ECOS 2002
Assignment 3
Due: May 1st
1. The Keynesian Beauty Contest: Go to Canvas and complete the Cavas Quiz for
assignment 3.
2. The Paradox of Thrift: Consider the simple model of the good markets:
Y = C + I +G
C = C0 + C1(Y − T )
I = I0 − I1r
G = G¯
T = T¯
Saving in the simple model of the goods market is defined as S = Y − C −G.
(a) Using the goods market equilibrium and the definition of saving, find the pre-
dicted change in aggregate savings if consumers decided to save more (C0 ⇓).
Explain why the effect of an aggregate increase in savings is called a paradox
using your answer.
3. Fine Tuning the Economy:
Consider the following behavioral equations:
IS LM
C = C0 + C1(Y − T )− C2r MSP = M¯P
I = I0 − I1r MDP = l0Y − l1i
G = G¯ i = r + pie
T = T¯
(a) The behavioral equation for consumption now includes the interest rate. Give
an economic reason for why consumption may depend on the interest rate.
Explain intuitively why C2r appears with a negative sign in front of it.
(b) Solve for the IS-LM equilibrium algebraically. How does the change in the
consumption function change the multiplier? Is it now larger or smaller?
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4. Demand Pull Inflation: Suppose that the central bank wants to increase output,
but the economy is already at the natural rate.
(a) Show the short and long run effects of a monetary expansion (M ⇑) in this sit-
uation in the AD/AS model. You may omit the labor market and production
function graphs and you should assume sticky prices for the SRAS.
(b) As you can see from above (hint), in the long run output is unchanged but
the price level is higher. What do you think would happens if the central
banks tries this strategy over and over again?
(c) Now assume that these repeated increases in the money supply have caused
expected inflation (pie) to increase. Furthermore, assume the central bank
stops its repeated increases of the money supply at the same time (assume
M is constant). What is the effect of the increase in inflation expectations on
output, the real interest rate, and the price level in the short run?
5. Combination Policy
(a) Graph an AD/AS model with sticky wages and show graphically and ex-
plain with words how the Australian government with the help of the Reserve
Bank could increase government spending while keeping the economy at full
employment without causing changes in the price level.
(b) If they pursue this policy, what happens to the amount of investment in the
economy?