Fernanda Matos De Oliveira
Welcome to Macroeconomics in Middle Earth!
Part 2*
Section 9
Treebeard runs the MENB (Middle Earth National Bank)
with “branches” all over the Shire. Merry Brandybuck
makes a deposit in the Shire’s MENB of $100 from the loot
he brought back from his travels in Wilderland.
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Fernanda Matos De Oliveira
'One felt as if there was an enormous well behind them,
filled up with ages of memory and long, slow steady
thinking; but their surface was sparkling with the
present: like sun shimmering on the outer leaves of a
vast tree, or on the ripples of a very deep lake. I don't
know, but it felt as if something that grew in the ground
-- asleep, you might say, or just feeling itself as
something between root-tip and leaf-tip, between deep
earth and sky -- had suddenly waked up, and was
considering you with the same slow care that it had
given to its own inside affairs for endless years.'
a)
If the reserve rate is set at 15%, how much of Merry’s deposit must the bank keep? How
much can the bank loan out to Pippin Took?
The bank must keep=15%×100=$15
Loan (excess reserves)=$100-(100×0.15)=$85
b) What would be the maximum change to the money supply from a)? Where does the change
come from and by what formula? Show reserve and loan amounts for the first 6 levels.
Maximum change to money supply=(1/0.15)×85=$566.67. The change comes from the excess
reserves.
YOU DON’T SUBTRACT OUT THE INITIAL DEPOSIT HERE—IT IS NEW TO M1 FROM OUT
OF THE COUNTRY. ALSO NEED TABLE SHOWING FIRST SIX LEVELS IN BANKING
SYSTEM
c)
Suppose Bilbo took $500 out of an old box he had buried at Bag End (Bilbo’s house in the
shire) and put it in MENB. What would be the maximum change to the money supply if the
reserve rate was now 20%?
RR=0.2
Total Reserves=$500
Excess reserves=$500-(0.2×500)=$400
Maximum change to money supply=(1/0.2)×400=$2000
d) What two assumptions are included in calculating the maximum change in the money supply
in a)? Explain the difference between a) and c).
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Assumptions
 Banks hold NO excess reserves
 Individuals DON’T hold money
We would expect the maximum change to money supply to be higher in c than in a because of a
higher reserve rate in c. Although the reserve rate is higher in b, the total reserves are high
enough to make the maximum change to money supply to be the highest.
THE MAIN DIFFERENCE IS A IS NEW TO MONEY SUPPLY, C IS NOT
'Of course we understand,' said Merry firmly.
'That is why we have decided to come. We know
the Ring is no laughing matter; but we are going
to do our best to help you against the Enemy.'
Section 10
The Federal Council of Elrond (Fed) controls the banking system in Middle Earth. The Council
is responsible for controlling the money supply and implementing monetary policy.
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a) The Council wishes to expand the money
supply. Describe precisely how this would
work through open market operations and
effects on reserves. NOTHING ELSE
The council can use open market operations to
expand money supply. What the economy
basically needs is for monetary policy to ease its
current policy stance. The council needs to
purchase bonds and securities from the people
on behalf of the government. By purchasing
bonds and securities, money will be ploughed
back to individuals. In addition, the council needs
to lower the reserve requirements to increase
the supply of money. This will mean that banks
will be required to keep less in required
reserves, thereby increasing the excess
reserves given out as loans. LOOK AT THE
HANDOUT 17 WHERE IT TALKS ABOUT
WHAT HAPPENS TO RESERVES WITH AN OM
PURCHASE.
b) The Council wishes to decrease the money
supply. Describe precisely how this would
work through the required reserve ratio and
effects on reserves.
If the council wishes to decrease money supply
following an increase in inflation, it can choose
to increase the required reserve ration. By doing
this, required reserves will increase, and hence
there will be less excess reserves. Bank will be
compelled to reduce the proportion of loans they
give to individuals and firms. The economy will
experience a decrease in money supply.
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c) The Council wishes to decrease
the money supply. Describe
precisely how this would work
through the discount rate and
effects on reserves.
If the council wishes to decrease
money supply through the discount
rate, it can achieve so by increasing
the discount rate. This will mean
that financial institutions will have
to pay more in terms of interests
for the money they borrow from the
central bank. They will pass on this
effect to individuals and firms by
increasing their interest rates. In
terms of reserves, the council
should increase the reserves so that
banks have less to give out in terms
of loans. Overall, these policies will
make the money supply to reduce.
LOOK AT THE HANDOUT 17
WHERE IT TALKS ABOUT WHAT
HAPPENS TO RESERVES WITH
HIGHER DISCOUNT RATE
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Fernanda Matos De Oliveira
If the money supply in Middle Earth is
$10,000, velocity of money is a constant 3,
the price level is 2.0, and output is
constant at 15,000,
d) What is aggregate demand? What is
nominal GDP? How did you get your
answer?
