Question 1: [10 marks]

a.[3.5 marks]Draw a 2 panel diagram for a small open economy to show the market for loanable funds and the market for foreign currency exchange. Show the initial equilibrium using all the appropriate variables on the diagrams. In both diagrams, explain the source of supply and demand also.

b.[3 marks]Now suppose the French suddenly develop a strong taste for British Columbia wines. Show on the diagram and explain what happens to the demand for dollars in the market for foreign-currency exchange?

c.[3.5 marks]As a result of change to demand for dollars in part b) what happens to the value of dollars in the market for foreign-currency exchange? What happens to the quantity of net exports? Carefully explain all the relevant details of this part.

Question 2: [10 marks]

a.[3 marks]Draw the aggregate supply and aggregate demand model to show the initial long run equilibrium in the real output market. Label the equilibrium point A. Now suppose that a recession happened in U.S. Show the impact of this on Canadian economy in the short run. Label the new short run equilibrium point B. Give a clear explanation about the change in quantity of output produced (use sticky wage explanation)

b.Following from a), show and explain clearly how the economy will reach the long run equilibrium when there is no policy involvement and the economy has to return back to natural level of output on its own. Call the new equilibrium point C. What happens to the price level and output?

c.[3.5 marks]Redraw the diagram from part a). Now suppose that the government wants to use the fiscal policy to bring the economy back to the natural level. What should it do to bring the economy back? What happens to the price level and the output in this case? How the long run equilibrium is different from part b)? What is the benefit of using the policy?

Question 3: [10 marks]Draw the initial long run equilibrium using AD-AS diagram. Now suppose a positive supply shock such as a fall in oil price happens.

a.[3 marks]Show the effect of this positive shock in the output market as well as on the short run and long run Phillips Curve diagram. Label the points in both diagrams clearly. If you label point A on one diagram, show point A on the other to demonstrate the situation of unemployment and inflation on the Phillips curve diagram too.

b.Show (on the diagrams you drew above) how the economy will adjust in the long run if Bank of Canada uses expansionary monetary policy (increasing money supply). What happens to inflation and unemployment?

c.Show what happens if the BoC uses contractionary monetary policy (decreasing money supply). What happens to inflation and unemployment? Draw a new set of diagrams to show this effect. Clearly show points A, B and C on both the diagrams.