MACROECONOMICS ASSIGNMENT Nº 2

Topic 7

1. Suppose that changes in bank regulations expand the availability of credit cards, so
that people need to hold less cash.

a. How does this event affect the demand for money?

If money demand refers to how much wealth people want to hold in liquid form, then money
demand will decrease. If people need to hold less cash, the demand for money shifts to the left,
because there will be less money demanded at any price level.

b. If the central bank does not respond to this event, what will happen to the price level? If
the Fed does not respond to this event, the shift to the left of the demand for money combined
with no change in the supply of money leads to a decline in the value of money (1/P), which
means the price level rises.

c. If the central bank wants to keep the price level stable, what should it do? If the Fed wants
to keep the price level stable, it should reduce the money supply by selling government bonds in
the market. Thus, money supply will shift to the left.

2. It is often suggested that central banks should try to achieve 0 inflation. If we assume
that velocity is constant, does this zero inflation goal require that the rate of money
growth equal zero? If yes, explain why. If no, explain what the rate of money growth
should be equal.

The quantity equation M*V=P*Y determines that when velocity (V) and quantity of output (Y)
remain
constant, if the inflation rate is reduced to zero, it would be necessary for the money growth to be
equal to the growth rate of output in order to keep the same proportion.

3. Let’s consider the effects of inflation in an economy composed only for two people:
Michael, a bean farmer, and Dorothy, a rice farmer. Michael and Dorothy both always
consume equal amounts of rice and beans. In year 2018 the price of beans was 1 and
the price of rice was 3.

Year 2018 (price) Year 2019 (price)

Beans 1 2

Rice 3 6

a. Suppose that in 2019 the price of beans was 2 and the price of rice was 6. What was
inflation? Was Michael better off, worse off or unaffected by the changes in prices? What
about Dorothy?

Inflation price beans=(2-1)/1*100=100%

Inflation price rice=(6-3)/3*100=100%
Both prices of products doubled due to inflation, so Michael and Dorothy were unaffected by the
changes in price.

b. Now suppose that in 2019 the price of beans was 2 and the price of rice was 4. What was
inflation? Was Michael better off, worse off or unaffected by the changes in prices? What
about Dorothy?

Year 2018 (price) Year 2019 (price)

Beans 1 2

Rice 3 4

Inflation price beans=(2-1)/1*100=100%

Inflation price rice=(4-3)/3*100=33,33%

Michael, the bean farmer, is better off than Dorothy, the rice farmer because the price of beans
has increased 66,67% more than the price of rice.

c. Now suppose that in 2019 the price of beans was 2 and the price of rice was 1.5 . What
was inflation? Was Michael better off, worse off or unaffected by the changes in prices?
What about Dorothy?

Year 2018 (price) Year 2019 (price)

Beans 1 2

Rice 3 1,5

Inflation price beans=(2-1)/1*100=100%

Inflation price rice=(1,5-3)/3*100=-50%

Michael, the bean farmer, is better off than Dorothy, the rice farmer. This means that Michael will
benefit from this situation due that his revenue will increase a 100%, and as the price of rice has
decreased he will be able to purchase the same quantity of rice for an inferior price. On the other
hand, Dorothy will be worse off because the price of beans has increased 100% and the price of
rice has decreased, so her revenue will decrease.

d. What matters more to Michael and Dorothy the overall inflation rate or the relative price
of rice and beans?

Relative price of rice and beans.

4. If the tax rate is 40, compute the before-tax real interest rate and the after-tax real interest
rate in each of the following cases.

a. The nominal interest rate is 10% and inflation rate 5%.

After tax nominal interest rate=0.60*nominal interest rate

After tax nominal interest rate=0.60*10=6
After-tax real interest rate=after-tax nominal interest rate-inflation rate
After-tax real interest rate=6-5=1

b. The nominal interest rate is 6% and inflation rate 2%

After tax nominal interest rate=0.60*nominal interest rate
After tax nominal interest rate=0.60*6=3.6
After-tax real interest rate=after-tax nominal interest rate-inflation rate
After-tax real interest rate=3.6-2=1.6

c. The nominal interest rate is 4% and inflation rate 1%.

