This problem set is due Tuesday, December 8, 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 Banco de Portugal (the Portuguese Central Bank) decides to increase the money supply in Portugal. In order to do that, it buys 400 E million (E = Portuguese Escudos) worth of Portuguese government bonds. You are also told that as a result of this action, consumers decide to increase their cash holdings by 90 E million.

a) If the required reserve ratio equals 8%, how much would the Portuguese money supply increase as a result of the Banco de Portugal action?

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

• Each 1,982.5 E million increase in the money supply reduces the rate of interest by 1 percentage point.
• Each 1 percentage point decline in interest rates stimulates 75 E million of new consumption spending.
• Each 1 percentage point decline in interest rates stimulates 200 E million of new investment spending.
• Each 1 percentage point decline in interest rates produces a depreciation of 3 percentage points in the value of the Portuguese Escudo.
• Each 1 percentage point depreciation in the value of the Portuguese Escudo increases net exports by 20 E million.
• The MPC = 0.85 and the MPM = 0.1.
• The economy is producing under potential output.

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: Fugazi and Orbital; and that they produce only two commodities: Matchboxes and Ginger. To produce one matchbox, Fugazi uses 1 labor hour and Orbital uses 0.5 labor hours. To produce 1 ton of ginger, Fugazi needs 20 labor hours, while Orbital needs 16 labor hours.

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

b) Before trade takes place, (1) What is the price of one ton of ginger in Fugazi? (2) What is the price of one ton of ginger in Orbital? (3) Where is ginger cheaper?

c) Assume that after trade opens up, one ton of ginger is traded for 25 matchboxes. Prove that if workers in both countries want to consume 2 matchboxes and 4 tons of ginger, both of them would benefit from free trade.

4. Visit the Federal Reserve Board of Governors web site (http://www.bog.frb.fed.us/). Review the minutes from the September 29, 1998 meeting of the Federal Open Market Committee.

a) Based on the information available in those minutes, write a short summary describing the state of the U.S. economy during the third quarter of 1998.

b) What action did the FOMC decided to take during the September 29, 1998 meeting? Why did the FOMC take that action?

c) What action did the FOMC decided to take during the October 15, 1998 conference call? Why did the FOMC take that action?