Aggregate demand is the same as the
output, which 15,000
Nominal GDP=Money supply×Velocity
Nominal GDP=10,000×3
Nominal GDP=$30,000
or
Nominal GDP=Real output×Price level
Nominal GDP=15,000×2
Nominal GDP=$30,000
e) The Council increases the money supply by $1,000. What is the net effect of the increase in
the money supply in this case? Graph the impact on the Middle Earth economy with a
constant level of real GDP and velocity (simple AD/AS model). Use actual numbers.
I DID THIS IN CLASS. THERE IS NO SRAS ONLY 1 VERTICAL AS CURVE AT 15,OOO.
REST IS OK.
When the money supply is increased, the Aggregate Demand curve shifts to the right from AD
to AD1. However, this increase in aggregate demand is offset by a decrease in supply, which
causes the short run aggregate supply curve to shift leftwards from SRAS to SRAS1. Although
real GDP remains constant, the price level increases from 2 to 2.2.
LRAS
Price
SRAS1
2.2
SRAS
2
AD1
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Fernanda Matos De Oliveira
AD
$15,000
Real GDP (Output)
f) Explain exactly and draw how the change in e) affects the money market in the short run.
What are the dynamics that make the nominal interest rate adjust in the long run? (don’t
use numbers—answer in general terms)
MS
MS1
Nominal
interest
rate
MD
Money Quantity
An increase in money supply causes a rightward shift of the money supply curve from MS to
MS1. As a result the quantity of money will increase. Nominal interest rates adjust in the longterm due to changes in the expected inflation. YOU DON’T SHOW INTEREST RATES
MOVING ON YOUR GRAPH. ALSO, YOU HAVE TO INCLUDE THE BOND MARKET
DYNAMICS. LOOK IN HANDOUT 17
g) Now suppose that the Council implements a technological innovation with ATM’s in Middle
Earth. Graph the change in the money market and explain how the change comes about.
(don’t use numbers—answer in general terms)
MS
Nominal
interest
rate
MD
MD1
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Fernanda Matos De Oliveira
Money Quantity
A technological innovation with ATM’s is likely to shift money demand to the left. This is
because use of Automatic Teller Machines would allow individuals in Middle Earth to hold
less cash.
YOU DON’T SHOW INTEREST RATES MOVING ON YOUR GRAPH. ALSO, YOU HAVE TO
INCLUDE THE BOND MARKET DYNAMICS. LOOK IN HANDOUT 17
Section 11
Bilbo Baggins loved to have parties and give
gifts. Since he came back from his adventures
with Thorin Oakenshield and the dwarves with
lots of gold, he could afford to import magical
toys and other special presents from the
foreign country of Dale where they are made.
The Shire (where Bilbo lives) and Dale have
different currencies.
a) Draw the foreign exchange market for the Shire dollar. Be sure to show the equilibrium
exchange rate and quantity traded.
Exchange
rate
S
Equilibrium
exchange
rate
D
Equilibrium Q
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Quantity
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Fernanda Matos De Oliveira
b) Real income in the Shire increases. Draw what
happens in the exchange rate market. What
happens to the exchange rate and quantity
traded? (Remember both sides of market can be
affected)
If real income in the Shire increases, domestic prices are likely to increase, thereby increasing
the interest rates. This will mean that the shire dollar will depreciate. The quantity traded will
increase, thereby increasing the net exports.
IF REAL INCOME INCREASES, BUY MORE FROM OTHER COUNTRIES. NEED MORE
FOREIGN CURRENCY SO BRING MORE DOLLARS TO MARKET AND INCREASE SUPPLY
(NOT DEMAND)
S
Exchange
rate
D2
D1
Q
c) The Shire’s interest rates fall compared to the rest of the world. Draw what happens in
the exchange rate market. What happens to the exchange rate and quantity traded?
(Remember both sides of market can be affected)
A decrease in Shire’s interest rates will mean that it would
be more attractive for Shire’s citizens to invest outside
because of the relatively higher interest rates in foreign
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countries. As a result, the
Shire dollar will depreciate
relative to foreign currency.
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Fernanda Matos De Oliveira
Foreign goods will be expensive to buy, thereby increasing
the quantity traded and consequently, the net exports.
BOTH SIDES ARE AFFECTED. FOREIGN INVESTORS
WILL BUY LESS SHIRE ASSETS SO DEMAND FOR
CURRENCY DECREASES. ALSO AS SHIRE INVEST MORE
IN FOREIGN, NEED MORE FOREIGN CURRENCY AND
BRING MORE DOLLARS SO SUPPLY INCREASES.
d) The exchange rate for the
Shire dollar is expected to
rise in the future. Draw
what happens in the
exchange rate market.
What happens to the
exchange rate and quantity
traded? (Remember both
sides of market can be
affected)
S
Exchange
rate
D2
D1
Q
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Fernanda Matos De Oliveira
If the exchange rate is expected to rise in the future, domestic firms know too well that they
will benefit because domestic currency will depreciate relative to the foreign currency. So if
they expect the exchange rate to rise in the future, they will tend to defer their investments
until that time. As a result, the Shire dollar will appreciate relative to the foreign currency.
Imports will be cheap, thereby reducing net exports. Overall, the quantity traded will reduce.
