Question 1 (30 points) – Chapters 3, 4, 5 & 6
Suppose the world consists of only one pair of small open economies, country A and country B, and these countries only trade with each other. Country A only produces food whose output is measured in standard units, where one unit of YA is equal to 250 kilograms of food. Country B only produces clothing in standard units, where one unit of YB is equal to 10 kilograms of clothing. The table below provides some selected information about the economies of these countries. Keep your answers to at least 3 or 4 decimal points.

Country A Country B
Production function: YA = K0.50L0.50
Capital stock: K = 1,000
Labour supply: L = 1,000 Production function: YB = K0.50L0.50
Capital stock: K = 800
Labour supply: L = 800
Marginal product of capital: MPK = 0.5K–0.5L0.5
Marginal product of labour: MPL = 0.5K0.5L–0.5 Marginal product of capital: MPK = 0.5K–0.5L0.5
Marginal product of labour: MPL = 0.5K0.5L–0.5
Consumption function: C = 150 + 0.6(Y-T) Consumption function: C = 110 + 0.65(Y-T)
Investment function: I = 200 – 80r Investment function: I = 150 – 90r
Gov’t sector: G = 100 & T = 100 Gov’t sector: G = 110 & T = 110
Net export function: NX = 644 – 630ε
Monetary sector: Md = 0.75Y – 100r
Money supply = MS = 894 Monetary sector: Md = 0.90Y – 200r
Money supply = MS = 781

Use the long-run classical model of the small open economy to answer the following questions. Both countries have perfect financial capital mobility and no risk premium.

Hint: Since these countries only trade goods and services with each other one country’s net export curve is the mirror image of the other country’s net exports curve (i.e. in some sense there is only one net export curve & one market for foreign exchange between these countries). Also, the sum of net foreign investment in both countries must equal to zero (as they only trade with each other), i.e., NFIA + NFIB = 0.

a) Determine the long-run equilibrium level of food and clothing production. (4 points)
Hint: Be careful when interpreting the units of food & clothing produced.
b) Suppose absolute purchasing power parity holds for these countries. For each country, determine the long-run equilibrium levels of:
• The domestic price level;
• The real exchange rate (in the usual orientation # of foreign per domestic, εFC/DC);
• The nominal exchange rate (in the usual orientation of # of foreign per domestic);
• The domestic real rate of interest; and
• The real wage rate of labour and real rental rate of capital; and
• The unemployment rate.
Support your answer with one set of diagrams (three in total), one for the Country A domestic loanable funds market, one for the Country B domestic loanable funds market, and one for the Country A (relative to Country B) foreign exchange market. (11 points)

Suppose the government of country A decides to implement a new law that imposes a minimum real wage of 0.53.

c) Provide a written explanation as to whether the variables of interest listed in parts (a) & (b) change or remain unchanged and why this is so. Also, support your answer with one NEW set of diagrams (three in total), one for the Country A domestic loanable funds market, one for the Country B domestic loanable funds market, and one for the Country A (relative to Country B) foreign exchange market. (15 points)
Hint: No need to do any calculation.

Question 2 (20 points) – Chapters 4 & 5
Home is a small open economy that can be described by the long-run classical model:
Consumption: C = 11250 + 0.75(Y – T) – 2000r
Investment: I = 16500 – 1500r
Government spending: G = 12000
Net exports: NX = 5000 – 4400FC/DC, FC/DC = real exchange rate
Money demand: L(r + e, Y) = 0.65Y – 200(r + e)
(Nominal) money supply: MS = 18000
Foreign price level: PF = 1.5
World interest rate: rw = 6%

Suppose the money supply in both the Home and Foreign countries has been growing by 5% per year for the past several years and this is expected to continue.

Note: Both r and e are measured in percentage points (for example, if we find r = 10, then r is interpreted as being equal to 10%). Keep your answer to at least 4 decimal points.

a) Initially, the government of Home runs a budget surplus of 3000 with an equilibrium (real) exchange rate is 1.25 FC per DC. Find the long-run equilibrium levels of output, national saving, net exports, and price level for Home. Find the equilibrium nominal exchange rate. (5 points)

Home is initially in its long-run equilibrium as described in part (a). Suppose an unfavourable article appears in Consumer Reports magazine that is widely reported via other world news media. This article claims that the output (i.e. exports) of the Home country are not only over-priced low quality items, but given the lax production laws in the Home country they are often made of unsafe materials. The article also claims that having these items around one’s home increases the chance of severe health problems. As a result Home’s autonomous net exports changes by 22%.

b) Find the new long-run equilibrium levels of output, national saving, net exports, price level, and real exchange rate. (5 points)
c) Suppose politicians in the Home country find the change(s) in part (b) undesirable, and pressures to the government to permanently double the rate of growth of the money supply. Determine the resulting new growth rates of the real and nominal exchange rate for the Home country currency. Describe in words the impact this has on Home’s net exports and level of output in long-run equilibrium. (5 points)
d) Suppose instead, the changes of part c have not occurred, but rather these news articles have not only caused Home’s autonomous net exports to change by 22%, but it also causes Home’s autonomous investment to rise by 20%, as factory owners realize they need to invest more in order to become competitive suppliers of safer products. Find the new long-run equilibrium levels of output, national saving, net exports, price level, and real exchange rate. (5 points)

Question 3 (25 points) – Chapters 9 & 10/11
The following question’s sub-parts are completely separate questions.

a) Some economists claim that the government should always use monetary policy to stabilize the economy in the short-run if they also wish to keep the resulting impact on (changes to) the government budgetary balance to a minimum. Is this claim true, false or uncertain? Provide a written explanation of your assertion. (5 points)
b) The government should always use fiscal policy to combat business cycle fluctuations coming from changes in autonomous consumption if it also wishes to keep movements in investment to a minimum. Is this claim true, false or uncertain? Explain by using words and a single IS/LM diagram. (10 points)
c) The government should never use fiscal policy to combat business cycle fluctuations coming from changes in money demand if it also wishes to keep movements in consumption to a minimum. Is this claim true, false or uncertain? Explain by using words and a single IS/LM diagram. (10 points)

Question 4 (25 points) – Chapters 9 & 10/11
Utopia is a closed economy and is characterized by the following equations:
Consumption: C = 410 + 0.75(Y – T) – 155r
Investment: I = 1500 – 720r
Government spending: G = 2200
Taxes: T = 2100
Real money demand: L(i, Y) = 0.5Y – 200i
Expected inflation: e = 0
Production function: Y = 5K1/3L2/3
Note: Interest rates, i and r, are expressed in decimal points, i.e., if r = 0.075, then r = 7.5%.

Suppose the IS-LM model can used be to describe Utopia, and answer the following questions. Keep your answers to a minimum of THREE decimal points (for fractions).

a) Derive the IS and LM equations for this economy. (4 points)
b) The supply of capital and labour in this economy are both equal to 2000; and the level of the nominal money supply is 4992. Calculate the long-run or full-employment values of the output, consumption, investment, real interest rate, public saving, private saving, national saving, and price level. (4 points)
c) Now suppose the government of Utopia raises government spending on goods and services by 200 and they print brand new money to pay for this spending. Assuming that the economy was initially at full-employment, what are the new values of output, consumption, investment, real interest rate, public saving, private saving, national saving, and price level in the short-run and the long-run? (8 points)
d) Suppose a prominent economist criticizes the policy recommended in part C by saying this policy goes too far. By aggressively raising the money supply the government will create high levels of inflation for many years to come and thereby discourage new physical capital investment. Use the IS/LM model to describe whether these criticisms are at all reasonable. Don’t forget to explain why each argument is or is not reasonable. (9 points)