Exercise Set 15
THE COMPLETE MODEL

I. Objectives

1. To show the linkages between the goods market and the money market
2. To explain changes in GDP, inflation and interest rates simultaneously
3. To show how fiscal and monetary policies affect the economy
   

II. Model

• Equilibrium in the goods market is depicted in the DD/SS framework (aka the AD-AS model). The intersection of DD and SS curves (equivalently, AD and SRAS curves) yields equilibrium GDP and price level in the short run. The long-run aggregate supply curve is denoted by Y^f, also known as potential GDP. See Fig. 1.
  Note: The DD curve will shift right if there is an increase in aggregate demand (or aggregate expenditure AE). The SS curve will shift right due to lower input prices and improvements in technology.
  
  
• Equilibrium in the money market is depicted using the  M^d/M^s framework. The intersection of the M^d and M^s curves yields the equilibrium interest rate. See Fig. 2.
  Note: Money demand will increase when GDP or the price level rises. Money supply is controlled by the central bank.

Fig. 1. Equilibrium in the Goods Market

Fig. 2. Equilibrium in the Money Market

III. Questions

1. Consider the goods market equilibrium in Fig. 1. 
1. Can we conclude that the economy is at full employment? 
2. Can we say that the current unemployment rate is greater than the natural rate of unemployment?
2. Suppose there is a decline in GDP in one of our major trading partners, say Canada. 
1. How will the fall in Canadian GDP affect the U.S. goods market--in particular, what will happen to U.S. GDP and the price level?
2. As a result of the changes in U.S. GDP and price level, what will happen in the U.S. money market? Explain the effect on U.S. interest rates.
3. Based on the foregoing, we conclude that a recession in a trading partner will lead to [ lower | higher ] incomes in the U.S.
3. Suppose labor productivity rises. 
1. Use Fig. 1 to explain the effects on GDP and the price level in the short run. 
2. Use Fig. 2 to establish the changes in the money market. What can we say about the net effect on interest rates?
3. What is the likely effect on the government's budget balance?
4. Suppose the government cuts spending on the military and infrastructure.
1. Use Fig. 1 to explain the effects on GDP and the price level in the short run. 
2. Use Fig. 2 to establish the changes in the money market. What can we say about the net effect on interest rates?
3. What is the likely effect on the government's budget balance?
4. What is the effect of the fiscal policy on unemployment?
5. Which other fiscal policy is likely to have similar effects as the decrease in G?
5. Suppose the Federal Reserve buys government securities in an open-market operation.
   1. Use Fig. 2 to establish the changes in the money market. What is the net change in interest rates?
   2. Use Fig. 1 to explain the effects on GDP and the price level in the short run. (Note: Investment and consumption are affected by interest rates.)
   3. What is the effect of the monetary policy on unemployment?
   4. Consider the effect of the monetary policy on the budget balance: Will the budget deficit increase or decrease?
   5. Consider the likely effect of the Fed's action on the exchange rate: Will the value of the dollar rise or fall?