MACROECONOMICS

Class 2. The AD-ERU model and the 3-equation modelDiscussion pointsIn this class, you will work through the medium run model and the dynamic 3-equation open economy model. Make sure that you have been through your answersto the problem set and that you can answer the following questions. You will be calledon in class to provide answers.PS2.1Assume you are modelling a small open economy.a) What does the ERU curve represent? What would happen to the ERU curve ifunemployment benefits were raised? What would you expect to happen toinflation? [30]b) What does the AD curve represent? Derive the AD curve graphically from theIS curve. Suggest two variables that shift both the IS and the AD curves andsummarize their effect on the medium-run real exchange rate. [30]c) Suppose there is a rise in the world interest rate. Describe the new MRE. Doesyour answer depend on the exchange rate regime? Explain. [40]1. Why is the ERU curve vertical? What is being assumed about the real wagewage-setters care about (in their utility function)? Does a rise inunemployment benefit affect the demand or supply side of the labour marketand how?2. Why does inflation change – how do you derive the relevant Phillips curvefollowing the rise in unemployment benefits?3. What are you holding constant when you derive the AD curve from the ISdiagram? What are you varying?4. What variables will shift the AD curve? Will they shift the IS curve?5. For one of the examples you gave in (b), explain in words the differencebetween the initial and the new MRE.6. Explain in words why the AD curve shifts to the left when the world interestrate is higher. What happens to the MRE?PS2.2 A positive permanent demand shock – dynamic adjustmenta) Using the simulator:• Apply shock: Permanent 3% positive demand shock. Give a plausibleexplanation of what could cause such a shock.• Use the impulse response functions to help explain the path of the economyfollowing the shock (output, inflation, real interest rate, real exchangerate). In particular, how can you explain the adjustment of the realexchange rate?• Save your data and use the button on the bottom left of the main page toswitch to the closed economy version of the simulator• Apply shock: Permanent 3% positive demand shock• Print the impulse response functions for the key variables (inflation,output, interest rates, exchange rates).b) If you cannot get the simulator to work, sketch the impulse-response functions forthe above exercise.c) Comment on the differences in the impulse response functions between the openand closed economy simulations (or in your sketches). Is the change in interestrate necessary to stabilise the economy larger in the open or closed economy?Why?d) The default setting in the simulator uses the same coefficient on the real interestrate in the open and closed economy (‘sensitivity of expenditure with respect toreal interest rate’). This means that ‘a’ is the same in the equation for the openand closed economy IS:1 11Open economy IS equationClosed economy IS equationt t tt ty A ar bqy A ar− −−= − += −Sketch each of these IS curves. Now, explain in words why we would not expectthe coefficient on the real interest rate to be the same in the open and closedeconomy IS curves. Would you expect the IS curve to be flatter or steeper in theopen economy?e) [Extension for the keen: Use the simulator to experiment with thesensitivity of output to the real interest rate in the open economy andcheck what happens to the CB’s choice of interest to respond to the shock.Hint: choose a much lower sensitivity to see the results in the graphs; youcan also enlarge the vertical scale to get a better view. ]7. If the coefficient on the interest rate in the IS curve is the same in the closedand open economy, why does the central bank raise the interest rate by less inthe open economy? How is the result in the impulse response functionproduced by the simulator reflected in the 3-equation model diagram? Why isthere no difference in the paths of inflation and output between the closed andopen economies? Match the simulator result to the diagrams and to yourverbal explanation.8. Why is investment less sensitive to the interest rate in the open economy?How does this affect the slope of the IS curve?9. Who tried the last part of the question – what results did you get from thesimulator?Is the simulator useful in helping you to understand the model? In helping you tounderstand macroeconomic policy-making in the world? Justify your answer.