Spring 2004	ECONOMICS 1312	J.G. Gonzalez
	Problem Set # 3

This problem set is due Thursday, April 29, at the beginning of the class period. Problem sets done on notebook paper or unstapled will not be accepted. Late problem sets are unacceptable also.

1. The Bank of Korea (South Korea’s Central Bank) decides to increase the money supply in South Korea. In order to do that, it buys W 55 billion (W = South Korean Won) worth of South Korean government bonds. You are also told that as a result of this action, consumers decide to increase their cash holdings by W 5 billion.

a) If the required reserve ratio equals 8%, how much would the South Korean money supply increase as a result of the Bank of Korea’s action?

b) Calculate the change in the South Korean GDP resulting from the variation in the money supply described above. In order to do this, take into consideration the following facts:

· Each W 180 billion increase in the money supply reduces the rate of interest by 1 percentage point.

· Each 1 percentage point decline in interest rates stimulates W 120 billion of new consumption spending.

· Each 1 percentage point decline in interest rates stimulates W 430 billion of new investment spending.

· Each 1 percentage point decline in interest rates produces a depreciation of 2.5 percentage points in the value of the South Korean Won.

· Each 1 percentage point depreciation in the value of the South Korean Won increases net exports by W 100 billion.

· The MPC = 0.75 and the MPM = 0.15

· The economy is producing under potential output.

2. Assume that the economy is producing at potential output and that the government is concerned with the high price level. With that purpose in mind, the Federal Government reduces its expenditures on goods and services.

a) What predictions would you make about the effects of this policy if you were a true monetarist and a firm believer of the Quantity Theory of Money. Explain fully and include a diagram in your answer.

b) What predictions would you make if you were a mainstream economist. Explain fully and include a diagram in your answer.

c) What predictions would you make if you were a classical economist. Explain fully and include a diagram in your answer.

3. Assume that there are only two countries in the world: Finland and Spain; and that they produce only two commodities: Pearls and Jam. To produce 1 pound of pearls, Finland uses 8 labor hours and Spain uses 3 labor hours. To produce 1 ton of jam, Finland needs 18 labor hours, while Spain needs 15 labor hours.

a) Which country has (1) absolute advantage in the production of pearls, (2) absolute advantage in the production of pearls, (3) comparative advantage in the production of jam, (4) comparative advantage in the production of jam?

b) Before trade takes place, (1) What is the price of one ton of jam in Finland? (2) What is the price of one ton of jam in South Korea? (3) Where is jam cheaper?

c) Assume that after trade opens up, one ton of jam is traded for 4.5 pounds of pearls. Prove that if workers in both countries want to consume 4 tons of jam and 3 pounds of pearls, both of them would benefit from free trade.

4. Visit the Federal Reserve Board of Governors web site (http://www.federalreserve.gov/). Review the minutes from the January 27-28, 2004 meeting of the Federal Open Market Committee (look for the in the Monetary Policy section).

a) Based on the information available in those minutes, write a short summary describing the state of the U.S. economy during the fourth quarter of 2003.

b) What action did the FOMC decided to take during the January 27-28, 2004 meeting with respect to their target for the federal funds rate? Why did the FOMC take that action?

c) What do the minutes indicate about possible future action by the FOMC? Why is the FOMC leaning in that direction?