1. Assume that the investment depends negatively on the real interest rate. That
ID: 1118897 • Letter: 1
Question
1. Assume that the investment depends negatively on the real interest rate. That is 1 = 1"(m) Write down the system of equations (in the short run) where (RH, EHIF,YH) are the endogenous variables. (Hints: make use of the Fisher's equation and assume that inflation rate is constant.) a. b. Are the shape of AA and DD curve different under assumption (1)? Explain In the short run, compare the effect of a temporary increase in government expenditure on output and nominal exchange rate with and without assumption (1)? Explain using a diagram. c. d. In the short run, what is the effect of a temporary increase in money supply on output and nominal exchange rate with and without assumption (1)? Explain using a diagram Write down the system of equations (in the long run) where (RH,EH/A Ee/P PH, YH) are the endogenous variables. e. In the long run, what is the effect of a permanent increase in government expenditure on output and nominal exchange rate with and without assumption (1)? f. g. In the long run, what is the effect of a permanent increase in money supply on output and nominal exchange rate with and without assumption (1)?Explanation / Answer
1 a - Dependent Variable is a model generated whose variable value is altered or determined according to the functional relationship in that equation. For example, consumption expenditure and income is considered endogenous to a model of income determination
1b The DD curve represents the set of equilibriums in the goods and services market. It describes an equilibrium gross national product level for each and every exchange rate that may prevail. Due to the assumption that firms respond to excess demand by increasing supply (and to excess supply by decreasing supply), GNP rises or falls until the economy is in equilibrium on the DD curve.
The AA curve represents the set of equilibriums in the asset market. It indicates an equilibrium exchange rate for each and every GNP level that might prevail. Due to the assumption that investors will demand foreign currency when the foreign rate of return exceeds the domestic return and that they will supply foreign currency when the domestic rate of return exceeds the foreign return, the exchange rate will rise or fall until the economy is in equilibrium on the AA curve.
1c Changes in any exogenous variable that is not plotted on the axes (anything but Y and E$/£) will cause a shift of the AA or DD curves and move the economy out of equilibrium, temporarily. Adjustment to a new equilibrium follows the principle that adjustment in the asset markets occurs much more rapidly than an adjustment in the goods and services market. Thus adjustment to the AA curve will always occur before adjustment to the DD curve.
1 d The effect of an increase in the money supply or a decrease in the price level, an increase in foreign interest rates, or an increase in the expected exchange rate is to shift the AA curve upward.The effect of a decrease in the money supply or an increase in the price level, a decrease in foreign interest rates, or a decrease in the expected exchange rate ]) is to shift the AA curve downward.
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