Beruflich Dokumente
Kultur Dokumente
YORK UNIVERSITY
Atkinson College
Department of Economics
ECON 2450 - Midterm Examination
July 13, 2006
Use diagrams and/or numerical examples where appropriate. Unsupported answers will
receive no marks. It is the explanation that is important.
B1. Using the debt-deflation theory, explain the effects of expected deflation on
equilibrium income, nominal interest rate and real interest rate.
B2. Graphically derive the aggregate demand curve with the IS-LM model. Explain why
the aggregate demand curve slopes downward.
See Figure 11-5 and pages 311 and 312 of the textbook.
The statement is uncertain because in a small open economy under floating exchange rates fiscal
policy is ineffective but under fixed exchange rates it is effective.
See Figure 12-6 and pages of 339-340 of the textbook for an explanation of the case of floating
exchange rates and see Figure 12-11 and pages of 347-348 of the textbook for an explanation of
the case of fixed exchange rates.
Page 2 of 8 Pages
Answer three of the following four questions in the answer booklet. Each question is worth 20
marks
Read each part of the question very carefully. Answer all parts of the question and show all
steps of your calculations to get full marks. Use diagrams where required.
Since the new short-run supply curve is horizontal at P 2 = 1.5, the new
short-run equilibrium output is pinned down by the value of aggregate
demand at P2=1.5.
d. Suppose that after the supply shock the central bank wanted to
hold output at its long-run level. What level of M would be
required? If this level of M were maintained, what would be long-
run equilibrium P and Y? Illustrate your answers in a diagram.
To hold output at its long-run level after the supply shock, the central bank has to
increase the level of M to stimulate demand. To have the aggregate demand equals 3000
at P2 = 1.5, the level of M has to be:
3000 = 3*(M/1.5)
or, M = (3000*1.5)/3
So, M = 1500.
This means that the central bank has to increase the level of M by 500 which will shift
the AD curve from AD1 to AD2, as shown in Figure C1-3.
If the level of M is maintained at 1500, that is, if AD curve stays at AD2, the economy
will move quickly from the short-run equilibrium at E2 to the new long-run equilibrium
at E3. So, the new long-run equilibrium price, P2=1.5 and output, Y2=3000.
At the new long-run equilibrium, SRAS, LRAS and AD curves intersect at the
same point. In
Figure C1-3, point E3 shows the long-run equilibrium, where SRAS 2, LRAS1 and
AD2 intersect.
Page 4 of 8 Pages
Since at Y=1500, planned spending (1600) is higher than current output, there
will be unplanned
inventory decumulation. The amount of inventory decumulation = (E-Y) =
(1600-1500) = 100.
At Y=1500, firms meet the excess demand by supplying goods from their
inventories, resulting
into an unplanned reduction in their stock of goods. Firms would respond to
this decline in
inventories by producing more goods. So, the equilibrium Y must be higher
than 1500.
So, equilibrium level of income is 1800. In Figure C2-1, the point A shows the
equilibrium.
So, the government spending multiplier is 3. We can use this multiplier to find
the change in
the equilibrium income.
C = 100 + (2/3)(Y – T)
T = 600
G = 500
I = 800 – (50/3)r
Md/P = 0.5Y – 50r
The IS curve can be derived from the goods market clearing condition:
Y=E
or, Y = C+I+G
or, Y = 100 +(2/3)(Y-T)+800-(50/3)r+500
or, Y = 1400 +(2/3)(Y-600) –(50/3)r
or, Y = 1400 +(2/3)Y-400-(50/3)r
or, 1/3Y = 1000-(50/3)r
or, Y = 3000-50r
Page 7 of 8 Pages
The LM curve can be derived from the money market clearing condition:
(M/P)s = (M/P)d
or, (1200/1) = 0.5Y-50r
or, (1/2)Y = 1200+50r
or, Y = 2400+100r
3000-50r = 2400+100r
or, 150r = 600
or, r = 600/150 = 4
Y = 2400+100*4
= 2400 + 400
= 2800
So, the equilibrium value of Y is 2800. The equilibrium values of Y and r are
shown in Figure C3-1.
M is raised from 1200 to 1400. With this new level of M, the money market
clearing condition becomes: 1400 = 0.5Y-50r
or, 0.5Y = 1400 +50r
or, Y = 2800 +100r
This means that the LM curve shifts right by the horizontal distance of 400 or
downward by the
vertical distance of 4. The new LM curve is plotted in Figure C3-1.
We have to solve equation (1) and (3) simultaneously to find the new
equilibrium values of Y and r.
3000-50r = 2800+100r
or, 150r = 200
or, r = 200/150 = 1.33
Y = 2800+100*4
= 2800 + 133.33
= 2933.33
So, the new equilibrium value of Y is 2933.33. The new equilibrium values
of Y and r are also shown in Figure C3-1.