After tax nominal interest rate=0.60*nominal interest rate

After tax nominal interest rate=0.60*4=2.4
After-tax real interest rate=after-tax nominal interest rate-inflation rate
After-tax real interest rate=2.4-1=1.4

5. Suppose that people expect inflation to equal 3% but in fact prices rise by 5%. Describe
how this unexpected high inflation help or hurt the following:

a. The government. Will help because the government’s revenue from taxes will be higher.

b. A home owner with a fixed-rate mortgage. Unaffected.

c. A union worker in the second year of a labour contract. Will be hurt because its real wage
will decrease. Real wage=W/P. If P rises, real wage falls. So he will have less purchasing power.

d. A retired person who has invested their savings in government bonds.

Real interest rate=Nominal interest rate-Inflation. Real interest rate will decrease, so he will get
less returns.

6. Explain whether the following statements are true, false or uncertain

a. Inflation hurts borrowers and helps lenders, because borrowers must pay a higher rate
of interest.

False
Inflation allows borrowers to pay lenders back with money worth less than when it was originally
borrowed, which benefits borrowers. When inflation causes higher prices, the demand for credit
increases, raising interest rates, which benefits lenders.

b. If prices change in a way that leaves the overall price level unchanged then no one is
made better or worse off.

False
When the prices change everyone will be affected directly or indirectly and some of them will be
better off and another worse off.

c. Inflation does not reduce the purchasing power of most workers.

True
Because if there is inflation, prices increase and wages too as a result people can buy the same
amount of goods as before
Topic 8

a) Suppose that Bill, a resident of the U.S., buys software from a company in Japan.
Explain why and in what directions this changes U.S. net exports and U.S. net
capital outflow.

Net capital outflow= the purchase of foreign assets by domestically residents - the
purchase of domestic assets by foreigner

NX = Exports - Imports

Nx = NCO

As Bill will buy software from a company in Japan, U.S imports will increase, and with
this Japan will achieve currency from Bill. This currency that Japan has gained maybe will
be reinvested in U.S assets making the purchase of domestic assets by foreigners
increase. This will make Net exports decrease and NCO decrease.

b) Why are net exports and net capital outflow always equal?

NX and NCO are always equal because every international transaction involves the
exchange of an asset for a good or service.

c) Suppose that a country has $120 billion of national savings, and $80 billion of domestic
investment. Is this possible? Where did the other $40 billion of national savings go?

Yes, this is possible due that National savings are equal to Domestic investment + Net
capital outflow, this 40 billion of national savings are gone to net capital outflow.

d) Suppose a bottle of wine costs 25 euros in France and 20 dollars in the United States. If
the exchange rate is 1.25 euros per dollar, what is the real exchange rate?

Real exchange rate= Nominal exchange rate * domestic price / foreign price

Real exchange rate= (1,25 euros per dollar) * 20 euros / 25 dollars = 1

This means that the price of a bottle of wine is the same in the US and in France.

e) According to purchasing-power parity, what is the relationship between changes in

price levels between two countries and changes in nominal exchange rates?

Implies that nominal exchange rates adjust to equalize the price of a basket of goods across countries. So,
nominal exchange rate between two countries should equal the ratio of price levels. e=P/P*
Exercises Topic 9/10

Explain how Spanish economy reacts and adjust by itself to long term equilibrium
when:

- Price on intermediate goods increase

- An economic recession occurs in France

- Prospects on economic performance are worsen

- Investment rate on building sector increases fast Now the government and ECB
is applying fiscal and monetary policy to adjust the economy, what the
government and ECB should do in these cases? Use graphs to explain all.