratio of 12%. Suppose that the banks in this system have no capital themselves ($0) but do still have deposits. Suppose to begin that there is no cash drain (0%) to begin with. 11. Suppose that there is a new deposit into a bank of 100 dollars. How much will this deposit change the total quantity of deposits in this banking system? 12. If the total banking system has $8,000 in deposits across the whole system, then what must have been the initial deposit into this banking system to generate these $8,000 in total deposits? Using the initial quantity of deposits that you calculated in the previous question (Q12), answer the following final two questions: 13. If the Central Bank lowers the reserve ratio from 12% to 10%, how much would this change the quantity of deposits across the total banking system? 14. Suppose that the reserve ratio remains at 10%. If there was also a cash drain of 10%, what would be the quantity of deposits across the total banking system?