1) Is the curve in this model steeper or flatter relative to the basic IS-LM model? Explain why in 3-5 lines, being as precise as you can.

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Answer ALL the questions. Marks are only awarded for brief justification (argument, algebra, graphs etc.) that you provide.

Question 1: (To answer the following questions you should have in mind the extended IS-LM model which includes a role for expectations. Recall the basic structure of the model:

 

IS: Y = A (Y, T, r, Ye, Te, re) + G

 

LM: M/P = Y L(r)

 

Where Y: Output, T: Taxes, r: the real interest rate and the superscript ‘e’ stands for an expectation about the future value of a variable. A is the sum of consumption and investment, which depends on current Y, T and r, as well as expected future variables Ye, Te, re.

 

M: Money supply, P: Price level. L(.) is the money demand function.

 

1)      Is the curve in this model steeper or flatter relative to the basic IS-LM model? Explain why in 3-5 lines, being as precise as you can.

2)      Following the end of the Eurozone financial crises and excitement about the positive impact thanks to the implementation of reforms in European countries, expectations about future output improve (i.e. Ye increases). Draw an IS-LM diagram, and show how the change in Ye affects Y and r. (Assume all other variables (M/P, T, Te, re, G) stay the same.)

3)      What is the effect of the change in Ye (i) current investment and (ii) the stock market (increase, decrease or ambiguous)? Explain why in 3-5 lines, be as precise as you can.

4)      Following the increase in Ye, how must the European Central Bank change the size of the money supply (M/P) to return the interest rate to its previous level? Use a diagram to help answer this question.

5)      Assume this year, many national governments of the Eurozone have decided to implement an income tax cut for the households. This cut is scheduled to take effect in a year. Based on the IS-LM framework, other things unchanged, what will happen to current output following the tax cut? Explain how and why your answer would be different if Ricardian equivalence was true. (State the answer to this question, there is no need to draw a diagram. Explain in 3-5 lines).

 

Question 2: A new source of energy has been discovered in Indonesia. This new technology will reduce the costs of production of Indonesian firms, and as a consequence will reduce the mark-up of price over wage charged by firms. Assume that the change in the mark-up is the only way in which the new technology affects the economy. As the finance minister of Indonesia, you would like to analyse the impact of this shock on the economy. Answer the following questions:

 

1)      In the AS-AD set up, the reduction in production costs shifts which curve, the AS or the AD? How? Explain in words.

2)      What happens in the short-run? Show in a graph and describe the effect on the price and the level of output. What happens in the medium-run? Describe the adjustment from the initial equilibrium towards the medium-run. Show in the graph.

3)      Compare the composition of spending (consumption, investment, and government spending) in the medium-run with the initial pre-shock situation.

4)      Suppose now that after the initial discovery, you as finance minister would like to accelerate the transition to the medium run by using fiscal or monetary policies. What kind of policies would you recommend? Can you stabilize the economy to its new medium-run equilibrium level of output and keep prices constant at the initial level? Show in a graph.

5)      Suppose that you achieved the objective in Q4 by changing government spending. What can you say about the new composition of aggregate demand (i.e. consumption, investment and government spending) and the interest rate? 

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