Department of Economics ECN 2215 Assignment 2
Instructions: Answer all Questions
Due: First Day of Residential
Question One
1. Suppose velocity of money (V) is constant, Money supply(M) is growing 5% per
year, Output(Y) is growing 2% per year, and interest rate( r) = 4. Use your knowledge of
the quantity theory of money and the fisher effect to answer the questions below.
a. Solve for i (the nominal interest rate).
b. If the CB increases the money growth rate by 2 percentage points per year, find∆𝑖.
c. Suppose the growth rate of Y falls to 1% per year. What will happen to inflation?
What must the CB do if it wishes to keep inflation constant?
d. Inflation is generally regarded as bad for society; however some level of inflation
is good for an economy. Outline at least two (2) benefits of inflation.
2. Expectations of Economic agents about the future exert a significant impact on the
effectiveness of macroeconomic policy.
a. Briefly explain the key difference between adaptive and rational expectations.
b. In the context of the Philips curve, explain the impact of a policy aimed at reducing
unemployment under adaptive expectations.
c. How would your answer in (b) change if economic agents behaved rationally?
d. Consider a simple aggregate supply –aggregate demand (AS-AD) model below,
𝐴𝐷: 𝑚 + 𝑣 = 𝑝 + 𝑦
𝐴𝑆: 𝑝 = 𝑝𝑒 + 𝜆(𝑦 − 𝑦 ∗ )
Where m= log of money supply; v=velocity; p= price level; y= GDP; pe = expected
price level; y*= potential GDP and 𝜆 = slope of the AS curve.
i. Derive the expression for the equilibrium price and output in terms of money
supply expected price level and other variables.
ii. If parameter 𝜆 = ½, find the percentage change in equilibrium output and price
following a 1% increase in money supply.
Question Two
1. Derive the AD curve from the IS-LM diagram. Explain intuitively why the AD curve slopes
downward. Show graphically how the AD curve shifts when there is an increase in money
supply.
2. Suppose spending is specified as:
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𝐶 = 𝑎 + 𝑏(𝑌 − 𝑇), 𝐼 = 𝑐 − 𝑑𝑟, 𝑎𝑛𝑑 𝑇 = 𝑇̅, 𝐺 = 𝐺̅. The demand for money is
specified as: 𝐿(𝑌, 𝑟) = 𝑒𝑌 − 𝑓𝑟), and the money supply is . Where a, b, c, d, e, and f are
positive constants.
i) Find an equation for equilibrium in the goods market.
ii) Find an equation for equilibrium in the money markets.
iii) Algebraically derive the aggregate demand schedule.
iv) Give an algebraic answer to each of the following questions. Then explain in words
the economics that underlies your answer. (di) How does the sensitivity of
investment to the interest rate affect the slope of the aggregate demand curve? (dii)
How does the sensitivity of money demand to the interest rate affect the slope of
the aggregate demand curve? (diii) How does the marginal propensity to consume
affect the response of aggregate demand to changes in government purchases?
4. How is the Phillips curve related to aggregate supply?
5. Explain and show graphically why continuous monetary growth is needed to generate
inflation. Describe how the inflation process is generated.
6. What are expectations? Distinguish between rational and adaptive expectations.
7. Demonstrate graphically and explain the short-run and long-run effects of an
unanticipated monetary expansion in the new classical model.
Question Three
1. (a) Derive the AD curve from the IS-LM diagram. Explain intuitively why the AD curve
slopes downward. (b) Show graphically how the AD curve shifts when there is an increase
̅ 𝑏𝑖, 𝑇 = 𝑇̅, 𝑎𝑛𝑑
in money supply. (c). Suppose spending is specified as 𝐶 = 𝐶̅ + 𝑐𝑌, 𝐼 = 𝐼 −
𝐺 = 𝐺̅ . The demand for money is specified as 𝐿 = 𝑘𝑌 − ℎ𝑖, and the money supply is 𝑀̅/𝑃̅
(i) Find an equation for equilibrium in the goods market. (ii) Find an equation for
equilibrium in the money markets. (iii) Algebraically derive the aggregate demand
Schedule. (iv). Find the fiscal and monetary policy multipliers.
2. Give an algebraic answer to each of the following questions. Then explain in words the
economics that underlies your answer.
i) How does the sensitivity of investment to the interest rate affect the slope of the
aggregate demand curve?
ii) How does the sensitivity of money demand to the interest rate affect the slope of
the aggregate demand curve?
iii) How does the marginal propensity to consume affect the response of aggregate
demand to changes in government purchases?
3. Monetary policy is better conducted by setting money targets rather than interest rate
targets. Explain.
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4. What are the inside lag and the outside lag? Which has the longer inside lag— monetary or
fiscal policy? Which has the longer outside lag? Why?
5. Evaluate the argument that monetary policy should be determined by a rule rather than
discretion. How about fiscal policy?
6. (a.) Inflation is a purely monetary phenomenon. Explain your viewpoint by making use of
fisher’s equation of exchange. (b) Using fisher’s equation, identify three sources of short-
run inflation.
7. Derive the aggregate supply curve graphically and algebraically and explain intuitively
why it is positively sloped. (b) Show graphically how the AS curve shifts when there is a
change in inflationary expectations.
8. What is a Phillips Curve? Explain how the aggregate supply and Phillips curve are related
to each other. Can any information be derived from one that cannot be derived from the
other?
9. What is meant by adaptive expectations? Explain how the Phillips curve is vertical in the
long run.
10. What is meant by rational expectations? How does rational expectations theory show that
aggregate supply curve is a vertical straight line and that there is no tradeoff between rate
of inflation and unemployment?
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