Economics with Prof. Sanjay Paul
Exercise
Set 15
THE COMPLETE MODEL
I. Objectives
To show the linkages between
the goods market and the money market
To explain changes in
GDP, inflation and interest rates simultaneously
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 Yf,
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 Md/Msframework.
The intersection of the Mdand
Mscurves
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
Consider the goods market
equilibrium in Fig. 1.
Can
we conclude that the economy
is at full
employment?
Can we
say that the current unemployment rate is greater
than the natural rate
of unemployment?
Suppose there is a decline
in GDP in one of our major trading partners, say Canada.
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?
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.
Based on the foregoing, we
conclude that a recession in a trading partner will lead to [ lower |
higher ] incomes in the U.S.
Suppose labor productivity
rises.
Use Fig. 1 to explain the
effects on GDP and the price level in the short run.
Use Fig. 2 to establish
the changes in the money market. What can we say about the net effect
on interest rates?
What is the likely effect
on the government's budget balance?
Suppose the government cuts
spending on the military and infrastructure.
Use Fig. 1 to explain the
effects on GDP and the price level in the short run.
Use Fig. 2 to establish
the changes in the money market. What can we say about the net effect
on interest rates?
What is the likely effect
on the government's budget balance?
What is the effect of the
fiscal policy on unemployment?
Which other fiscal policy
is likely to have similar effects as the decrease in G?
Suppose the Federal Reserve
buys government securities in an open-market operation.
Use Fig. 2 to establish
the changes in the money market. What is the net change
in interest rates?
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.)
What is the effect of
the monetary policy on unemployment?
Consider the
effect of the monetary policy on the budget balance: Will the
budget deficit increase or decrease?
Consider the
likely effect of the Fed's action on the exchange rate: Will the value
of the dollar rise or fall?