NORTHWESTERN UNIVERSITY

Kellogg Graduate School of Management

EMP 52 - Macroeconomics

Professor Martin Eichenbaum

Fall Quarter 2001

Assignment 2

The purpose of this assignment is to help familiarize you with the determinants of aggregate money demand and the actions of the Federal Reserve system.

1. Suppose that money demand in an economy is given by

.

Here M^d denotes the demand for money, P denotes the price level, Y denotes real income, and i denotes the nominal interest rate.

A. Suppose that P=100, Y=1000, and i=0.10. Find real money demand, nominal money demand, and velocity.

2. Suppose that the price level doubles from P=100 to P=200. Find real money demand, nominal money demand, and velocity.
3. Starting from the values of the variables given in part (a) and assuming that the money demand function as written holds, determine how velocity is affected by a 10% increase in real income, by a 10% increase in the nominal interest rate and by a 10% increase in the price level.

2. All else equal, how would each of the following affect the demand for M1 and M2? Explain.

a. The maximum number of checks per month that can be written on money market mutual funds and money market deposit accounts is raised from three to thirty.

b. Home equity loans of credit that allow homeowners to write checks against the value of their homes are introduced.

c. The stock market crashes and further declines in the market are widely feared.

d. Banks introduce overdraft protection, under which funds are automatically transferred from savings to cover checks.

e. A crackdown reduces the illegal drug trade (which is largely carried out in currency).

3. In this internet exercise, we will look at the long-term economic growth of several economies and examine why some economies have done better than others. One of the best places to start looking at economic growth in general and comparing the economic growth across countries is the website of Dr. Nouriel Roubini, a professor at New York University's Stern School of Business and a member of President Clinton's Council of Economic Advisors. His site focuses mainly on the Asian and other currency crises, but he offers nice overviews of economic growth. Let's start with the basics at his introduction to Growth and Business Cycles. Please read the first five paragraphs (until the discussion on "year-on-year" GDP growth rate). After doing so, please answer the following questions:

a. In Figure 1, what are the two "obvious features" of the performance of the United States' GDP over the past few decades? What do these features signify?

b. Now go on to Figure 2, which illustrates per capita GDP for the U.S., Japan, and Argentina during the postwar period. Examine the figure and read the accompanying explanation in the Growth and Business Cycles overview.

c. What are the differences between the economic performance of the U.S., Japan, and Argentina?

d. Examine Figure 3, which illustrates per capita GDP for the U.S., Korea, and China. Look over the figure and the accompanying text and answer the following question. Both the U.S. and Korea have undergone prolonged increases in per capita GDP. From the figure, it is apparent that China's per capita GDP is low and has grown much more slowly. Yet, economists estimate that China's GDP has grown substantially over this period and now ranks as one of the largest in the world. How can these characteristics both be true?

4. One of the important functions that the World Bank performs is the collection of international economic data. The Bank's wealth of information can be accessed at no cost via its website. Go to the World Bank's homepage; under "Resources," click on "Data" and browse the site. When you have done so, please answer the following questions.

a. On the "Data and Maps" page, click on the link for "Development Goals." What are the Bank's main seven social development objectives in the 21st Century?

b. Go back to "Data and Maps," and then click on "Country Data." From the pull-down menu you see there, select "World." (You will need to download Adobe Acrobat Reader, if your computer does not have it already. Acrobat Reader is easily available for download at www.adobe.com). What was the dollar value of the world's GDP in 1999 and 2000?

c. What was the dollar value of the world's GDP per capita in 1999 and 2000? To do this you must divide the dollar value of the world's GDP by the world's population. The latter is available at the same web page.

d. What was the world's real GDP growth rate in 1999?

e. The growth rate in real GDP per capita is equal to the real GDP growth rate minus the population growth rate. What was the world's growth rate of real GDP per capita in 1999?

f. The Rule of 70 is a "quick and dirty" way to estimate how long it will take something to double if it is growing at a specified constant rate. To use the Rule of 70 to find the time to double, divide 70 by the annual percentage rate of growth. For example, if an economy is growing at a rate of 2% per year, it will take approximately 70/2 = 35 years to double. If the world economy grew at the 1999 rate, approximately how long will it take for world real per capita GDP to double? How long would it take if the world economy grew at the 1996 rate (numbers for 1996 are available from the same table)?

g. Click back to the pull-down menu on the World Bank Country Data page. Check out the GDP and GDP growth rate information for the Lower Middle Income Countries and for the High Income Countries for 1999. What is the per capita GDP for each of the two country groupings?

h. What are the growth rates in real GDP per capita for each of the two country groupings?

i. Do your answers to g and h support the claim that the standard of living in poor countries is likely to catch up soon to that of rich countries? Why or why not?

5. West Bubble makes ordinary soap bars that are sold for 5 guilders each. East Bubble makes deluxe soap bars that are sold for 100 florins each. The real exchange rate between West and East Bubble is two ordinary soap bars per deluxe soap bar.

a. What is the nominal exchange rate between the two countries?

b. During the following year West Bubble has 10% domestic inflation and Easy Bubble has 20% domestic inflation. Two ordinary soap bars are still traded for a deluxe soap bar. At the end of the year what has happened to the nominal exchange rate? Which country has had a nominal appreciation? Which country has had a nominal depreciation?