PROBLEM SET #4
1. Consider the following policies put into place during the late 1960s to 1970s by the fiscal
and monetary authorities of the United States. Assume that these policy changes are all
temporary. Make use of the DD-AA model and your general knowledge of macroeconomics
to answer the following questions.
a. President Johnson and Congress passed large increases in government spending to
finance the Great Society programs and the Vietnam War. Explain briefly how this
policy change would affect the nominal exchange rate, output, and trade balance.
b. Beginning in the mid-1970s, Federal Reserve Chairman Arthur Burns sought to decrease
unemployment below its full employment level by decreasing interest rates. Does this
require a monetary expansion or contraction? Explain how this would affect the nominal
exchange rate, output, and trade balance.
c. Illustrate the combined effects of the fiscal and monetary policies mentioned previously
using the DD-AA model and state the overall effects of these policies on the following
variables: output, interest rate, nominal exchange rate, consumption, investment, and the
trade balance. (Note the change in interest rates in part b would suggest that the
monetary policy effect dominates the fiscal policy effect).
d. Go to the St. Louis Fed’s website and make use of their FRED database to find the data
for the following variables from 1975 to 1978: effective federal funds rate, trade
weighted exchange rate index against major currencies (note that an increase in the index
indicates a depreciation of the dollar), current account balance, and gross private
domestic investment (% change from one year ago). Plot the data. Based on these
figures, are the data consistent with the model in this case? Which variables, if any, do
not behave according to the model during this period?
2. True or False and Why?
a.
In an open economy DD-AA model, a permanent increase in domestic government
purchases leads to an increase in domestic equilibrium interest rate and output,
and results into a depreciation of domestic currency against foreign currency in
the short run.
b.
Both the temporary and permanent expansionary fiscal policy raises the current account
balance. [Diagrams required]