Homework #3

Due June 18th, 3:00pm, 2023

1. Initially, the government budget is balanced and trade is balanced (NX = 0). Suppose the
government runs a budget deficit. How does the budget deficit affect the real interest rate?
Net capital outflow? The real exchange rate? The balance of trade?

1) The real interest rate will increase. This is because the government deficit will lead to an
increase in the demand for loanable funds, which will drive up the interest rate.

2) Net capital outflow is the difference between the amount of capital that flows into a
country and the amount of capital that flows out of a country. When the government runs a
budget deficit, it borrows money from the private sector. This increase in the demand for
loanable funds will also lead to an increase in net capital outflow.

3) The real exchange rate is the relative price of domestic goods and services to foreign goods
and services. A budget deficit can affect the real exchange rate through its impact on net
capital outflow. If the deficit leads to an increase in net capital outflow, it can put downward
pressure on the domestic currency's value. Consequently, the real exchange rate may
depreciate when a government runs a budget deficit.

4) The balance of trade is the difference between the value of exports and the value of
imports. When the government runs a budget deficit, it increases the demand for domestic
goods. This increase in demand will lead to an increase in the price of domestic goods, which
will make them more expensive for foreign buyers. This will then reduce the demand for
domestic goods, which will lead to a decrease in exports.

2. Explain the intuition behind the short-run Philips curve.

The Phillips Curve is the negative relationship between unemployment and inflation. The
idea behind the Phillips curve is intuitive. When the unemployment rate is low, firms will
raise wages to attract needed workers and raise their prices at a more rapid rate because of
the shortage of workers in the labor market.

The intuition behind the short-run Phillips curve is based on the idea that there is a trade-off
between inflation and unemployment in the short term. The curve suggests that when the
economy is operating below its potential, there is excess unemployment, but inflation
remains low. Conversely, when the economy is operating above its potential, there is low
unemployment, but inflation tends to be high.
 It is important to note that the short-run Phillips curve implies a temporary trade-off
between inflation and unemployment and is applicable only in the short term. The short-run
Phillips curve is a dynamic relationship, meaning that it can change over time. For example,
the relationship between unemployment and inflation may be different in a high-inflation
economy than in a low-inflation economy. The short-run Phillips curve is also affected by
government policies. For example, if the government pursues a policy of fiscal expansion,
this will lead to an increase in aggregate demand and an increase in the rate of inflation. As a
result, the short-run Phillips curve will shift to the right.

3. Draw the AD-SRAS curves. Assume that there is a positive productivity shock ,that shifts
SRAS curve to the right. What monetary and fiscal policies would you suggest to take output
back to its original level? How those policies would affect the price level? Illustrate your
answer graphically.

SRAS 1 A positive productivity shock would shift the SRAS

AD
SRAS 2 curve to the right, which would lead to an increase in
P1
output and a decrease in the price level. In the short run,
this would be a good thing for the economy, as it would
P2
lead to lower unemployment and higher economic
growth. However, in the long run, the price level would
start to decrease, which could lead to deflation.
Q1 Q2

To take output back to its original level, the government could implement contractionary
monetary and fiscal policies. Contractionary monetary policy would involve the central bank
raising interest rates, which would make it more expensive for businesses to borrow money
and invest. Contractionary fiscal policy would involve the government cutting spending or
raising taxes, which would reduce aggregate demand.

Both contractionary monetary and fiscal policies would have a negative impact on the price
level. Raising interest rates would make it more expensive for consumers to borrow money
and spend, which would lead to lower aggregate demand. Cutting government spending or
raising taxes would also reduce aggregate demand.
4. Due to credit card fraud, the demand for money goes up. How would this change in
money demand affect AD curve? Illustrate your answer graphically.

P
When the demand for money increases, it
means that people are holding more cash and
less of other assets, such as bonds or stocks.
This reduces the amount of money available P1

to be spent on goods and services, which leads

P2
to a decrease in aggregate demand. The
decrease in aggregate demand will cause the
AD curve to shift to the left. This means that
at any given price level, there will be a lower
Q2 Q1
Q