SPECULATORS WILL BUY THE SHIRE CURRENCY NOW SO THEY CAN SELL LATER AT A
HIGHER PRICE. DEMAND INCREASES. AT SAME TIME, IF SHIRE’S IS EXPECTED TO GO
UP, OTHER CURRENCY IS EXPECTED TO GO DOWN. SHIRE WON’T BE BUYING FOREIGN
CURRENCY NOW (WILL BE CHEAPER IN FUTURE) SO FEWER DOLLARS BROUGHT TO
MARKET AND SUPPLY DECREASES.
S
Exchange
rate
D1
D2
Q
Section 12
Denethor, son of Echthelion II, is Steward of Gondor in the absence of the rightful king.
He is a firm believer in Say’s Law and the laissez-faire approach to the economy of Gondor.
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He is not as other men of this time, Pippin, and whatever be his
descent from father to son, by some chance the blood of
Westernesse runs nearly true in him; as it does in his other
son, Faramir, and yet did not in Boromir whom he loved best.
He has long sight. He can perceive, if he bends his will thither,
much of what is passing in the minds of men, even of those
that dwell far of. It is difficult to deceive him, and dangerous
to try.
a) Draw aggregate demand, aggregate short run
supply and aggregate long run supply for Gondor’s
economy in long run equilibrium. What is the
unemployment level?
Price
SRAS
AD
Un
Output
Un is the natural rate of
unemployment. NEED PRICE
LABELS, NOT LABEL Un BUT
SHOULD BE Qn. NEED LRAS
LABEL
b) Consumers in Minas Tirith believe there will be an acute shortage developing in
the supply of rings and anticipate higher future price levels in the economy. Draw
and explain what happens to aggregate demand in the Gondorian economy in the
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Fernanda Matos De Oliveira
short run. Identify any change in determinant(s) and explain why and how the
change occurs. What happens to the price level, unemployment and real GDP in
the short run? Is there an inflationary or recessionary gap?
If consumers expect that there will be a shortage of rings and higher price levels
in the economy, we can expect that they will spend more now due to the prevailing
lower prices. As a result, aggregate demand will increase in the short run. In
particular, the component of aggregate demand that will be influenced by this
change is consumption by households. Individuals will increase their consumption
of rings now. If aggregate demand increases, the price level will also increase.
Also, unemployment will tend to decrease, while real GDP will increase. The
economy will face an inflationary gap.
LOOK IN HANDOUT 21 FOR CORRECT GRAPH FOR INFLATIONARY GAP.
Price
LRAS
SRAS
AD1
Un
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AD
Output
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c) Draw and explain what happens to the
Gondorian economy in the long run as a
result of b). What happens to the price
level, unemployment and real GDP in the
long run? Include all the dynamics in
your explanation and graph.
In the long-run, however, the increase in aggregate demand will
be offset by a decrease in aggregate supply. Therefore, as the
aggregate demand curve shifts to the right, the short run
aggregate supply curve will shift leftwards from SRAS1 to
SRAS2. This shift will occur because workers will revise their
price expectations and demand more wages. This will increase
the cost of production for firms, hence shifting the short run
supply curve to the left. While the price level will increase,
unemployment and real GDP will remain unchanged.
LOOK IN HANDOUT FOR PROPER LABELS AND MOVEMENTS
OF U AND Q. NEED PRICE LABELS
SRAS2
LRAS
Price
SRAS1
AD1
AD
Un
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Output
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Fernanda Matos De Oliveira
d) The Gondorian dollar appreciates. Draw and explain what
happens to aggregate demand in the Gondorian economy
in the short run. Identify any change in determinant(s)
and explain why and how the change occurs. What
happens to the price level, unemployment and real GDP in
the short run? Is there an inflationary or recessionary
gap?
e)
If the Gondorian dollar appreciates, it will be cheaper to
purchase foreign goods AND MORE EXPENSIVE TO BUY
GONDOR GOODS.. EXPORTS DECREASE IMPORTS INCREASE,
This will mean that net exports will reduce, thereby leading to a
decrease in aggregate demand. The aggregate demand curve will
shift leftwards from AD to AD1. As a result, the price level will
reduce, while unemployment will increase. Real GDP will reduce.
The economy will experience a recessionary gap.
LOOK IN HANDOUT FOR LABELS AND NOTATIONS.
Price
SRAS
AD
AD1
Output
Un
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Fernanda Matos De Oliveira
f) Draw and explain what happens to the Gondorian
economy in the long run as a result of d). What
happens to the price level, unemployment and real
GDP in the long run? Include all the dynamics in
your explanation and graph.
In the long-run, as the AD curve shifts to the
left, the short-run aggregate supply curve will
shift to the right from SRAS to SRAS1. The
price level will reduce, while unemployment and
real GDP will remain unchanged. This is because
the decrease in demand will be offset by an
increase in supply.
LOOK IN HANDOUT FOR PROPER LABELS AND
DYNAMICS NOTATIONS.
SRAS
LRAS
Price
SRAS1
AD
AD1
Output
Un
g) A new discovery of mithril (a valuable metal
resource) is located in the White Mountains of
Gondor. Draw and explain what happens to the
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kingdom’s economy.
