1. IS/LM Model with Budget Balance (50 points.)

I. (a) See Figure 1. Y increases to Y1 (2 points), r increases to r1 (2 points), and the budget deficit increases from AB to AB1 (2 points).

(b) See Figure 1. Y2 – Y1 is crowded out. (3 points.)

(c) Planned investment (2 points) and autonomous consumption (2 points), Ip + a.

(d) When Y rises L (the demand for money) increases as well. Crowding out occurs because r must rise in order to reduce L to the size supply of M. (3 points.) The composition of Y changes, shifting toward consumption and away from planned investment so that longer-term growth is likely to be slighted. (3 points.)

(e) The magnitude of the change in fiscal policy is measured by the vertical shift in the Budget Balance line measured at natural Y. [See Figure 1.] (5 points.)

II.

(f) See Figure 1. Income increases from Y1 to Y2 (2 points), r decreases from r1 back to r (2 points) and the actual budget deficit shrinks from AB1 to AB2 (2 points).

(g) When economic activity is very weak, e.g., a recession; specifically when Y < Yn. (5 points.)

(h) Open market purchases of securities [would increase the supply of high- powered money and lead to a multiple expansion of the money supply]. (5 points.)

(i) Nothing. The structural deficit measures changes in fiscal policy not monetary policy. (5 points.)

(j) The cyclical deficit has gotten smaller. As Y increases with expansionary monetary policy, induced taxes increase as well, shrinking the actual budget deficit (or increasing the actual budget surplus). As Y will be rising toward Yn the cyclical deficit will get smaller. (5 points.) 2. Money and Financial Markets (50 points.)

I. (a) The money multiplier is the relationship between changes in the money supply and changes in high-powered money. (5 points.) [Given by the equation: delta(M)/delta(H) = {1 + c}/{c + e}where c is the public’s cash holding ratio and e is the banking system’s reserve holding ratio.]

(b) The money multiplier depends upon 5 assumptions (1 point each): (1) the equivalence of currency and deposits (2) the redeposits of loan proceeds (3) the holding of cash reserves (4) the presence of willing borrowers (5) The presence of willing leaders

(c) (1) Open Market Operations (1 point.) [The buying and selling of government securities by the central bank in the open market.] (2) Reserve Requirements (1 point.) [The regulatory minimum reserves that bank’s must hold in relationship to their deposits.] (3) Discount Rate (1 point.) [The interest rate central banks charge depository institutions to borrow from the central bank.]

(d) (1) Open market sales of securities would decrease the amount of high- powered reserves and lead to a multiple contraction of the money supply. (2 points.) (2) Raising reserve requirements would lead to less lending for any given base of reserves and lead to a multiple contraction of the money supply. (2 points.) (3) Raising the discount rate would deter banks from borrowing reserves from the central bank and lead to a multiple contraction of the money supply. (2 points.) II.

(e) The public’s cash-holding ratio, c (3 points.)

(f) Decreases the money supply (2 points.)

If the public holds more of its money in the form of currency and less in the form of deposits, bank reserves and lending will decline and lead to a multiple contraction of the money supply. (3 points.)

(g) Open market purchases of securities will increase the supply of high- powered money and allow banks to maintain their reserves and lending. (2 points.)

Lower reserve requirements will allow a smaller level of reserves to support a higher level of bank lending and money supply. (3 points.)

III.

(h) The banking system’s reserve holding ratio, e. (3 points.)

(i) Decreases the money supply. (2 points.)

If banks decide to hold more reserves relative to their deposits they will have fewer reserves to lend out and this will lead to a multiple contraction of the money supply. (3 points.)

(j) Same as (g) above (although a lower reserve requirement in this case may not serve much purpose if banks have decided to hold more than is minimally required). (5 points)

IV. No change in the money supply (2 points.)

If all of the change in high-powered money goes into bank reserves which are not lent out then there is no multiple expansion of the money supply. The money multiplier process breaks down because the condition of willing lenders does not exist. (3 points.) 3. International Trade and Exchange Rates (50 points.)

I. (a) See Figure 2. Lower Yw leads to lower X which shifts the IS curve to the left. Y falls to Y1 and domestic r falls below world r. (5 points)

(b) With fixed exchange rates and domestic r below world r the country would experience massive capital outflows, leading to a smaller money supply. This shifts the LM curve to the left until domestic r rises to meet world r. Y falls further. [See Figure 2a.] (5 points)

(c) With flexible exchange rates and domestic r below world r the country would experience a depreciating currency which would boost exports and retard imports and shift the IS curve back to its original position where domestic r equals world r and Y = Yn. [See Figure 2b.] (5 points)

(d) Expansionary fiscal policy. [This will shift the IS curve to the right raising domestic r above world r, provoking capital inflows and increasing the money supply, shifting the LM curve to the right, which lowers domestic r to world r and lifting Y back to Yn.] (5 points)

(e) Nothing. [Flexible exchange rates act as the equilibrating mechanism. When domestic r is below world r, the currency depreciated which raises net exports and pushed the economy back to its initial position.] (5 points) II.

(f) See Figure 3. World r increases above domestic r, so BP line shifts up. (5 points.)

(g) With fixed exchange rates and domestic r below world r there will be a capital outflow that reduces the money supply and shifts the LM curve left until domestic r rises to world r. Y will drop below Yn. [See Figure 3a.] (5 points)

(h) With flexible exchange rates and domestic r below world r, the currency depreciates, raising net exports, and shifting the IS curve to the right until domestic r reaches world r. Y will now exceed Yn. [See Figure 3b.] (5 points)

(i) Expansionary fiscal policy. [Which shifts the IS curve to the right and will raise domestic r above world r, provoking a capital inflow that will increase the money supply and shift the LM curve to the right, lowering domestic r until it reaches world r and Y returns to Yn.] (5 points)

(j) Contractionary monetary policy. [Because Y > Yn, we need a contractionary monetary policy, shifting the LM curve to the left, which will raise domestic r above world r, allow the currency to appreciate, dampen net exports and shift the IS curve to the left, lowering domestic r until it reaches world r and Y returns to Yn.] (5 points)