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Atul A. Dar Economics 3301.1 Assignment 2 October 19, 2017 This assignment is due in class on October 26th. You must use the same group you used for the last assignment. Those who made individual submissions can continue to do so. You will be marked for both the content the clarity of your answers. IMPORTANT: do not hand in assignments that are identical to those of others. Question 1 (8 points) A. Suppose there is an increase in taxes. In the IS-LM model, which curve will be affected and how? How will this affect output and the interest rate. Explain with the help of a graph. (3 points) B. Suppose the central bank is committed to maintaining a fixed interest rate monetary policy. What type of monetary action would it take to prevent the interest rate from changing in (A)? How would output change as a result? (2 points) C. How would consumption, total saving and investment change in A. and in B? Explain fully. (3 points) Question 2 (12 points) Consider a simple Keynesian model of the goods market only. Assume that there is no government, so G=T=0. Consumption function: C= c0 + c1Y - c2ī Investment function: I = h0 – h1ī Equilibrium condition: Y=C+I c0 > 0, 0< c1 < 1, and c2 > 0 h0> 0, h1 >0 Note: since we are considering only the goods market, the interest rate is assumed to be exogenous. Also, in this model, consumption is also inversely related to the interest rate. a. Solve for equilibrium income. (3 points) b. Suppose that c0= e0 + e1F̄, where F is an exogenous measure of consumer confidence, and the constants e0 and e1 are both positive. Show the impact of a change in consumer confidence on equilibrium output. (3 points) Then use the consumption function to determine the impact of a change in consumer confidence on equilibrium consumption. (3 points) c. What is the impact of a change in the exogenous interest rate on equilibrium income? (3 points) Question 3 (15 points) A. Define the real exchange rate. Explain briefly how it would affect the choice between domestic and foreign goods. (3 points) B. For the country assigned to you (see below), obtain data for its exchange rate (per US dollar) for the period 20002016. This data can be obtained from the OECD site: https://data.oecd.org/conversion/exchange-rates.htm. Be sure that you identify the currency of your country. If you are not sure what this is, use the following link: https://www.moneycurrencyconverter.com/world-currencies.html Then go the IMF site you used in the first assignment, and obtain the GDP deflators for your country and the US for 2000-2016. Calculate the real exchange rate, and present it and the nominal exchange rate in a table. If you wish, you can additionally present them in two separate charts (although this not mandatory). (4 points) Based on the data in your table, answer the following questions: (2 points each) 1. Do you think that the nominal exchange rate is a good indicator of changes in the cost of US goods relative to those of your country? Explain. 2. Can you identify periods of real appreciation and depreciation of your country’s currency? Explain. 3. From the data, can you draw any implications for how your country’s exports and imports might have changed over this period? 4. Is there a long-term tendency for the real exchange rate ton appreciate, depreciate, or remain constant? Explain. Downloading exchange rate data from the OECD site: scroll down to the bottom of the table and click on “Highlighted Countries” and choose your country. Then make sure that “None” is selected in the panel just to the right of the countries panel. Then scroll back up to the top of the table and click on the “download” button and choose the “Selected data only” option. You can open the downloaded file in Excel. Question 4 (5 points) Parts A and B are independent Consider the following information for 1-year Canadian and US bonds. Value at maturity (X) Price (PB) Canada (1-year bonds) CA$10 thousand CA$ 9.61536 thousand US (1-year bonds) US$ 13.333 thousand US$ 12.69810 thousand 1. What are the rates of interest on Canadian and US bonds (2 points) 2. If the current exchange rate E=CA$0.95/US$1, then if the interest parity condition holds, what is the market is expecting the exchange rate 1 year from now to be. (2 points) 3. Suppose you buy a US bond at the exchange at CA$ 0.95/US$1 and 1 year from now the exchange rate turns out to be CA$ 0.90/US$1. As a result, what is the actual rate of return earned on the US bond (in Canadian dollars? (1 point) Countries for Question 3 Student ID A00403579 A00411822 A00373934 A00396917 A00323165 A00398061 A00397827 A00367480 A00401920 A00374814 A00384026 A00425248 A00339183 A00380063 A00380719 A00389207 A00395588 A00383991 A00362070 A00360826 A00379403 A00396053 Country Argentine Japan Austria Germany Belgium Spain Greece France Finland UK Canada Ireland Norway Korea Portugal New Zealand India Denmark Bulgaria Netherlands Italy Mexico A00384419 A00403085 A00405867 A00405868 A00380390 A00415359 A00368008 A00378599 A00388881 A00400070 A00405709 A00373646 A00396285 A00402240 A00376541 A00393515 A00404631 A00394254 A00391779 A00394817 A00374845 A00404657 A00374847 A00399174 UK South Africa Estonia Brazil Saudi Arabia Switzerland Australia China Czech Republic Peru Israel Iceland Poland Turkey Costa Rica Colombia Russia Indonesia Croatia Lithuania Chile Hungary Latvia Slovenia ...
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School: University of Virginia

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Work Outline
Question one; IS-LM model
Question two; Keynesian Model
Question three; exchange rates
Question four; bonds value


Question one
A. An increase in taxes leads to a leftward shift in the IS curve. It does not cause any shift in the

LM curve. The increase in taxes has no effect on the L-M cure because the economy runs on
the LM curve. The leftward shift in the IS curve is as shown below;

Figure 1: changes in IS-LM model as a result of increase in taxes
An increase in taxes leads to a leftward shift in IS curve from IS to IS1 as shown in figure one
above. This shift in IS curve is as a result of an increase in taxes leads to a decrease in the output
or income, at equilibrium point x, from Y to Y1. As taxes increases, the consumption decreases
and thus the output decreases.
With a decrease in the output, as a result of a decrease in consumption, the demand for money
reduces. This is because the is a reduction in the income or output from Y to Y1. With a decrease
in the demand for money, interest rates must decrease from i to i1 in order to maintain the market
equilibrium.

B. In order to prevent the interest rate from reducing in (A) above as explained, the Central
Bank can use the expansionary monetary policy. This shall increase the supply of the money
in the economy. The expansionary action by the Central Bank can be achieved through
actions like Open Market Operations like buying of short-term Government Bonds. This
shall increase the supply of money in the economy. With an increase in the money supply,
there shall be a reduction in the unemployment, an increase in spending and a boost in th...

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