What happens to the
price level and real
GDP in the long run?
Following a new discovery
of mithril, aggregate
demand is likely to
increase, thereby causing
the aggregate demand
curve to shift to the
right. Aggregate demand
will increase the new
resource will increase
productive capacity. In
the long-run, price level
will increase, while real
GDP will remain
unchanged.
THIS MOVES PPF SO WILL
MOVE LRAS AND
SRAS. SEE HANDOUT
SRAS2
Price
LRAS
SRAS1
AD1
AD
Un
Page 16 of 46
OutputThe Dwarves delved deep at that time, seeking beneath
Barazinbar for mithril, the metal beyond price that was
becoming yearly ever harder to win.
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Section 13
The (returned) king, Aragorn the King Elessar, is a Keynesian advocate, as is his chief Steward,
Faramir, younger son of Denethor.
Then Frodo came forward and took the crown from
Faramir and bore it to Gandalf; and Aragorn knelt, and
Gandalf set the White Crown upon his head, and said:
'Now come the days of the King, and may they be
blessed while the thrones of the Valar endure!'
a) Draw the total expenditures and total production model for the Gondor economy. Show the
equilibrium level of real GDP being produced. What are the slopes of the TE and TP curves?
The TE and TP curves have a negative slope. THEY SLOPE UP TO RIGHT SO CERTAINLY NOT
NEGATIVE. LOOK IN HANDOUT 22 FOR ALL LABELS FOR GRAPH AND LABLES FOR SLOPE.
TP
and
TE
TP=Real
GDP
TE=G+C+I
E
Real GDP
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b) Draw the Gondor economy in a recessionary gap, using the Keynesian total expenditures and
total production model. What can you say about unemployment and real GDP?
During a recessionary gap, unemployment is high, while real GDP is low. In other words, real
GDP is lower than the equilibrium GDP. LOOK IN HANDOUT. YOUR QN IS WRONG SIDE.
ALSO NEED UNEMPLOYMENT ON GRAPH RELATIVE TO Un
TP
and
TE
TP=Real
GDP
TE=G+C+I
E
Q1
Qe
Real GDP
c) Draw the Gondor economy in an inflationary gap, using the Keynesian total expenditures and
total production model. What can you say about unemployment and real GDP?
TP
and
TE
TP=Real
GDP
TE=G+C+I
E
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Qe
Q1
During an inflationary gap, unemployment isReal
low,GDP
while real GDP is high
LOOK IN HANDOUT. YOUR QN IS WRONG SIDE. ALSO NEED UNEMPLOYMENT ON
GRAPH RELATIVE TO Un
The King has set the income tax rate at 20% for Gondorian citizens.
Faramir has provided the following information
to King Elessar:
Personal Income
$1375
$1625
$1875
$2125
$2375
Personal
Income
$1,375
$1,625
$1,875
$2,125
$2,375
Consumption
$1,000
$1,120
$1,240
$1,360
$1,480
Consumption
$1000
$1120
$1240
$1360
$1480
Δ Personal
Income
Δ Consumption
$250
$250
$250
$250
$120
$120
$120
$120
Savings
$375
$505
$635
$765
$895
Δ Savings
$130
$130
$130
$130
d) What are the marginal propensity to consume (MPC) and the marginal propensity to save
(MPS) in Gondor?
MPC= ΔConsumption/ΔPersonal Income DISPOSABLE INCOME
MPC=120/250
MPC=0.48
MPS= ΔSavings/ΔPersonal Income DISPOSABLE INCOME OR 1-MPC
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MPS=130/250
MPS=0.52
e) What is the Gondorian economy’s multiplier?
Multiplier=1/(1-mpc)
Multiplier=1/(1-0.48)
Multiplier=1/0.52
Multiplier=1.923
We are truth-speakers, we men of Gondor. We boast seldom, and then perform, or die in the
attempt. Not if I found it on the highway would I take it, I said. Even if I were such a man as to
desire this thing, and even though I knew not clearly what this thing was when I spoke, still I
should take those words as a vow, and be held by them.
f) The economy of Gondor is in an inflationary gap of
$1,000. What type of fiscal policy can King Elessar
undertake to bring the economy to back to the
natural unemployment rate? By what method? Graph
using the total expenditures and total production
model and explain how the policy would work. Be
numerically precise, using the information in d) and
e). Include unemployment.
King Elassar should conduct contractionary fiscal policy.
He can achieve this by increasing taxation and reducing
government expenditures. This will shift the total
expenditure curve to the left until it reaches a point
where it intersects the total production curve. Since
the multiplier is 1.923, this means that to close the
inflationary gap, the King should reduce government
expenditures by (1000/1.923), which is $520.02. HAVE
TO REDO NUMBERS
TP
TP
and
TE
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Qe
TE1
TE
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Q1
Fernanda Matos De Oliveira
Eventually, unemployment will increase and output will move back to its full potential level.
g) The economy of Gondor is in a recessionary gap of $500. Faramir suggests a different type
and method of fiscal policy to King Elessar. Graph using the total expenditures and total
production model and explain how the policy would work. Be numerically precise, using the
information in d) and e). Include unemployment.
