Homework 3
Economics 503
Foundations of Economic Analysis
Assigned: Week 3
Due: Week 4
1. Money Market. The central bank has a policy of maintaining a fixed interest rate.
Real GDP increases in the economy which increases people’s need for liquidity
for shopping purposes. The central bank would like to keep the short-term
nominal interest rate stable. Demonstrate how the central bank’s setting of money
supply should change to keep the interest rate from adjusting.
Money Market: To keep the interest rate at the target level, the central bank must expand
reserves to meet demand. Output increases which increases the quantity of transactions
which means people will have to hold more money. Liquidity tightens and the interest
rates that banks must offer to raise liquidity would face upward pressure. To prevent that
from translating into higher interest rates, the central bank must increase the money
supply to match the rise in money demand .
Money
Supply
i
Money
Supply´
2
iTGT
1
Money
Demand´
Money
Demand
Y
2. Loanable Funds Market Some economists argue that the savings behavior is not
very responsive to the interest rate. Other economists argue that savings is
strongly affected by the interest rate. Use the loanable funds framework for a
large, closed economy. Compare the effect of expansionary fiscal policy (i.e. an
increase in government deficits) on the interest rate and investment in A) an
economy in which the supply of loanable funds (S) was inelastic with respect to
the interest rate; with the effect in B) an economy in which the supply of loanable
funds is very elastic. Draw a graph of each theory to show under which theory
there is a bigger impact on investment and under which theory there is a bigger
impact on the interest rate.
Expansionary fiscal policy, a cut in taxes or an increase in spending, leads to an
increase in the budget deficit. There is a drop in domestic saving. An inward shift in
the savings curve leads to excess demand for loanable funds. Market forces push up
the real interest rate, leading to a contraction in investment and an increase in
savings. When saving is inelastic, savings increases by little and the interest rate must
rise sharply so that investment declines by almost the entire size of the increase in the
deficit. When the savings is very interest elastic, a small rise in the interest rate would
attract a lot of extra savings and the interest rate would not rise sharply nor would
investment decline as much.
r
S
r
2
r
1
S
I
Loanable Funds
r
rUS$
2
r
S
US$
1
S
I
Loanable Funds
3. Loanable Funds Market Imagine an open economy described by the following
equations:
I  100  200  r
S  30  500  r
KA  50  800  r
Investment is the demand for loanable funds; the supply of loanable funds is
S+KA. Solve for the equilibrium real interest rate, investment, savings, and the
capital account. What would the real interest rate and investment level be if the
government cut off international borrowing so KA=0?
First solve for the real interest rate at which the supply of loanable funds is equal to
the level of investment
100  200  r*  I  S  KA  30  500  r * 50  800  r*  20  1300  r *
120
 .08
1500
I*  100  200  (.08)  84, S  30  500  (.08)  70, KA  14
What if net capital flows are set equal to zero, then we see that
100  200  r*  I  S  30  500  r *
120  1500  r*  r* 
70
 .10
700
I*  100  200  (.10)  80  S
Zero capital flows means higher interest rates and less investment (but more
savings)!
70  700  r*  r* 
4. Foreign Exchange Market. Diamonds are discovered in Australia. Foreigners
want to buy these diamonds and need Australian dollars to do so. Assume that this
discovery has no particular effect on Australian demand for foreign goods or
assets. Draw two graphs of the Forex market: 1) Demonstrate the effect on the
Australian dollar exchange rate if Australian monetary policy remains unchanged
so the exchange rate is allowed to fluctuate; 2) Demonstrate the effect on the
market if the Reserve Bank of Australia conducts monetary policy to keep the
exchange rate from changing.
YP
S
Supply
Supply′
1
S*
S**
2
Demand
YP
S
Q
Supply
Supply′
1
3
S*
S**
Demand′′
2
Supply′′
Demand
Q
Foreigners need Aussie dollars to buy Aussie diamonds. They will supply more US
dollars to the Oz Forex market, pushing down the price of US dollars in that market. If
the Reserve Bank of Australia cuts the interest rate, then Australians will switch to US$
increasing demand for US$ and US investors will keep their funds at home reducing the
supply of US dollars in OZ Forex market.