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In: Economics

Question 1: [55 marks] When we derived money demand function in class, we assumed that money...

Question 1: [55 marks]

When we derived money demand function in class, we assumed that money demand

depends on income and interest rate. Consider an economy that its money demand does not

depend on income and is only a function of interest rate.

M

d

=

L

(

i

)

Suppose that the economy is an open economy that is on a áexible exchange rate system.

1. Draw the money demand and supply curves with money demand and supply on x-axis

and interest rate on y-axis. [3 marks]

2. Show what happens to money demand and supply curves if income changes. [2 marks]

3. Derive the

LM

curve. [5 marks]

4. Derive the

AD

curve. [5 marks]

5. In response to the COVID-19 crisis, suppose that the government of the

ABOVE

ECONOMY

increases transfer payments to help people struggling during the COVID-

19 pandemic.

(a) Show the short run e§ects of this policy using the

Five-Figures Diagram

we drew in class; goods market, money market, the

IS

-

LM

curves, the interest

parity condition curve, and the

AS

-

AD

curves. Explain your answer. [8 marks]

(b) How about the e§ects of this policy in the medium run? Assume that before

and after the changes, the economy is still in a recession (i.e. its output is below

its natural level). To answer this question, draw the

Two-Figures Diagram;

the

IS

-

LM

curves and the

AS

-

AD

curves. Explain your answer. [5 marks]

(c) Do you think this policy is su¢ cient to compensate for damage done to the

economyís production and consumption of goods and services during the epi-

demic? Explain your answer. [2 marks]

6. In response to the COVID-19 crisis, suppose that the foreign government increases

investment in new hospitals. Show the short run e§ects of this foreign policy on the

ABOVE ECONOMY

using the

Five-Figures Diagram

we drew in class; goods

market, money market, the

IS

-

LM

curves, the interest parity condition curve, and the

AS

-

AD

curves. Explain your answer. [10 marks]

7. Suppose that the central bank of the

ABOVE ECONOMY

lowers its target for the

overnight rate and buys government bonds to provide support to the economy during

the COVID-19 pandemic.

2

(a) Show the short run e§ects of this policy using the

Five-Figures Diagram

we drew in class; goods market, money market, the

IS

-

LM

curves, the interest

parity condition curve, and the

AS

-

AD

curves. Explain your answer. [8 marks]

(b) How about the e§ects of this policy in the medium run? Assume that before

the changes, the economy was at the natural level of output. To answer this

question, draw the

Two-Figures Diagram;

the

IS

-

LM

curves and the

AS

-

AD

curves. Explain your answer. [5 marks]

(c) The more the central bank buys, the lower the interest rates that the govern-

ment has to pay on new borrowing, and the more the government can borrow.

Does this mean the government can spend as much as it wants and protect the

economy from damage done by the virus? Explain your answer. [2 marks]

Solutions

Expert Solution

Question 1: [55 marks]

When we derived money demand function in class, we assumed that money demand

depends on income and interest rate. Consider an economy that its money demand does not

depend on income and is only a function of interest rate.

M

d

=

L

(

i

)

Suppose that the economy is an open economy that is on a áexible exchange rate system.

1. Draw the money demand and supply curves with money demand and supply on x-axis

and interest rate on y-axis. [3 marks]

2. Show what happens to money demand and supply curves if income changes. [2 marks]

3. Derive the

LM

curve. [5 marks]

4. Derive the

AD

curve. [5 marks]

5. In response to the COVID-19 crisis, suppose that the government of the

ABOVE

ECONOMY

increases transfer payments to help people struggling during the COVID-

19 pandemic.

(a) Show the short run e§ects of this policy using the

Five-Figures Diagram

we drew in class; goods market, money market, the

IS

-

LM

curves, the interest

parity condition curve, and the

AS

-

AD

curves. Explain your answer. [8 marks]

(b) How about the e§ects of this policy in the medium run? Assume that before

and after the changes, the economy is still in a recession (i.e. its output is below

its natural level). To answer this question, draw the

Two-Figures Diagram;

the

IS

-

LM

curves and the

AS

-

AD

curves. Explain your answer. [5 marks]

(c) Do you think this policy is su¢ cient to compensate for damage done to the

economyís production and consumption of goods and services during the epi-

demic? Explain your answer. [2 marks]

6. In response to the COVID-19 crisis, suppose that the foreign government increases

investment in new hospitals. Show the short run e§ects of this foreign policy on the

ABOVE ECONOMY

using the

Five-Figures Diagram

we drew in class; goods

market, money market, the

IS

-

LM

curves, the interest parity condition curve, and the

AS

-

AD

curves. Explain your answer. [10 marks]

7. Suppose that the central bank of the

ABOVE ECONOMY

lowers its target for the

overnight rate and buys government bonds to provide support to the economy during

the COVID-19 pandemic.

2

(a) Show the short run e§ects of this policy using the

Five-Figures Diagram

we drew in class; goods market, money market, the

IS

-

LM

curves, the interest

parity condition curve, and the

AS

-

AD

curves. Explain your answer. [8 marks]

(b) How about the e§ects of this policy in the medium run? Assume that before

the changes, the economy was at the natural level of output. To answer this

question, draw the

Two-Figures Diagram;

the

IS

-

LM

curves and the

AS

-

AD

curves. Explain your answer. [5 marks]

(c) The more the central bank buys, the lower the interest rates that the govern-

ment has to pay on new borrowing, and the more the government can borrow.

Does this mean the government can spend as much as it wants and protect the

economy from damage done by the virus? Explain your answer. [2

(Question 1,2,34 ) : Md= f(Y, r)

From below diagram we can see that money demand curve is download sloping and supply curve is vertical straight line. Both intersect at the point A and equilibrium rate of interest at that point is r0 . When income increases than money demand curve shift upward and a new equilibrium point is generated at B here rate of interest is r2 which is greater than r1. We can derive LM curve from Md and Ms curve. Diagram is given below.

Question 4:

Answer : the AD curve or the IS curve can be derived as follows

From the above diagram you can see that 1st diagram is investment demand curve second diagram is the diagram from where we can draw IS curve. As investment increases than C+I curve shift upward to C+I1 and further to C+I2 due to increment in investment .From the 3rd diagram we can conclude that there is inverse relationship between income and rate of interest.

Question:(5 19(a), b, c)

Answer: as government increases the transfer payments then IS curve will shift right ward from point A to point B rate of interest increases from r0 to r1 and income also increases from Y0 to Y1 . This is in short run in long run LM curve shift to left and at new equilibrium point at C established at that point interest rate is r2 but income level is at y0. Diagram is given below.

Question 6:

Answer : as investment increases than AD curve shifted towards upward leads to increase in output and IS curve Also derived from that curve from IS curve we can see that increase in investment leads to decrease in rate of interest and also increases the net export. Exchange rate decreases from e to e1.

Question 16

Answer: borrowing will not correct the situation of the economy because for borrowing government either have to print new notes or take loans from other source. In both the condition borrowing leads to increase in interest rates and decrease in investment. Government expenditure is excess which will leads to deficit in BOP.

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