To close the recessionary gap, the fiscal policy undertake is expansionary. The King can either
increase government expenditures or reduce taxes. Since the multiplier is 1.923, this means
that the King can close the gap by increasing government expenditures by (500/1.923), which is
$260.01. HAVE TO REDO NUMBERS. This policy will make the TE curve to shift rightwards
from TE to TE1. Eventually, unemployment will reduce and output will move back to its full
potential level.
TP
TP
and
TE
TE1
Q1
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TE
Qe
Real GDP
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h) Draw and explain the effect of a change in the price level, using the TE/TP model and the
AD/AS model in combination.
LOOK AT HANDOUT 23 PAGE 5 BOTTOM 2 GRAPHS.
TP
and
TE
TP
Price
level
TE/SRAS
TE1/SRAS1
AD
AD1
Qe
Real GDP
In our case, we consider the effect of a price increase. If the price level increases, the AD
curve is likely to shift to the left. At the same time, the TE curve is also likely to shift to the
left. The former would occur because high prices would scare of consumers. For the latter,
high prices would reduce total expenditures, thereby shifting the TE curve to the left.
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Section 14
Gandalf wishes the economy of Middle Earth to operate smoothly after he sails from the Grey
Havens to the never-ending lands in the West. He gathers King Elessar of Gondor, King Eomer
of Rohan, Thain Pippin Took of the Shire, King Thorin III Stonehelm of the Lonely Mountain,
King Bard II of Dale, King Thranduil of Mirkwood, Gimli son of Gloin of Aglarond, Prince
Faramir of Ithilien, Prince Imrahil of Dol Amroth, Treebeard of Fangorn Forest and other
councilors and leaders of the various countries of Middle Earth to instruct them on fiscal
policies designed to smooth out the business cycle.
Even as the first shadows were felt in Mirkwood there
appeared in the west of Middle-earth the Istari, whom
Men called the Wizards....[A]terwards it was said among
the Elves that they were messengers sent by the Lords of
the West to contest the power of Sauron, if he should
rise again, and to move Elves and Men and all living things
of good will to valiant deeds. In the likeness of Men they
appeared, old but vigorous, and they changed little with
the years, and aged but slowly, though great cares lay on
them; great wisdom they had, and many powers of mind
and hand.
a) Describe a budget deficit, a budget surplus and a balanced budget. Include relationship of
tax revenues and government spending. What impact will each have on the market for
loanable funds?
A budget deficit occurs when total expenditures exceed total revenues. A budget surplus,
on the other hand, describes a situation where total revenues exceed total expenditures.
Finally, a balanced budget is one where total expenditures are equal to total revenues. A
budget deficit would imply that an economy would not be in a position to pay off its debts in
case it is given a loan. A budget supply, on the other hand, would increase the probability of
a country receiving loans.
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Fernanda Matos De Oliveira
b) Describe and graph how an income tax affects potential
GDP and aggregate supply. Indicate the income tax
wedge. (2 graphs) How do taxes on expenditures affect
the income tax wedge?
AS1
Price
AS
D
GDP
Income
Tax wedge
AS1
AS
D
GDP
An increase in income tax reduces GDP and aggregate supply.
This is because an income tax translates to reduced
expenditures, which reduces aggregate supply and GDP.
Taxes on expenditures, on the other hand, reduce the
income tax wedge
Page 24 of 46
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Fernanda Matos De Oliveira
c) Draw the Laffer curve. Show where the maximum tax
revenues would be. From this point does an increase in
tax rates increase or decrease tax revenues?
Tax
Rate
Maximum tax revenues
Tax Revenue
Page 25 of 46
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Fernanda Matos De Oliveira
From the maximum tax revenues point, any further increase in the tax rates reduces the
tax revenues.
d) Describe the three multipliers for government fiscal policy and describe the differences in
size of impact. How does each affect the economy?
The three fiscal multipliers are impact multiplier, peak multiplier and cumulative multiplier. The
peak multiplier has the greatest impact, followed by the cumulative multiplier, then the impact
multiplier. Each affects the economy depending on time frame.
Q1
Qe
The two fiscal actions that the
government can undertake to close
the recessionary gap are;
i) reduction of taxes
ii)
increase of government
expenditures.
e) Draw expansionary fiscal policy
that is applied when the economy
is in a recessionary gap using the
AD/AS model. What are the two
fiscal actions that the government
could take to implement this
policy?
Price
AS
AD1
AD
Page 26 of 46
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questions—it’s there just for Tolkien fun. Go forth and read!!!
GDP
Fernanda Matos De Oliveira
f) Draw contractionary fiscal policy that is applied when the economy is in an inflationary gap
using the AD/ AS model? What are the two fiscal actions that the government could take
to implement this policy?
Price
AS
AD
AD1
Qe
Q1
GDP
The two fiscal actions that the government can undertake to close the inflationary gap are;
Increase of taxes
Decrease of government expenditures.
g) List and briefly describe the five lags that cause problems in implementing fiscal policy.
