Macroeconomic Analysis for International and Public Affairs U6401
Problem Set 7
Due on April 2 at 6:00pm
1. Please drop your homework in mailboxes 7 or 10 in the 6th-floor mail room, close to the Office of Student Affairs.
2. You only have to submit ONE homework paper per group.
3. Please make sure you write both first and last names of each group member on the first page of the homework paper.
4. While your answers should be typed, you do not have to draw the graphs in Word or Excel.
Just take pictures of your hand-drawn graphs and paste them to your problem set paper before printing
Question 1
In this question, assume that Brazil is a closed economy.
The table below illustrates some indexes of real macroeconomic data from Brazil (1995 = 100).
Quarter 1
2015
Quarter 2
2015
Quarter 3
2015
Gross Domestic Product 172 168 166
Personal Consumption Expenditures 180 177 174
Gross Private Domestic Investment 176 161 155
a)
1. During this time, is Brazil experiencing a recession or an expansion?
Consider the following alternative explanations for the Brazilian cycle during this time.
First Explanation: The Brazilian cycle is only driven by a drop in consumers’ optimism about the future.
Prices are sticky.
b)
1. Illustrate the short run effects of this shock on the goods market graph, the asset market graph and the
IS-LM-FE graph. Indicate with A and B, respectively, the equilibrium before and after the shock.
2. Which of the variables on the table above are consistent and which are inconsistent with the first
explanation?
Second Explanation: The Brazilian cycle is only driven by a contraction in real money supply.
c)
1. Illustrate the effects of this shock on the goods market graph, the asset market graph and the IS-LM-FE
graph. Indicate with A and D, respectively, the equilibrium before and after this shock.
2. If a curve shifts, explain – in no more than one line -why it shifts
3. Which of the variables on the table above are consistent and which are inconsistent with the second
explanation?
d)
1. Using an IS-LM-FE graph (and this graph only) illustrate the combined short-run and long-run effects of
an i. exogenous reduction in full employment GDP (due to a drop in oil prices)1 together with ii. an
exogenous reduction in consumption if the combined two shocks cause P to increase in the long run.
Assume that, before these two shocks, the Brazilian economy was at full employment. Indicate with A,
B and C, respectively, the equilibrium before the two shocks, the short-run equilibrium and the long-run
equilibrium.
2. Under these circumstances, can you unambiguously predict the effects of these two shocks on
investment in the long run (from equilibrium A to equilibrium C)? Explain (there is no need to draw
any graph).
During 2015, Banco do Brasil – the Brazilian Central Bank – implemented a monetary policy to prevent prices
from increasing in the long run.
e)
1. If this policy was attained through open market operations, should Banco do Brasil have purchased or
sold assets?
Suppose that a contraction in full-employment GDP due to a drop in oil prices causes an increase in expected
inflation in Brazil. Disregard any exogenous consumption shock.
f)
1. How would an increase in expected inflation affect Brazilian nominal interest rates and real interest rates
in the short run?
2. How would an increase in expected inflation together with a drop in full-employment GDP affect
Brazilian nominal interest rates and real interest rates in the long run? Explain.
Question 2
Throughout this question, assume that Japan is a closed economy.
Suppose that you only know that the Japanese national saving increases.
a)
1. Is it possible that this increase in saving is associated with an increase in GDP? Explain in no more than
one sentence.
2. Is it possible that this increase in saving is associated with a drop in GDP? Explain in no more than one
sentence.
The Japanese government was expected to increase taxes in April 2017.
b)
1. Could the increase in taxes (assuming that they are lump-sum) have had no effect on the Japanese
consumption? Explain in no more than one sentence.
2. Following what we discussed in our course, provide two reasons for which the Ricardian equivalence
does not hold in the real world.
1 The oil industry represents 13% of the Brazilian GDP
Suppose that the Japanese Government increased lump-sum taxes in April 2017.
c)
1. Assuming that the Ricardian equivalence does not hold, how would the increase in lump-sum taxes have
affected i. national saving, ii. government saving and iii. consumption in the short run?
2. Illustrate the short-run effects of this tax increase on the Japanese saving and investment graph. Indicate
with A and B, respectively, the equilibrium before and after this shock.
3. If the Japanese investment is very sensitive to changes in the real interest rate, would short-run GDP
have responded more or less to the tax increase? Explain.
Suppose that in April 2017 the risk on Japanese Government bonds dropped.
d)
1. How would this drop in risk, and this shock only, have affected the Japanese i. consumption and ii.
saving in the short run?
2. Illustrate the short-run effects of this drop in risk on the Japanese asset markets graph. Indicate with A
and B, respectively, the equilibrium before and after this shock.
Suppose that Japan was affected by two shocks in April 2017: i. an increase in lump-sum taxes (assuming that
the Ricardian equivalence does not hold) and ii. a drop in risk on bonds
e)
3. Illustrate the short-run and long-run effects of these two shocks on the Japanese IS-LM-FE graph if the
combined shocks are deflationary in the long run. Indicate with A, B and C, respectively, the
equilibrium before the two shocks, the short-run equilibrium and the long-run equilibrium. Assume that
A is at full employment.
2. Under these circumstances, can you predict whether investment increases or decreases in the short run?
3. Suppose that the Bank of Japan wants to maintain long-run output prices constant. Indicate with the
letter D, the equilibrium that the Bank of Japan wants to attain on the graph of part e1.
The increase in lump-sum taxes in April 2017 was eventually postponed.
In December 2017 the Japanese government decided to cut corporate taxes to firms that satisfy both of the
following two requirements: 1. raise wages by at least 3% (which causes full-employment GDP to drop), and 2.
make a certain amount of high-tech investment (to provide an incentive to invest).
f)
Assuming that this cut in taxes is successful on both fronts, and that the tax revenue does not change,
can you unambiguously predict whether this policy is expansionary or contractionary in the short run?
Can you unambiguously predict whether this policy is inflationary or deflationary in the long run?
Explain and illustrate your answer on the AD-SRAS-LRAS graph indicating –with the letter A – the
initial equilibrium (at full employment), with the letter B the short-run equilibrium and with the letter C
the long-run equilibrium.
