Question 3 (25 points) - Chapters 9 & 10/11 The following question's sub-parts are completely separate questions. ) Some economists claim that the government should always use monetary policy to stabilize (or target) the real interest rate in the short-run if they also wish to keep the resulting impact on (changes to) the government budgetary balance to a minimum. Is this claim true, false or uncertain? Explain by using words and one IS/LM diagram. (5 points) b) The government should always use monetary policy to combat the effect of business cycle fluctuations coming from changes in autonomous consumption if it wishes to keep movements in unemployment & investment to a minimum. Is this claim true, false or uncertain? Explain by using words and a single IS/LM diagram. (10 points) c) The government should never use fiscal policy to combat business cycle fluctuations coming from changes in money demand if it also wishes to keep longer term movements in the price level to a minimum. Is this claim true, false or uncertain? Explain by using words and a single AS/AD diagram. (10 points) Question 4 (25 points) - Chapters 9 & 10/11 Utopia is a closed economy and is characterized by the following equations: Consumption: C = 1510 + 0.95(Y - T) - 510r Investment: I = 2000 - 900r Government spending: G = 2400 Taxes: T = 2200 Real money demand: (M:/P) = L(Y,i) = 0.5Y - 200i Expected inflation: I= = 0 Production function: Y = 5K131 23 Note: Interest rates, i and r, are expressed in decimal points, i.e., if r = 0.075, then r = 7.5%. Suppose the IS-LM model can used be to describe Utopia, and answer the following questions. Keep your answers to a minimum of THREE decimal points (for fractions). a) Derive the 15 and LM equations for this economy. (4 points) b) The supply of capital and labour in this economy are both equal to 4000; and the level of the nominal money supply is 9600. Calculate the long-run or full-employment values of the output, consumption, investment, real interest rate, public saving, private saving, national saving, and price level. (4 points) c) Now suppose the government of Utopia is deciding on a new monetary policy regime. They are considering targeting the real interest rate. It is considering either setting it real interest rate target at 1.759% or 2.209%. Assuming that the economy was initially at full-employment, for each real interest rate target what are the new values of output, consumption, investment, real interest rate, public saving, private saving, national saving, and price level in the short- run? (8 points) d) Suppose a prominent economist criticizes the policy recommended in part (c) by saying this policy goes too far. By aggressively altering the money supply the government will create high levels of inflation for many years to come and thereby discourage new physical capital investment. Another economist, also critical of this policy, says that the economist above AND the government are both wrong, she says this policy is terribly flawed at its very core and should only be used temporarily when the economy is hit by a bad business cycle shock