1. Data lags-relate to changes that policy makers are not cognizant of.
2. Wait-and-see lags-Relate to the tendency of policy makers to relax even when they have
identified a problem in the economy
3. Legislative lags-relate to legal procedures that must be followed once a policy has been
proposed.
4. Transmission lags-relate to the time a policy takes before in is effected.
5. Effectiveness lags-relate to the time a policy prescription takes before actual effect is
felt on the economy.
Page 27 of 46
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questions—it’s there just for Tolkien fun. Go forth and read!!!
Fernanda Matos De Oliveira
Page 28 of 46
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*Quotes from The Lord of the Rings, or The Hobbit by JRR Tolkien. Nothing written in italics applies to the
questions—it’s there just for Tolkien fun. Go forth and read!!!
Fernanda Matos De Oliveira
Section 15
Thorin III Stonehelm, son of Dain, became King of the Lonely Mountain after his father’s fall
in the War of the Ring. The dwarves of his kingdom were busy and prosperous producing the
weapons, armor and jewelry for which they were famous and which the inhabitants of Middle
Earth were demanding now that there was peace. But Thorin III Stonehelm began to notice
that prices were rising in his kingdom and he went to consult with King Bard II of Dale (son of
Brand) to see why this was happening.
The lands opened wide about him, filled with the waters
of the river which broke up and wandered in a hundred
winding courses, or halted in marshes and pools dotted
with isles on every side; but still a strong water flowed on
steadily through the mist. And far away, its dark head in a
torn cloud, there loomed the Mountain! Its nearest
neighbours to the North-East and the tumbled land that
joined it to them could not be seen. All alone it rose and
looked across the marshes to the forest. The Lonely
Mountain!
a) Draw (in the AD/AS model) and explain what happens to aggregate demand in the short
run. What happens to the price level, unemployment and real GDP in the short run? Is
there an inflationary or recessionary gap?
In the short-run, the aggregate demand increases, thereby causes a rightward shift of the
demand curve from AD to AD1. At the same time, the price level increases, while the
unemployment level decreases. Real GDP increases. The economy is facing an inflationary gap.
Page 29 of 46
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questions—it’s there just for Tolkien fun. Go forth and read!!!
Fernanda Matos De Oliveira
Price
LRAS
SRAS
p1
pe
AD1
AD
Qe
Page 30 of 46
Q1
Real GDP
1/30/13
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questions—it’s there just for Tolkien fun. Go forth and read!!!
Fernanda Matos De Oliveira
b) Draw (in the AD/AS model) and explain what happens to the Lonely Mountain economy on
its own in the long run as a result of a) if no policy response occurs. What happens to the
price level, unemployment and real GDP in the long run? Include all the dynamics. Is this
inflation? Explain why or why not. If so, what is it called?
In the long-run, the increase in aggregated demand will be offset by a decrease in aggregate
supply. As the aggregate demand curve shifts to the right, the aggregate supply curve will
shift to the left. This shift in the supply curve to the left will occur because laborers will
demand higher wages upon realizing that prices have increased, yet their incomes have not
increased. This will be costly to firms since they will incur higher business costs. This will
result in a decrease in supply. Also, in the long-run, the price level will increase, while
unemployment and real GDP will remain constant. The economy faces inflation because the
price level increases considerably.
Price
LRAS
SRAS1
SRAS
AD1
AD
Qe
Page 31 of 46
Real GDP
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Fernanda Matos De Oliveira
c) Draw (in the AD/AS model) and explain what happens to the
Lonely Mountain economy in the long run as a result of a) if
the Council (Fed) immediately applies monetary policy and
contracts the money supply rather than wait for the economy
to self-correct like in b). What happens to the price level,
unemployment and real GDP in the long run? What is the final
difference in the result of the monetary policy and the
results in b)?
If the Fed applies contractionary monetary policy, the AD
curve will shift to the left. This will cause a decrease in the
price level. At the same time, unemployment will increase,
while real GDP will reduce. The difference that occurs when
the council chooses to let the economy to self-correct itself
and when it chooses to apply contractionary monetary policy
is that in the former, unemployment and real GDP will remain
unchanged, while in the latter, these will change.
h)
Price
SRAS
AD
AD1
Qe Q1
Output
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Fernanda Matos De Oliveira
d) The Federal Council of Elrond (Fed) gets on a roll and increases the money supply each
year for 3 years. Draw (in the AD/AS model) and explain the long-run effect of these
increases on the economy of the Lonely Mountain. What happens to the price level,
unemployment and real GDP in the short run and in the long run? What is the end result
of these continued increases? Is there inflation? Explain why or why not. If so, what is it
called?
In the long-run, a continued increase of money supply will be counterproductive because it
will not be met by a proportionate increase in production. The price level is likely to increase
significantly, both in the short-run and the long-run. Unemployment is likely to increase in
the short-run, but will tend to remain constant in the long-run. As for real GDP, it will reduce
in the short-run, but will remain unchanged in the long-run. As a result of the continued
increase in money supply, the situation experienced is one where a lot of money is chasing
few goods. This results in inflationary tendencies.
