Homework 3 Due Date: 11 December 2017 1. Assume that the investment depends nega

Question

Homework 3 Due Date: 11 December 2017 1. Assume that the investment depends negatively on the real interest rate. That is 1 = 1"(m) a. Write down the system of equations (in the short run) where (RH,EH/F·h) are the endogenous variables. (Hints: make use of the Fisher's equation and assume that inflation rate is constant.) b. Are the shape of AA and DD curve different under assumption (1)? Explain. c 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. 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 (Rx-EH/FEH/PR-, %) are the endogenous variables. e. f. 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)? 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

Solution:

We have a function deplicts negative relationship between investment and real interest rate

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

b]
The curve of AA depicts the equilibrium in the asset market. This curve determine an equilibrium exchange rate for each level of GNP that prevail in the market. Assuming that the demand for foreign currency rises when domestic return is less than foreign exchange rate and excess of domestic return over foreign return create supply of foreign currency, there will be rise in exchangerate or fall untill the economy achieve equilibrium on curve AA

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.

c] Due to change in variable other than Y and E, there will be shift of DD and AA curve. also in short run the economu will not be in equilibrium. The new equilibrium level will be achieved with adjustment in the both markets but the extent of adjustment in asset market is greater than the goods market.

d]
The upward shift in AA curve will be occur due to increase in money supply decrease in level of price, an increase in foreign interest rates or an increase in the expected rate of exchange.

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