Economics 102

Spring 2014
Homework #5
Due May 7, 2014

Directions: The homework will be collected in a box before the lecture. Please place your name,
TA name and section number on top of the homework (legibly). Make sure you write your name
as it appears on your ID so that you can receive the correct grade. Please remember the section
number for the section you are registered, because you will need that number when you submit
exams and homework. Late homework will not be accepted so make plans ahead of time. Please
show your work. Good luck!

Please remember to
 Staple your homework before submitting it.
 Do work that is at a professional level: you are creating your “brand” when you submit
this homework!
 Not submit messy, illegible, sloppy work.

1. Use the Keynesian Model to answer this set of questions. Suppose that in the economy
under consideration the consumption function can be written as C = 300 + .8(Y – T).
Furthermore, you know that taxes are autonomous and equal to $50.
a. Draw a graph of the consumption function with respect to disposable income.
Measure consumption spending on the vertical axis and disposable income on the
horizontal axis. In your graph indicate the value of consumption spending when
disposable income is equal to $0, $100, $200. $300, and $400.
b. Now, suppose that government spending is constant and equal to $200 at every
level of disposable income. Alter your graph to show the C + G line.
c. Now, suppose that investment spending is constant and equal to $400 at every
level of disposable income. Alter your graph to show the C + I + G line.
d. Now, suppose that (X – M) is constant and equal to $200 at every level of
disposable income. Alter your graph to show the C + I + G + (X – M) line.
e. Suppose that (a) through (d) are all true for this economy and you also know that
full employment output in this economy (Yfe) is equal to $5000. Given this
information, what do you predict is happening to inventories if the full employment
level of output is produced? Hint: to answer this question you will need to compare
this full employment level of output with the level of aggregate expenditure at this
level of output.
f. What is the equilibrium level of output for this economy?
g. Suppose that government spending is increased from its initial level to $300.
Holding everything else constant, what will be the change in the equilibrium level of
output given this spending change?
h. Suppose that government spending is decreased from its initial level by $100.
Holding everything else constant, what will be the change in the equilibrium level of
output given this spending change?

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2. This question is designed to give you some practice working with a consumption
function, C = a + b(Y – T), where C is consumption spending, a is autonomous consumption,
b is the marginal propensity to consume, Y is real GDP, and T is autonomous taxes. For this
problem we will assume that the aggregate price level is fixed and unchanging.

Suppose you are given the following table where (Y – T) is disposable income and Sp is
private savings:

Y T Y–T C Sp
0 80 340
100
200
300 -345
400
500

a. Fill in the missing cells in the above table. Verbally describe how you found the values for
the different cells.

b. Suppose in this economy government spending is equal to $400 and investment

spending is equal to $100. Furthermore, assume this economy is a closed economy and
therefore both exports and imports are equal to $0. What is the value of real GDP in this
economy when the economy is in equilibrium? What is the value of consumption when the
economy is in equilibrium? What is the value of private savings when this economy is in
equilibrium?

c. Suppose you are told that full employment real GDP for this economy is 4000. Given your
answer in (b) would you advocate that the government increase or decrease spending if
this economy is to reach full employment real GDP using fiscal policy. Assume that only the
level of government spending changes in making your policy prescription. What would be
the necessary change in government spending to return this economy to full employment?

3. Use the following graph and the Keynesian Model to answer this question. Assume that
the aggregate price level is fixed in this problem.

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 a. Given the above graph, what is the equilibrium level of real GDP for this
economy?
b. When the economy is in equilibrium, what do you know about inventories in this
economy?
c. When this economy is in equilibrium, what do you know about the relationship
between aggregate expenditure and aggregate production?
d. At the equilibrium level of output in the above graph, what do you know about
how this economy is performing?
e. When this economy is in equilibrium, what do you know about the
unemployment rate compared to the natural unemployment rate? What do you
know about the cyclical unemployment rate in this economy?
f. Suppose the government mandates that producers produce Yfe for one period.
Assume there have been no monetary or fiscal policy changes to accompany this
mandate. Describe the effect of this mandate on this economy given the above
graph.
g. Given the situation in the above graph, what policy (policies) do you advocate if
the sole goal of the government is to restore this economy to full employment?
Explain your reasoning.

