Q1:
Consider Mankiwβs Dynamic Model of Aggregate Demand and Aggregate Supply (DAD-DAS) that comprise the following five equations (all notation as defined in lectures):
a. Derive the long-run equilibrium values of all variables in this economy. Clearly set out what assumptions you are making in deriving these. Comment on the links between real and nominal variables in these long-run equilibrium values. [30]
b. Derive the long-run equilibrium values of all variables in this economy. Clearly set out what assumptions you are making in deriving these. Does the classical dichotomy and money neutrality hold in the long-term? [30]
c. Assume that there is an increase in the inflation target πtβ .
(i) Use the DAD-DAS diagram to show the short and long-run impact of an increase in the inflation target πtβ on output (πt) and actual inflation (πt). [20]
(ii) Sketch the phase diagrams for output (πt), actual inflation (πt) and the nominal interest rate (πt) following this change in the inflation target. [20]
d. Assume that there is a decrease in the inflation target πtβ .
(i) Use the DAD-DAS diagram to show the short and long-run impact of a decrease in the inflation target πtβ on output (πt) and actual inflation (πt). [20]
(ii) Sketch the phase diagrams for output (πt), actual inflation (πt) and the nominal interest rate (πt) following this change in the inflation target. [20]
e. Explain how the treatment of monetary policy in the DAD-DAS model differs from the traditional AD-AS model. [30]
Q2:
a. Consider a two country Mundell-Fleming model under perfect capital mobility and flexible exchange rates. Show graphically and explain verbally the effects of an expansionary domestic fiscal policy on the domestic and foreign levels of output and the interest rate. [30]
b. Consider a two country Mundell-Fleming model under perfect capital mobility and fixed exchange rates. Show graphically and explain verbally the effects of an expansionary domestic fiscal policy on the domestic and foreign levels of output and the interest rate. Explain how the choice of the country responsible for pegging the exchange rate affects the answer. [40]
c. Assume two large economies using the instrument of monetary policy to attain an output and an inflation target. Consider the following two equilibria: (a) Nash equilibrium and (b) cooperative equilibrium. Explain the meaning of each equilibrium and show graphically the above two equilibria. Which equilibrium leads to a higher welfare level and why? In your analysis you may assume that domestic monetary policy is transmitted abroad negatively. [35]
