TEXTBOOK SOLUTIONS FOR Macroeconomics 5th Edition Assume that there are no surpr
ID: 1225600 • Letter: T
Question
TEXTBOOK SOLUTIONS FOR Macroeconomics 5th Edition
Assume that there are no surprises, with all economic agents and the central bank having full information about shocks that are hitting the economy. Suppose that the central bank adopts a nominal GDP target, and interpret this in the model as a goal of maintaining some constant level of nominal GDP.
(a) Suppose that there is an increase in total factor productivity. What should the central bank do in response, given its goal? What are the effects on aggregate variables? Explain.
(b) Now suppose that there is a positive shift in the money demand function. What should the central bank do? Determine the effects on aggregate variables. Explain.
Explanation / Answer
When central bank targets a certain level of nominal GDP, then it must intervene in the goods market or the money market whenever the nominal GDP fluctuates from its target level. Increase or decrease in price level, productivity, cost of production all tend to affect the nominal GDP
a) An increase in TFP will improve the nation’s ability to grow and produce more output with given resources. This implies that Long run Aggregate Supply Curve will shift outwards permanently. Such a shift will increase real GDP and because there is no change in the price level in the short run, this will increase nominal GDP as nominal GDP = P * Y where P is price level and Y is real output. Higher Y with stable P implies higher PY or nominal GDP
Central bank must intervene and do something to reduce nominal GDP. If it does not intervene, then the economy will self-correct itself by reducing the price level and expanding the aggregate demand downwards so that nominal GDP remains unchanged but a new real GDP will establish.
However, due to its short run target value of nominal GDP, it must reduce it. Hence, central bank reduces money supply in order to depress domestic spending. This will reduce the price level, before the long-run and therefore, nominal GDP is restored.
b) In case of a rise in the domestic money demand, money demand curve shifts to the right and with fixed money supply, interest rate in domestic market rises. Higher interest rate leads to currency appreciation, trade deficits, lower investment spending, and ultimately leftward shift of the aggregate demand AD. This implies a lower value of nominal GDP.
To resurrect the economy, an expansionary monetary policy must be adopted. This will increase the aggregate demand and shifts AD to the right. This brings nominal GDP to the targeted level.
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