4. Use the AD-AS Model to answer this question. For each description assume that the AD-
AS Model is initially in long-run equilibrium.
a. Suppose that the government in this economy has been at war for the last ten
years. But, this year it stops all its defense operations. Holding everything
else constant, what do you predict will happen to real GDP and the aggregate
price level in the short run? Holding everything else constant, what do you
predict will happen to real GDP and the aggregate price level in the long run?
Explain your answer.
b. Suppose that the price of energy decreases in the economy due to the oil
boom in North Dakota. Holding everything else constant, what do you predict
will happen to real GDP and the aggregate price level in the short run?
Holding everything else constant, what do you predict will happen to real
GDP and the aggregate price level in the long run? Explain your answer.

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 c. Suppose that the government increases taxes and at the same time an
announcement is made that a major new oilfield has been discovered in
western Nebraska and this oilfield is anticipated to be so large that the
country no long will need to import oil. Holding everything else constant,
what do you predict will happen to real GDP and the aggregate price level in
the short run? Holding everything else constant, what do you predict will
happen to real GDP and the aggregate price level in the long run? Explain
your answer.

5. Suppose that an economy has one bank for the public’s financial transactions and a
central bank authorized to manage the economy’s money supply. In this economy no one
holds currency (i.e., there are no currency drains) and all purchases are made by writing
checks (or using debit cards). Furthermore, First United never holds excess reserves after it
makes full adjustment for any monetary policy. There are three people-Ringo, Paul and
George-that live and work in this economy. The following t-accounts provide us with the
initial situation in this economy.

a. Given the above information, what is the required reserve ratio in this economy? Explain
how you got your answer.

b. Given the above information, what is the money supply in this economy? Explain how
you got your answer.

c. Suppose Ringo writes a check in order to purchase $5000 worth of camera equipment
from George who owns and operates a camera store. Describe the impact of this purchase
on First United’s demand deposits and reserves. Does this purchase affect the Central
Bank’s t-account? If so, explain all the changes in this t-account.

d. For this question start with the initial t-accounts. Suppose the central bank decides to
purchase $2000 worth of T-bills from First United. Show how this decision first impacts
these t-accounts before any adjustment with regard to returning to the required reserve

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levels has been made (show the first round effects of this transaction and not the final full
adjustment).

e. Given (d), right after the central bank purchases the T-bills does First United have
insufficient or excess reserves? Quantify the level of these reserves relative to the required
amount for the given amount of demand deposits.

f. Given (d), suppose Ringo, Paul and George approach First United and take out a series of
loans such that at the end of this process First United has no excess reserves and the
percentages of total demand deposits held by Ringo, Paul and George are the same as they
were initially. Draw this final t-account. [Hint: this will be a t-account where First United
has made full adjustment to the central bank’s purchase of $2000 worth of T-bills.] Show in
your answer how you calculated the values in your t-account.

g. Given the transaction in (d), what is the change in the money supply? Provide two
different ways (one of these methods should use the money multiplier) to get this change in
the money supply.

6. Use the AD-AS Model to answer this set of questions. Suppose you are given the following
information:
Long run aggregate supply (LRAS): Yfe = 3000
Short run aggregate supply (SRAS): Y = 1000P – 10,000
Aggregate demand (AD): Y = 20,000 – 1000P
where Y is real GDP and P is the aggregate price level.

a. Given the above information, find the short run equilibrium level of real GDP and the
aggregate price level.

b. Draw a graph representing the SRAS curve, the AD curve, and the LRAS curve. Label the
short run equilibrium.

c. Given your answers in (a) and (b), in this economy in the short run in a boom or a
recession? Explain your answer.

d. In the long run, holding everything else constant, what do you predict will happen in this
economy?

e. Given the above information, provide a numerical answer for the long run values of real
GDP and the aggregate price level in this economy.

f. Given your answers in (d) and (e), provide an equation for the new SRAS curve.

g. At each aggregate price level, what was the decrease in real GDP given your new SRAS
curve for (f)?
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7. You should definitely use a calculator on this problem and you will want to work neatly
since you will need to look back at times for information you have already calculated.
Suppose you are given the following information about an economy:

