Question I
Monetary policy is considered to be neutral while fiscal policy is not. In this question, you will
examine and contrast an economy’s short-run and medium-run responses to expansionary
monetary and fiscal policies.
a. What characterizes an economy’s medium-run equilibrium? Where is it? How do you
know you’re there when you’re there? (5 points)
b. Consider monetary expansion in an economy initially at medium-run equilibrium.
i. What happens in the short-run in response to an increase in M? Assume adaptive
expectations, Pte = Pt-1, and describe and explain what happens to i, I, Y, C, W, and P in
the short-run when M increases. (10 points)
ii.
How does the economy move from its short-run equilibrium position to a new
medium-run equilibrium after a monetary expansion? Assume adaptive expectations,
Pte=Pt-1, and describe and explain what happens to W, P, i, I, C and Y as the economy
moves from its short-run equilibrium position to its new medium-run equilibrium. (10
points)
iii.
Compare the initial values of W, P, i, I, Y and C (before the increase in M) with their
final values once a new medium-run equilibrium is achieved. (5 points)
Consider fiscal expansion in an economy initially at medium-run equilibrium.
i. What happens in the short-run in response to an increase in G? Assume adaptive
expectations, Pte = Pt-1, and describe and explain what happens to Y, W, P, i, I and C in
the short-run when G increases.(10 points)
ii. Compare the initial values of W, P, i, I, G, Y and C (before the increase in G) with their
final values once a new medium-run equilibrium is achieved. (10 points)
c. Why is monetary policy considered to be neutral while fiscal policy is not? (10 points)
Question II
Discuss the following statement.
a. As long as we do not mind having high inflation, we can achieve as low a level of
unemployment as we want. All we have to do is increase aggregate demand using
expansionary monetary and fiscal policies. (20 points)