Problem Set # 3

This problem set is due Tuesday, December 5, 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 Federal Government of the United States has a large budget deficit. Because of this, people there are getting increasingly nervous about the possible long-run consequences of this deficit. However, the government is afraid of doing anything because it does not want output in the economy to fall under potential output and/or inflation to increase. Suggest a mix of fiscal and monetary policies that could reduce the budget deficit and maintain the same level of real GDP and inflation.

2. The Banque de France (the French Central Bank) decides to increase the money supply in France. In order to do that, it buys 100 FF million (FF = French Francs -France's currency-) worth of French government bonds. You are also told that as a result of this action, consumers decide to increase their cash holdings by 20 FF million.

a) If the required reserve ratio equals 20%, how much would the French money supply increase as a result of the Banque de France action?

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

* Each 120 FF million increase in the money supply reduces the rate of interest by 1 percentage point.

* Each 1 percentage point decline in interest rates stimulates 30 FF million of new consumption spending.

* Each 1 percentage point decline in interest rates stimulates 50 FF million of new investment spending.

* Each 1 percentage point decline in interest rates produces a depreciation of 2 percentage points in the value of the French Franc.

* Each 1 percentage point depreciation in the value of the French Franc increases net exports by 10 FF million.

* The MPC = 0.9 and the MPM = 0.3.

* The economy is producing under potential output.

3. Assume that the Federal Government wants to increase national output. With that purpose in mind, the Federal Government reduces taxes.

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.

4. Assume that there are only two countries in the world: S. Korea and Taiwan; and that they produce only two commodities: Pearls and Jam. To produce 1 pearl, S. Korea uses 3 labor hours and Taiwan uses 5 labor hours. To produce 1 ton of jam, S. Korea needs 10 labor hours, while Taiwan needs 12 labor hours.

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

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

c) Assume that after trade opens up, one ton of jam is traded for 3 pearls. Prove that if workers in both countries want to consume 10 pearls and 1 ton of jam, both of them would benefit from free trade.