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ECON 304 – Summer 2016 (Session I)

ECON 304 – Summer 2016 (Session I)
Homework 4
DUE: June 23rd (THURSDAY), 2016
From the Syllabus:
1. Homework must be turned in on the day it is due. Late homework will NOT be
2. You may work with your friends / classmates. However, you MUST put names of other
group members on your homework. You also MUST write up your own answers.
3. TYPE your work. Long equations and graphs may be hand-written.
4. BUY A STAPLER! (10% deduction from your homework grade if you do not staple
your homework)
5. Carefully explain your work! This means you MUST SHOW YOUR WORK FOR
6. Write your name! (Homework will not be graded if you do not put your name on your
Course: ECON 304 (Summer I, 2016)
Group members (if any):
Question 1
Suppose that the price level is fixed in the short run so that the economy does NOT reach
general equilibrium immediately after a change in the economy. For each of the following
changes, what are the short-run effects on the real interest rate and output? Assume that,
when the economy is in disequilibrium, only the labor market is out of equilibrium; assume
also that for a short period firms are willing to produce enough output to meet the aggregate
demand for output.
(a) A decrease in the expected rate of inflation. (Draw the FE-IS-LM diagram to explain
and answer the question.)
(b) An increase in consumer optimism that increases desired consumption at each level of
income and the real interest rate.
(c) A temporary increase in government purchases.
Question 2
An economy is described as follows:
Desired consumption:
Cd = 600 + 0.5(Y T) 50r
Desired investment:
Id = 450 50r
Real money demand:
L = 0.5Y 100i
Full-employment output: Y ¯ = 2210
Expected inflation: πe = 0.05
In this economy the government always has a balanced budget, so T = G, where T is
total taxes collected.
(a) Suppose that M = 4320 and G = 150. Use the classical IS-LM model to find the
equilibrium values of output, the real interest rate, the price level, consumption, and
investment. (Hint: In the classical model, output always equals to what?)
(b) The money supply rises to 4752. Repeat part (a). Is money neutral?
(c) With the money supply back at 4320, government purchases and taxes rise to 190.
Repeat part (a). Assume for simplicity that Y ¯ is fixed (unaffected by G). Is fiscal
policy neutral in this case? Explain.
Question 3
The discovery of a new technology increases the expected future marginal product of
(a) Use the classical IS-LM model to determine the effect of the increase in the expected future MPK on the real interest rate, employment, real wages, consumption, investment,
and the price level. Assume that expected future real wages and future incomes are
unaffected by the new technology. Assume also that current productivity is unaffected.
(b) Find the effects of the increase in the expected future MPK on current output and
prices from the AD-AS diagram based on the misperceptions theory. What accounts
for the difference with part (a)?
Quesiton 4
An economy has the following AD and AS curves.
AD curve:
Y = 300 + 30(M
AS curve:
Y = Y ¯ + 10(P P e)
Here, Y ¯ = 500 and M = 400.
(a) Suppose that P e = 60. What are the equilibrium values of the price level P, and
output Y ?
(b) An unanticipated increase raises the money supply to M = 700. Because the increase
is unanticipated, P e remains at 60. What are the equilibrium values of the price level
P and output Y ?
(c) The FED announces that the money supply will be increased to M = 700, which the
public believes. Now what are the equilibrium values of the price level P , the expected
price level P e, and output Y ?

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