Homework 3
Economics 503
Foundations of Economic Analysis
Assigned: Session 6
Due: Session 7
1.
Consider the situation of an emerging markets economy liberalizing their
corporate sector. This increases the number of investment projects that are expected to
earn profitable returns at any given interest rate. This also makes households in the
emerging market optimistic about their future income relative to current income.
a.
Use an open economy model of the loanable funds market to demonstrate the
effects of this on the international lending of a single emerging market that faces
this situation at a fixed world real interest rate.
r
SLF
1
rW
International Borrowing
S' LF
D'LF
YP
DLF
LF
b.
Assume this is a world wide trend, so that it happens simultaneously around the
world. Draw a graph of the global loanable funds market to demonstrate the
impact on equilibrium world real interest rates.
r
SLFW
2
rWW
1
rW
S' LFW
D'LFW
YP
c.
DLFW
LFW
Draw a graph of a single developed economy that does not experience any
improvement in future income or profitability of investment projects. Use an open
economy loanable funds model of this situation to demonstrate the impact of the
change in world interest rates from 1.b. on international lending in the developed
economy.
r
SLF
International Lending
rWW
1
rW
YP
2.
DLFW
LFW
Construct an AS-AD model of the economy. Begin by assuming the economy is in a
long-run level of equilibrium with the aggregate supply curve crossing the aggregate
demand curve at the level of potential output. For simplicity, also assume potential output
is constant. Use the model to describe how each of the events will change the
macroeconomic equilibrium in the short-run. Suppose that policymakers allow the self
correction mechanism to bring GDP back to the long-run equilibrium. Use the model to
describe how each of the events will change the economy in the long-run. Illustrate with
diagrams.
a.
An increase in the level of GDP of a leading trading partner.
P
SRAS
lt
st
SRAS'
o
AD'
YP
b.
AD
Y
The household and corporate sector becomes pessimistic about the future.
P
YP
SRAS
AD'
SRAS'
o
st
lt
AD
Y
3.
In December 2010, The People’s Bank of China increased their reserve
requirement. Assume this increases the demand for reserves.
a.
Draw a graph of the interbank market when a central bank increases the reserve
requirement while maintaining a fixed supply of reserves. Demonstrate the impact
of this increase in reserve requirements on interbank interest rates.
The increase in the reserve ratio will increase the demand for reserves at any level of
deposits. The equilibrium interest rate will rise.
iIBOR
DBR
SBR
DBR'
2
i**
i*
1
Reserves
b.
If the central bank wants to prevent the change in reserve requirements from
impacting the interest rate, they must engage in open market operations. In
another graph, demonstrate the type of open market operation they must engage in
to keep an increase in reserve requirements from impacting the interest rate.
iIBOR
DBR
SBR
DBR'
SBR'
Open Market Purchase to
increase supply of reserves
to meet demand
3
i*
1
Reserves