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Atul A. Dar
Economics 3301.1
Assignment 4
November 16, 2017
This assignment is due in my office no later than 6pm on November 28. You must use the same group you used for
the last assignment. Those who made individual submissions can continue to do so. You will be marked for both the
content the clarity of your answers. You must provide adequate explanations. Please see me if you have any
IMPORTANT: do not hand in assignments that are identical to those of others.
Question 1 (12 points)
Consider a short run IS-LM model of an economy under flexible exchange rates. The price level is exogenous so AD-AS
considerations are not relevant. Suppose the government and central bank co-ordinate their policy actions in the
following way: the government has to cut its budget deficit, but the central bank is ready to offset the contractionary
fiscal policy through monetary expansion to prevent output from falling.
a. Use an IS-LM graph to show how these policy actions can keep output constant. What happens to the interest
rate and the value of the domestic currency? (3 points)
Explain the effects on investment, consumption and net exports, if the policy co-ordination is achieved (on the
fiscal side) through (i) a cut in government spending only, and (ii) an increase in taxes only. (3 points)
Is it true to say that the change in investment (in absolute value) is smaller than the change in consumption (in
absolute value), regardless of whether the fiscal contraction is a cut in G or an increase in T? Explain. (2 points)
b. If the fiscal and monetary coordination was attempted under fixed exchange rate, how would output and the
interest rate change? What would be the final effects on consumption, investment, and net exports, compared to
the initial equilibrium? Explain. (4 points)
Question 2 (12 points)
Consider the following AS-AD model. In the model, there is no G or T, and to simplify the analysis, we assume that
output depends upon the difference between M and P rather than on their ratio.
AD: Y = c(M-P) where c is a positive constant
AS: P =Pe + d(Y-YN), where d is a positive constant.
1. What is the natural level of output? If M is equal to M0, what is the initial price level? (P0). (3 points)
Assume that the expected price level is equal to this initial price level.
Suppose that in an effort to increase investment, the Bank of Canada adopts an expansionary monetary policy and
Doubles the money supply to to M1=2M0
2. Solve for equilibrium output in the short run. (3 points)
3. What happens to investment behind the scenes? Explain briefly in words. (2 points)
4. What would output be in the medium run? (2 points)
5. What happens to investment in the medium run? Explain in words. (2 points)
Question 3 (6 points)
An expansionary monetary policy is neutral in the medium run but an expansionary fiscal policy is not. Explain
clearly why, using IS-LM and AD-AS graphs to support your answer. A detailed description of the adjustment from
short run equilibrium to medium run equilibrium is not needed.

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