Spring 2005

ECONOMICS 1312

J.G. Gonzalez

 

 

 

 

Problem Set # 3

 

 

            This problem set is due Thursday, April 28, 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 Sveriges Riksbank (Sweden’s Central Bank) decides to decrease the money supply in Sweden.  In order to do that, it sells 180 kr million (kr = Swedish Krona) worth of Swedish government bonds.  You are also told that as a result of this action, consumers decide to decrease their cash holdings by 60 kr million.

 

a)  If the required reserve ratio equals 4%, how much would Sweden’s money supply decrease as a result of the Sveriges Riksbank action?

 

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

·  Each 2040 kr million decrease in the money supply increases the rate of interest by 1 percentage point.

·  Each 1 percentage point increase in interest rates produces a 220 kr million decline in consumption spending

·  Each 1 percentage point increase in interest rates produces a 480 kr million decline in investment spending.

·  Each 1 percentage point increase in interest rates produces an appreciation of 5 percentage points in the value of the Swedish Krona.

·  Each 1 percentage point appreciation in the value of the Swedish Krona reduces net exports by 50 kr million.

·  The MPC = 0.65 and the MPM = 0.15.

·  The economy is producing under potential output.

 

 

2.  Assume that the economy is in the middle of a recession and that the government wants to revive it.  With that purpose in mind, the Federal Government increases expenditures on welfare programs.

 

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:  the Netherlands and Brazil; and that they produce only two commodities:  Guns and Roses.  To produce 1 box of guns, the Netherlands uses 10 labor hours and Brazil uses 12 labor hours.  To produce 1 ton of roses, the Netherlands needs 22 labor hours, while Brazil needs 42 labor hours.

 

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

 

b)  Before trade takes place, (1) What is the price of one ton of roses in the Netherlands?  (2) What is the price of one ton of roses in Brazil?  (3) Where are roses cheaper?

 

c)  Assume that after trade opens up, one ton of roses is traded for 2.5 boxes of guns.  Prove that if workers in both countries want to consume 8 tons of roses and 5 boxes of guns, 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 March 22, 2005 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 first quarter of 2005.

 

b)  What action did the FOMC decided to take during the March 22, 2005 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?

 

 

5.  Visit the Federal Reserve Bank of St. Louis’ FRED web site (http://research.stlouisfed.org/fred2/).  Click on “Gross Domestic Product and Components” and then on “GDP/GNP.”

 

a)  Click on “Real Gross Domestic Product, 1 Decimal” and on “Real Potential Gross Domestic Product.”  Write down the figures for these indicators for every quarter from the first quarter of 1991 until the fourth quarter of 2004.  Use these data to calculate the difference between Potential GDP and Actual GDP for every quarter form 1991 until 2004.

 

b)  Use the information found for part a) to answer the following questions:  What direction should U.S. Fiscal and Monetary policies have today?  Should they be expansionary?  Should they be contractionary?  Explain.