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ECO 2201: Assignment 3
Due Date: 1st December (11 AM)
- Assignments have to be submitted in groups (2 or 3 students) with student names and IDs clearly men- tioned on the answer sheet. Groups must be from your own section.
- Max grades - 25 points.
- All answer sheets have to be submitted/uploaded to the Moodle page before the deadline.
- No late assignments will be accepted.
Question 1
(4 pts) Consider the effects of a lump-sum tax cut, from T 0 to T 1 , in an economy with flexible and fixed ex- change rate. In which case would the tax cut have a larger impact on income? Explain using graphs.
Question 2
(2 pts) An economy has the option of being in a clean float or fixing the exchange rate. Suppose the econ- omy greatly values investment and is employing measures to boost investor confidence and you expect world interest rates to rise. Which exchange rate system would you prescribe to the economy? Examine what you might be leaving yourself vulnerable to when prescribing such a system?
Question 3
(4 pts) Suppose that higher income implies higher imports and thus lower net exports. That is, the net exports function is
NX = NX(e, Y)
Examine the effects in a small open economy of a fiscal contraction on income and the trade balance under the following
- A floating exchange rate
- A fixed exchange rate
Question 4
(5 pts) Examine the effects of a fiscal expansion brought in by an increase in government expenditure, when an economy is closed, an economy is small, open, and under floating exchange rate, and finally when the economy is open and large. You may use graphs to ascertain under which regime would this policy be most effective and why? Which factors would render it less effective in others and how?
Question 5
(10 pts) Suppose that people’s expectations of inflation are subject to random shocks. That is, instead of being merely adaptive, expected inflation in period t, as seen in period t − 1, is E t− 1 π t = π t− 1 + η t− 1 , where η t− 1 is a random shock with E η t− 1 = 0. Similarly, E t π t+ 1 = π t + η t.
- Derive the long-run equilibrium for the dynamic AD–AS model. Assume that η t = vt = ε t = 0 and π t = π t− 1. Be sure to show each step you follow. (3 pts)
- Derive the two equations for dynamic aggregate demand and dynamic aggregate supply. (3 pts)
- Suppose that the economy experiences an inflation scare. That is, in period t, for some reason people come to believe that inflation in period t + 1 is going to be higher, so η t increases. What happens to the DAD and DAS curves in period t? Show graphically what happens to output, inflation, and nominal and real interest rates in that period? (4 pts)