Price
LRAS
SRAS
AD1
AD
Qe
Page 33 of 46
Q1
Real GDP
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Fernanda Matos De Oliveira
The economy of the Lonely Mountain is dependent on iron for
its armor and weapon manufacturing. A pack of Orcs fleeing the
destruction before the gates of Barad-Dur make their way to
the Iron Hills where the dwarves mine ore and force battle.
The attack on the Dwarves’ mines causes a temporary supply
shock to the economy of Middle Earth due to the reduction of
raw materials.
e) Draw (in the AD/AS model) and explain the shortrun effect of the supply shock on economy of the
Lonely Mountain. What happens to the price level,
unemployment and real GDP in the short run? Is
there an inflationary or recessionary gap?
A supply shock is likely to cause a left-ward shift of
the demand curve to the left. As a result, the price
level will increase, while unemployment will increase.
Real GDP will reduce. The economy will face a
recessionary gap.
Price
SRAS1
SRAS
LRAS
AD
Page 34 of 46
Q1
Qe
Real GDP
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Fernanda Matos De Oliveira
Draw (in the AD/AS model) and explain what happens to the Lonely Mountain economy on its own
in the long run as a result of e) if no policy response occurs. What happens to the price level,
unemployment and real GDP in the long run? Include all the dynamics. Is there inflation? Explain
why or why not. If so, what is it called?
In the long-run, the decrease in supply will be offset by an increase in demand. Consequently, the
price level will increase, while unemployment and real GDP will remain constant. The situation
witnessed of sluggish economy and high inflation is called stagflation.
Price
LRAS
SRAS1
SRAS
AD1
AD
Q1
Qe
Real GDP
f) Draw (in the AD/AS model) and explain what happens to the Lonely Mountain economy in
the long run as a result of e) if the attacks continually re-occur and the Council (Fed)
applies expansionary monetary policy and increases the money supply one time rather than
Page 35 of 46
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Fernanda Matos De Oliveira
wait for the economy to self-correct like in f). What happens to the price level,
unemployment and real GDP in the long run? Include all the dynamics. Is there inflation?
Explain why or why not. If so, what is it called? What is the final difference in the result
of the monetary policy and the results in f)?
If Fed applies expansionary monetary policy and increases money supply, the price level is
likely to reduce, while unemployment will reduce. Real GDP will increase. The difference
when the council chooses to let the economy to self-correct itself and when it chooses to
apply expansionary monetary policy is that in the former, the economy will face a mildrecession, while in the latter, it will face inflation.
Price
SRAS1
SRAS
AD
Q1
Page 36 of 46
Qe
Real GDP
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*Quotes from The Lord of the Rings, or The Hobbit by JRR Tolkien. Nothing written in italics applies to the
questions—it’s there just for Tolkien fun. Go forth and read!!!
Fernanda Matos De Oliveira
Section 16
After the War of the Rings, Legolas returns to Mirkwood, where his father rules the
Woodland Elves. Due to new ideas gained in his wide travels, Legolas convinces King Thranduil
to implement continuing expansionary monetary and fiscal policy to reduce unemployment in
Mirkwood. (Actually, a reduction in the consumption of barrels of wine would work better.)
There was also a strange Elf,
clad in green and brown, Legolas,
a messenger from his father,
Thranduil, the King of the Elves
of Northern Mirkwood.
a) Draw and explain the short-run Phillips curve for the economy of Mirkwood on which
Legolas is basing his ideas. What is held constant along the short-run Phillips curve?
In the short-run Phillips curve expected inflation and actual inflation are held constant.
Inflation
rate
Short-run Phillips
curve
Unemployment rate
b) Draw the short-run and long-run Phillips curve for the Mirkwood economy. Explain what
happens to the price level and unemployment in the long run?
Page 37 of 46
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In the long-run, the price level increases, while unemployment remains at its natural rate.
This occurs because laborers revise their wages upon realizing that the price level has
increased. Others even choose to renounce their job positions. This combination of some
laborers renouncing their positions and others revising their expectation of inflation
causes wages to increase and consequently, prices. This shift the supply curve to the left,
taking the economy back to its full potential point.
Long-run Phillips
curve
Inflation
rate
Short-run Phillips
curve
Unemployment rate
c) Explain and show by graph the
connection through unemployment
and changes in the price level
between the business cycle as
shown by the AD/AS model and the
long run Phillips curve (show 3
points on the graph).
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Inflation
Rate
3
2
1
U1
Un
Unemployment Rate
Point 1: Shows an increase in
output following a shift of the
aggregate demand curve to the
right.
Point 2: Shows the decrease in
unemployment that is brought
about by an increase in aggregate
demand.
Point 3: Shows how the economy
moves back to its full potential
point when laborers revise their
inflation expectations. This
causes the short-run aggregate
supply curve to shift to the left.
d) Suppose job search time in
Mirkwood suddenly becomes easier.
Draw and explain what happens to
the Phillips curve in Mirkwood.
