IOBM

Principles of Macroeconomics

ASSIGNMENT 2
Q1. How does an increase in desired national saving in a large open economy affect the world real interest
rate? How does an increase in desired investment affect it? Why do changes in desired saving or
investment in large open economies affect the world real interest rate but changes in desired saving or
investment in small open economies do not?

An increase in desired national saving in a large open economy will make the world real interest rate fall.
Because when we talk about large open economies, we usually consider two countries that are having
trades with each other. As shown in figure a) is the home country, while b) is depicting the foreign country.
Now it is clear from the figure that at the world real interest rate r1 our surplus is equal to their deficit
which is the equilibrium condition. Hence our lending is equal to their borrowing. Let’s assume the sd in
the home country rises shifting its curve right wards to s2 , which means it is now in surplus of 200. But at
this rw foreign country’s deficit is still 100. To get out of this disequilibrium, the rw will fall to r0. Now our
surplus of 150 is equal to their deficit of 150. Hence the rw will fall to our lending and surplus is again equal
to their borrowing and deficit.
However, an increase in desired investment in large open economies will create a shortage of funds. This
pull will raise the world real interest rate.

The change in large open economies affects the world real interest rate whereas the change in small open
economy doesn’t. the change in savings or investment in the large open economy can significantly change
the aggregate world savings or investment of the world. On the other hand, this change in small economy
is so negligible that it doesn’t affect world real interest rate.
Q2. How would each of the following affect national saving, investment, the current account balance, and
the real interest rate in a large open economy?

a. An increase in the domestic willingness to save (which raises desired national saving at any given real
interest rate).
An increase in domestic desired national saving will:
✓ Shift our saving curve rightwards
✓ Increase in investment
✓ Current account surplus
✓ World Real interest rate will fall
b. An increase in the willingness of foreigners to save.
An increase in the foreigners desired saving will:
✓ Shift their saving curve rightwards
✓ decrease in their investment
✓ Their Current account balance surplus
✓ World Real interest rate will rise
c. An increase in foreign government purchases.
✓ Shift their saving curve leftwards
✓ Decrease in their investment.
✓ Their Current account balance deficit
✓ world Real interest rate will fall
d. An increase in foreign taxes (consider both the case in which Ricardian equivalence holds and the case
in which it doesn't hold).
If Ricardian equivalence holds, there is no effect. If Ricardian equivalence does not hold, then the result is
the same as in part b, as the foreign country's saving curve shifts to the right.
Q3. Who determines the nation's money supply? Explain how the money supply could be expanded or
reduced in an economy in which all money is in the form of currency.
Expansion and contraction of money supply comes under the domain of monetary policy. The Central
bank has a number of tools that it can use to change the money supply in a country. The most common
tool is Open Market Operation. When the Central Bank wants to increase money supply, it buys
securities in the market for securities and sells security when it wants to decrease money supply.

Q4. What is the relationship between the price level and the nominal money supply? What is the
relationship between inflation and the growth rate of the nominal money supply?
inflation is equal to the growth rate in the nominal money supply (controlled by the Fed) minus the growth
rate in real money demand. Notice that if the growth rate of the nominal money supply is equal to growth
rate of money demand, then inflation is equal to zero.
Also, whenever nominal money supply of demand is divided by inflation or price level, it generates real
money supply and demand.

Q5. All else being equal, how would each of the following affect the demand for Ml? The demand for M2?
Explain.
a. The maximum number of checks per month that can be written on money market mutual funds and
money market deposit accounts is raised from three to thirty.
b. home equity lines of credit that allow homeowners to write checks against the value of their homes are
introduced.

c. The stock market crashes, and further sharp declines in the market are widely feared.

d. Banks introduce overdraft protection, under which funds are automatically transferred from savings to
checking as needed to cover checks.

e. A crackdown reduces the illegal drug trade (which is carried out largely in currency).
Q6. What terms are used to describe the way a variable moves when economic activity is rising or falling?
What terms are used to describe the timing of cyclical changes in economic variables?
Procyclical and countercyclical terms are used to describe the way a variable moves in terms of direction
when economic activity is rising or falling.

The terms 'leading, coincident and lagging' are used to describe the timing of cyclical changes in
economic variables. Leading indicators consider a point in future events. Lagging indicators confirm the
pattern that is used currently. Coincident indicators occur in the real-time and takes state of the
economy into consideration.

Q7. During the period 1973-1975, the United States experienced a deep recession with a simultaneous
sharp rise in the price level. Would you conclude that the recession was the result of a supply shock or a
demand shock? Illustrate, using AD-AS analysis.
In early 1970, the United States was in long run equilibrium. So, its equilibrium point was intersection of
AS- AD and LRAS curves at point A with p = p1.

Now during the period 1973-1975, the United States experienced a deep recession with a simultaneous
sharp rise in the price level. So let us say that p had gone to p2 with a decrease in output because obviously
there was a recession. Now to attain equilibrium AS would move to AS1 and LRAS move to LRAS1 so the
decrease or back shifts are found in LRAS and AS. Thus, it was clearly a supply shock.
Q8. What determines the position of the FE line? Give two examples of changes in the economy that
would shift the FE line to the right.
FE line refers to full employment line. Labor Market Equilibrium FE. FE Line represents Labor market
equilibrium. On this line, labor demand equals labor supply.
FE line can shift left due to any of these factors

Decrease in Capital Stock (K)

Decrease in Technology (A)
Change in Labor market equilibrium level of Labor = N due to
Decrease in labor supply
Marginal productivity of labor Decrease

Q9. Use the IS-LM model to analyze the general equilibrium effects of a permanent increase in the price
of oil (a permanent adverse supply shock) on current output, employment, and the real wage.

A permanent increase in the price of oil i.e., a permanent adverse supply shock will reduce the marginal
product of labor, leading to a leftward shift in the demand for labor curve.

As both full employment output and productivity fall, the FE line shifts to the left. Since the output falls,
firms will raise their prices to equate the demand with reduced supply. With a fall in prices, the real
supply of money falls and shifts the LM curve to the right.

Since in the given case the supply shock is permanent and the future marginal product of capital falls,
the IS curve will also shift to the left, so that the rise in the real interest rate is less than in case of a
temporary shock. All this can be seen graphically as:

The new equilibrium point is C.

Net Result:

Future output falls

Consumption falls

Real wage falls

Price level increases

Real interest rate net effect is ambiguous (Depends on the magnitude of shifts)

Savings and investment net effect is ambiguous.

The price level will increase and shift the LM curve upward to pass through the new equilibrium point.
The result is an increase in the price level, but an ambiguous effect on the real interest rate.