1. Fiscal policy in the Keynesian cross model Consider an economy described by t

Question

1. Fiscal policy in the Keynesian cross model Consider an economy described by the following behavioral equations:

C = C0 +C1  (Y-T)

I =bo +b1 Y

T = t1 Y

Government spending and investment are exogenous; Yd refers to disposable income; and 0 < C1 < 1, c1 + b1 < 1, and 0 < t1 < 1.

a. What is the expression for equilibrium income?

b. What is the government spending multiplier in this economy? Explain (intuitively) why the multiplier is greater than one.

c. Consider a change in government spending. Calculate the effect of a one-dollar increase in government spending on the government budget. [Hint: the government budget is the relationship between taxes and government spending, specifically T G. So, you want to know how much taxes change when government spending changes by $1, and compare this to the $1 change in G. Notice that taxes change when output changes!].

2. Bond prices and interest rates

Consider a bond that promises to pay $100 in one year.

a. What is the equilibrium interest rate on the bond if its price today is $75? $85?

b. Explain why there is an inverse relationship between bond prices and interest rates. (Explain the economic logic, not only the mechanics of the formula).

c. If the interest rate is 8%, what is the price of the bond today?

3: Monetary policy and open market operations. Suppose that money demand is given by: Md = $Y (0.25 i ) Where $Y is $100. Also suppose the supply of money is $20.

a. What is the equilibrium interest rate?

b. If the Federal Reserve wants to increase i by 10 percentage points, at what level should it set the money supply?

c. Show graphically how a change in the money supply leads to an increase in the interest rate.

d. A liquidity trap: i. What is the demand for money when interest rates are zero? ii. Define a liquidity trap.

Explanation / Answer

Ans 2)

Ans Part a)

If the Price of Bond today is $75 then interest rate would be

75=100/(1+r)

r=100/75-1=33.33%

If Price of Bond is $85 then r is

85=100/(1+r)

r=100/85-1=17.64%

Ans B)

Interest rate is an opportunity cost paid to the lender by borrower that means if price of bond moves below the par value it increases the opportunity cost and vice versa

Price of the bond today is the discounted sum of future cash flows hence we multiply cash flows with discount factors as Interest rate increases discount factor decreases which will decrease the Sum of PV of future cash flow

Ans C)

Price of the bond today=100/1.08=$92.59

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