Page 39 of 46
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Fernanda Matos De Oliveira
Inflation
Rate
2
1
U1
Un
If job search time in Mirkwood
becomes easier, this means that
the economy will move point 1 to
2. That is, the rate of
unemployment will reduce.
Page 40 of 46
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Fernanda Matos De Oliveira
Section 17
Elrond, Chairman of the Council, is a monetarist and believes that prices and wages are flexible
so that the economy is self-regulating. But unlike Denethor, he feels that money is the key to
the economy.
The face of Elrond was ageless, neither
old nor young, though in it was written the
memory of many things both glad and
sorrowful. His hair was dark as the
shadows of twilight, and upon it was set a
circlet of silver; his eyes were grey as a
clear evening, and in them was a light like
the light of stars. Venerable he seemed as
a king crowned with many winters, and yet
hale as a tried warrior in the fulness of
his strength. --
a) What are the monetary policy objectives and goals of the Federal Council of Elrond (Fed)?
What tradeoff does the council face for its goals? Explain.
The main objective of monetary policy is to keep prices stable by changing money supply in
the economy. In doing this, the Fed faces tradeoffs. Because of the tendency of the
economy to self-correct itself following a recession or an inflation period, the Fed faces the
tradeoff of allowing the economy to self-correct itself or implementing policy to correct the
imbalance. Either way, there is a cost of each decision.
b) Graph the implementation of expansionary monetary policy on the economy of Middle Earth
when there is a recessionary gap (in both money market and AD/AS model). What happens
Page 41 of 46
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questions—it’s there just for Tolkien fun. Go forth and read!!!
Fernanda Matos De Oliveira
to the price level, unemployment and real GDP? Specify 3 different actions the Council (Fed)
could do to accomplish this policy.
AS
AD1
AD
Q1
Qe
GDP
Following the implementation of expansionary monetary policy, the price level increases, while
unemployment reduces. Real GDP increases.
The three actions that the Fed can undertake to close a recessionary gap are;
 Purchase of bonds and securities
 Decrease of interest rates
 Reduction of reserve requirements.
Page 42 of 46
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questions—it’s there just for Tolkien fun. Go forth and read!!!
Fernanda Matos De Oliveira
c) Graph the implementation of contractionary monetary policy on the economy of Middle Earth
when there is an inflationary gap (in both money market and AD/AS model). What happens
to the price level, unemployment and real GDP? Specify 3 different actions the Council (Fed)
could do to accomplish this policy.
Price
AS
AD
AD1
Qe
Q1
GDP
Following the implementation of contractionary monetary policy, the price level will reduce,
while unemployment will increase. Real GDP will reduce.
The three actions that the Fed can undertake to close an inflationary gap are;
 Sell of bonds and securities
 Increase of interest rates
 Increase of reserve requirements.
Page 43 of 46
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Fernanda Matos De Oliveira
d) Draw the effect on the federal funds rate if the Council (Fed) performs an open market
purchase. Describe in detail or graphs the ripple effects of this action. Be sure to include
the end result in each market and how those results affect the components of aggregate
demand.
An open market purchase is likely to increase aggregate demand, thereby causing a shift of the
aggregate demand curve to the right. In the money market, an open market purchase will lead to
more money in the economy. The component of aggregate demand that will be affected is
consumption. Individuals will consume more because the purchase will increase the money they
hold
AS
AD1
AD
Q1
Qe
GDP
Page 44 of 46
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questions—it’s there just for Tolkien fun. Go forth and read!!!
Fernanda Matos De Oliveira
e) Draw the effect on the federal funds rate if the Council (Fed) performs an open market
sale. Describe in detail or graphs the ripple effects of this action. Be sure to include the end
result in each market and how those results affect the components of aggregate demand.
An open market sale is likely to reduce aggregate demand, thereby causing a shift of the
aggregate demand curve to the left. In the money market, an open market purchase will lead to
less money in the economy. The component of aggregate demand that will be affected is
consumption. Individuals will consume less because the sale will reduce the money they hold.
Price
AS
AD
AD1
Qe
Q1
Real GDP
Then Círdan led them to the Havens, and there was a white ship lying, and upon the quay
beside a great grey horse stood a figure robed all in white awaiting them. As he turned and
came towards them Frodo saw that Gandalf now wore openly on his hand the Third Ring, Narya
the Great, and the stone upon it was red as fire. Then those who were to go were glad, for
they knew that Gandalf would also take ship with them....
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Fernanda Matos De Oliveira
Then Frodo kissed Merry and Pippin, and last of all Sam, and went aboard; and the sails
were drawn up, and the wind blew, and slowly the ship slipped away down the long grey firth;
and the light of the glass of Galadriel that Frodo bore glimmered and was lost. And the ship
went out into the High Sea and passed on into the West, until at last on a night of rain Frodo
smelled a sweet fragrance on the air and heard the sound of singing that came over the water.
And then it seemed to him that as in his dream in the house of Bombadil, the grey rain-curtain
turned all to silver glass and was rolled back, and he beheld white shores and beyond them a
far green country under a swift sunrise.
Page 46 of 46
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questions—it’s there just for Tolkien fun. Go forth and read!!!