PS-2 Free Response

Directions¶

• There are 5 FR questions, and each question is worth 7 course points (for 35 out the total 45 points for this problem set).

• Type/write in your name(s) at the top of your solutions.

• You may work in a group of 3 or less. Do not collude with other groups. Do not “divide and conquer” the questions.

• Do not use GenAI; this is exam practice.

• Start each answer/solution to a question on a new page (i.e., start Q1 at the top of page 1, Q2 on of page 2, etc...).

• Scan/take pics, combine into a PDF, and upload to Gradescape by Tuesday, Oct 14, 9am.

Gradescope Reminders

1. Only submit one assignment per group (of 3 members or less).

2. Add all group members to the one submission.

3. Select all the pages where your solutions appear to each question (i.e., not just the first page for each question).

Q1¶

Consider an economy with a corn producer, some consumers, and a government. In a given year, the corn producer grows 30 million bushels of corn and the market price for corn is $5 per bushel. Of the 30 million bushels produced, 20 million bushels are sold to consumers, 5 million are stored in inventory, and 5 million are sold to the government to feed the army. The corn producer pays $60 million in wages to consumers and $10 million in taxes to the government. Consumers pay $5 million in taxes to the government, and receive $5 million in Social Security payments from the government. The profits of the corn producer are distributed to consumers. Calculate

• disposable income

• private saving

• public saving

• national saving

Q2¶

Consider the following goods market with endogenous investment:

where $b_0$ is autonomous investment and $0 < b_1 < 1$ is the elasticity of investment out of current revenues.

A) Use algebra to solve for equilibrium output. How does the investment multiplier depend on the revenue elasticity of investment ($b_1$)?

B) Suppose firms become more optimistic about future revenues and increase autonomous investment ($b_0$).

• Graph the goods market and the resulting shift in aggregate expenditure.

• Indicate on the graph that the final change in equilibrium output is greater than the initial change in $I$.

• What is the slope of the aggregate expenditure curve, $ZZ$?

C) Given the initial increase in $I$, how does the goods market transition from the initial to final equilibrium output?

Q3¶

Answer the following questions related to the money market.

A) Assume the money market starts in equilibrium and the money supply is fixed. Now suppose income increases. Graph the effect in the money market.

B) At the initial equilibrium interest rate, is there a shortage or a surplus of money? How do people rebalance their portfolios of money and short-term bonds?

C) What happens to the price of short-term bonds and the interest rate? Why? As the interest rate changes, what happens to the quantity of money demanded?

Q4¶

Answer the following questions related to the IS-LM model:

A) In the money market, assume the central bank targets the short-term interest rate, $i = i^*$. Starting with a graph of the money market, derive the LM curve in the $(i,Y)$ space. Explain the steps. Does the LM curve have a positive, negative, or flat slope? Why?

B) In the goods market, assume that investment, $I$, is a decreasing function of the interest rate, $i$. Starting with a graph of the goods market, derive the IS curve in the $(i,Y)$ space. Explain the steps. Does the IS curve have a positive, negative, or flat slope? Why?

Q5¶

Answer the following questions about the economic response to the COVID-19 pandemic.

A) The Fed lowered its interest rate target to nearly $0\%$. Graph the money market, and show the change in equilibrium interest rate. How does the interest rate adjust to its new equilibrium (i.e., what happens to portfolios and the bond market)?

B) The U.S. Congress increased government spending and cut taxes. Graph the goods market, and show the change in equilibrium output. How does output adjust to its new equilibrium (i.e., what happens to inventories and production)?

C) Graph the above policy mix in the IS-LM model (i.e, in the $i$ vs. $Y$ space). Be sure to indicate and explain any shifts in either the IS and/or LM curves. What is the total effect on the equilibrium interest rate and output?