E487 Intermediate Macroeconomic Theory

Second Exam

Spring 1999

Dr. Christopher J. Waller

1. Derive the IS curve. Explain the reasoning behind the derivation. Then show and explain how an increase in taxes affects the IS curve.

 

2. Using the indifference curve model of intertemporal consumption, derive the saving curve when the substitution effect dominates the income effect.

 

3. The following quote appeared in the Lexington Herald Leader on December 24, 1998:

"Japan's Cabinet unveiled a draft budget for 1999 yesterday that will double the size of its annual deficit in an effort to jump-start its economy. It would include $86 billion in new spending on public works and tax cuts worth more than $78 billion."

How would a classical economist respond if asked whether or not this plan will 'jumpstart' the Japanese economy? Show and explain your answer.

4. In our portfolio model of money and bonds we assumed that money was 'riskless.' However, even though money pays no interest it has 'inflation risk', i.e., an unexpected increase in inflation lowers the purchasing power of currency. Using the indifference curve model of risk and return, show and explain how an increase in the risk associated with holding money affects the money demand curve (when the substitution effect dominates the income effect). [Note: Recall that s_M was the risk on money. For this problem assume that r_M = 0 but 0 < s_M < s_B.]