Required reserve ratio is 10%

Money Supply = Ms: Ms = 5,000
Money Demand = Md: Md = 10,000 – 1250r where r is the interest rate (for this problem
we will assume that there are no expectations of inflation so that the nominal interest rate
is the same as the real interest rate-this is a simplifying assumption that will make this
rather-long problem less complex)(i.e., When the interest rate is 7%, it means r = 7.)
Investment Spending = I: I = 10,000 - 1000r
Aggregate Expenditure = AE: AE = C + I + G + (X – M)
Consumption Spending = C: C = 800 + .8(Y – T) -100P where P is the aggregate price level
Government Spending = G: G = 1000
Net Exports = (X – M): (X – M) = 400
Autonomous Taxes = T: T = 800
Aggregate Demand = AD: AD = AE = C + I + G + (X – M)
Long run Aggregate Supply = LRAS: LRAS = Yfe = 32,000
Short run Aggregate Supply = SRAS: Y = 4000P – 34,200

a. There is a lot of information given to you in this problem. There is information about the
money market; information about aggregate expenditure; and information about the AD,
LRAS and SRAS curves. Take a moment and look at this information carefully. Now, focus
on the consumption function: what does consumption spending depend upon in this
economy? What is the relationship between consumption spending and disposable income
(e.g., is it a positive or negative relationship)? What is the relationship between
consumption spending and the aggregate price level? Do both of these relationships seem
plausible to you? Explain your reasoning.

b. Given the above information, what is the equilibrium interest rate in this economy?
Explain how you found this interest rate.

c. Given the above information, what is the level of investment spending in this economy?
Explain how you found this level of spending.

d. Given the above information, calculate an equation that expresses this economy’s
aggregate demand for goods and services.

e. Given the above information and your work in (a) through (d), find the short run
equilibrium level of real GDP (Y) and the short run aggregate price level (P). Then draw a
graph illustrating this short run equilibrium. In your graph include the LRAS curve as well.
Measure the aggregate price level on the vertical axis and real GDP on the horizontal axis.

f. Suppose the government sets a goal of using fiscal policy to reach the full employment
level of output. If the government changes the level of government spending to reach this
goal, how much will government spending need to change by holding everything else
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constant? After you compute the change in government spending, use this new level of
spending to recalculate the equilibrium level of real GDP and see if your answer is correct.
(Hint: the simple multiplier calculation will result in “too small” a level of stimulus since the
aggregate price level will change when the AD curve shifts.) Show your work and your
computations.

g. Suppose the government sets a goal of using fiscal policy to reach the full employment
level of output. If the government changes the level of autonomous taxes to reach this goal,
how much will the autonomous taxes need to change by holding everything else constant?
After you compute the change in autonomous taxes, use this new level of taxes to
recalculate the equilibrium level of real GDP and see if your answer is correct. (Hint: the
simple multiplier calculation will result in “too small” a level of stimulus since the
aggregate price level will change when the AD curve shifts.) Show your work and your
computations.

h. Suppose the government, for political reasons, finds that fiscal policies are simply not
possible to implement in this economy. But, the government is still determined to restore
this economy to Yfe, perhaps because the government is concerned with the social
instability that high levels of unemployment may create, or because the government is
morally concerned about the impact of high unemployment on people in their society, or
because….(fill in your own rationale).The government sets a goal of using monetary policy
to reach the full employment level of output. Can the government reach this goal using only
monetary policy? In your answer remember that it is not possible to have the nominal
interest rate go below 0%. Holding everything else constant, what is the highest level of
real GDP this economy can attain if the government engages in activist monetary policy?
(Hint: you will definitely need your calculator on this one!) And, what will be the monetary
policy that is implemented to reach this level of real GDP? In your answer to this last
question be specific with the type of policy as well as providing a quantitative number for
this policy.

i. Now, after doing (h), let’s enact monetary policy that will just get this economy to the full
employment level of output holding everything else constant. This is a hard question, but if
you make it through this analysis consider what you have learned over the course of the
semester! Congratulations!