ECON-2010: ASSIGNMENT 2017-FALL (SOLUTION)

Note: No ripped off pages from the notebooks will be accepted, such assignments will not be
either accepted or graded. Unstapled assignments will be awarded 5% penalty. Late
submissions will be penalized 25% per day. Questions and parts must be properly numbered
violations will be penalized by 10% grade.
Q.1: Explain why government budget deficits crowd out private investment spending in a closed
economy, but crowd out net exports in a small open economy. Assume prices are flexible and
that factors of production are fully employed in both economies. Use the basic version of the
open-economy model where net exports is function of real exchange rate. Use diagrams to
explain your answer. [10] [5 each, 3 diagram and 2 marks for explanation]

Q.2: The real interest rates and real exchanges rates are constant and equal in North Country and
South Country. The Fisher equation and purchasing power parity hold in both countries. If the
nominal interest rate is 8 percent in North Country and 10 percent in South Country, do you
expect North Country's nominal exchange rate to appreciate, depreciate, or remain the same?
Explain. [10] [8 for explanation and 2 for equation]
Ans: From the Fisher equation [ = + ], inflation is expected to be higher in South
Country than in North Country, since the nominal interest rate equals the real interest rate
plus the expected rate of inflation and the real interest rate is the same in both countries
while the nominal interest rate is higher in South Country. According to purchasing power
parity, the change in the North Country's nominal exchange rate equals the change in the
real exchange rate (which is constant) plus the difference in inflation rates (foreign
inflation minus domestic inflation).

% = % + % %
Since South Country's expected inflation is higher, then North Country's nominal
exchange rate should appreciate.
Q.3: In classical macroeconomic theory, the concept of monetary neutrality means that changes
in the money supply do not influence real variables. Explain why changes in money growth
affect the nominal interest rate, but not the real interest rate. Use quantity theory of money and
fisher equation to answer this question. [10] [explanation]
Ans: According to the Fisher equation [ = + ], the nominal interest rate equals the
real interest rate plus the expected rate of inflation. The expected rate of inflation depends
on the rate of money growth, so the nominal interest rate depends on the rate of money
growth. According to classical macroeconomic theory, the real interest rate adjusts to bring
the level of saving and investment (both real variables) into equilibrium without reference
to the rate of money growth.
Q.4: Consider a money demand function that takes the form (M/P)d = Y/3i, where M is the
quantity of money, P is the price level, Y is real output, and i is the nominal interest rate
(measured in percentage points). [10] [5 each]
a) What is the velocity of money if the nominal interest rate is constant?

Ans: From above information: P/M = 3i/Y and from quantity theory of money
MV = PY, it ; yields V = PY/M = 3iY/Y = 3i

b) How will the level of the velocity of money change if there is a permanent (one time)
increase in the nominal interest rate, holding other factors constant?

Ans: A one-time increase in the nominal interest rate will increase velocity by
reducing the demand for money
Q.5: Assume that an employer believes that the efficiency (e) it can get from a particular
worker, as a function of the hourly wage (w), is given by function e = 0.125w + 0.15w2
0.005w3, at least up to a wage of 30. [15] [9 for table calculation, 3 each for other parts]
a) Create a table of w, e, e/w, and w/e for wages equal to 5, 10, 14, 15, 16, 20, and 25.
Ans:

b) Which wage gives the highest ratio of efficiency per unit of labour cost?

Ans: Wage rate 15 gives the highest ratio of efficiency.

c) Once the firm has hit on an optimal w, whatever it is, would cutting wages whenever
demand falls off increase or decrease wages per unit of efficiency?
 Ans: Cutting wages (any wage lower than 15) would increase wages per unit of
efficiency.

Q.6: Assume that we have an economy where a certain share (f) of the unemployed (U) manage
to find work during a given period of time. Assume also that a certain share (s) of the employed
are separated from their jobs every period. Denote employment by E and the total labor force by
L. [10] [6 for (a) and 4 for (b) marks]
a) Derive an expression for the unemployment rate (U/L) in a steady state. What is
unemployment if s = 0.02 and f = 0.5?
Ans:
= + ,
, ! ".
Now, L = fU + sE in the steady state fU = sE.
% %
fU = s(L U) then = $% & , = = = = ). )-.* -. .*%
' %' / %').*,).)+

b) Repeat the exercise for f = 0.25.

% %
= ).+* = ). )/0% /. 0%%
%' / %' ,).)+

Q.7: Consider the following Neoclassical model of the economy, where the domestic interest
rate 1 and the world interest rate 1 are in percentage terms. Show all your work. [15][5 each]

2 = 1000, 3 = 50 + 0.7(2 4), NX= 100 1005, 6 = 200 101, = 5%, 7 = 200, 4 = 100
(a) Find the equilibrium real interest rate, national saving, and investment in a closed economy.
Show the equilibrium real interest rate on a saving-investment diagram with 1 measured on the
vertical axis.

National saving is 8=9:;=%)))<.)+))=%+).

Investment is ==+))(.)=+)).)=%+).
The equilibrium real interest rate is =.%.

(b) Now assume the small economy opens up to trade. Calculate the real exchange rate (5), trade
balance and net capital outflow. Show the trade balance on a saving-investment diagram with 5
measured on the vertical axis

National saving remains 8=%+).

Investment is now ==+))(*)=+))*)=%*).
Net capital outflow is 8==%+)%*)=-).
Net exports are @A=8==-).
The real exchange rate is B=%.-.
(c) Assume that contractionary fiscal policymakers enacted by reducing government spending to
100. Find the new real exchange rate, trade balance and net capital outflows. Redraw the diagram
from part (b) to show the changes.

After government spending falls to ;=%)).

National saving rises to 8=%)))<.)%))=++).
Investment remains ==%*).
Net capital outflows turn positive to 8==/). The country is now a net lender.
Net exports are @A=8==/).
The real exchange rate depreciates to B=).-.

Q.8: A hypothetical economy can be described by the Solow growth model. Answer the below
questions for this economy by using the following information: [20][5 each part]

C = E
saving rate (s) = 0.20
depreciation rate () = 0.12
initial capital per worker (k) = 4
population growth rate (n) = 0.02

Noter: initial k=4 is not used in the below

answer. However, if you are doing it with
excel that it is used.

a. What is the steady-state level of capital per worker?

J J
G JKL 0.2 JKR.S
F = $ & =M Q = 2.04
H+I 0.12 + 0.02
b. What is the steady-state level of output per worker?

U = F = 2.04 = 1.43
c. What is the level of steady-state consumption per worker?

W = (1 G)U = (1 0.2)(1.43) = 1.143

d. What is the steady-state level of investment per worker?

X = GU = (0.2)(1.43) = 0.286

QUESTION-9 IS DROPPED. DO NOT GRADE IT