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The effort of a firm\'s workers depends on their real wage according to the following schedule


Q.1 Consider the following model of an extended classical economy: 1. Y = (12350 (7)+(10/7)(M/F) 2.1+100 [Fr]

4. T-6000

5. T=0.05

6. M=88950

(a) What do equations 1, 2 and 3 represent in the above model? Briefly explain.

(b) Suppose that F29.15. What are the short run equilibrium values of P, Y and U?

(e) Is the economy in long run equilibrium? If not, why? Explain this adjustment using labour market analysis. What are the long run equilibrium value of and P'?

(d) Find out the values of cyclical unemployment and unanticipated inflation. Does the Phillip curve relation hold?

(e) Draw diagram(s) indicating all points.

(D) Suppose that the central bank decides to take advantage of the low price expectations and announces a contractionary monetary policy (so that actual price also adjusts in line with expectations) before any labour market adjustment has taken place. By what percentage should the central bank change the money supply? What will be the new equilibrium?

Q.2 The effort of a firm's workers depends on their real wage according to the following schedule:

Real Wage (w)

Effort (E)

16 10







20 25

21 26

The marginal product of labor is MPN=-E-(400-4N), where E is effort level and N is number of workers employed.

(i) Using the table, calculate the effort-wage ratios and hence determine the efficiency wage. How many workers should the firm hire?

(ii) Suppose an adverse productivity shock reduces the marginal product of labor to MPN-E-(360-4N). How would your answers to parts (a) change?

(iii) Draw diagram(s) and explain.

An open economy is described by the following set of equations:



C-240 +0.67-200

4. NX=120-0.21-0.58




R=16+600 r

3. G-80

6. F=720

(a) Using the given model, derive the equation of the open economy IS curve? (b) What are the equilibrium values of the endogenous variables?

(c) Suppose government adopts an expansionary fiscal policy such that the new level of its expenditure is 134, which also leads to an increase in potential output to 750. What are the new equilibrium values of real interest rate, real exchange rate, consumption, investment and net exports?


(d) Explain the direction of movement of all variables.

(e) Draw diagram indicating all points.

Consider a two economy world following a fixed exchange rate system. The domestic economy produces commodity X while the foreign economy produces commodity Y with P, = Rs.100 and F$5. The real exchange rate between the two commodities is 2X for 1Y. What is the nominal exchange rate between two currencies? Suppose during the following year monetary policies lead to 10% inflation in the domestic economy and 20% in the foreign economy. 2X are still


traded for 1Y. At the end of year what has happened to nominal exchange rate. Which country has had a nominal appreciation? Which has had a nominal depreciation? Which country will benefit/loose from the change in value of currency? Draw graphs and explain.

Consider the following classical economy.

AD: 1000+100 (M/F)

AS: F-1500

This economy produces only wine, its output is measured in terms of wine, and its currency is florins. It trades with a country that produces only wheat, and the currency of that country is crowns. The real exchange rate R equals 3 bushels / bottle of wine. The foreign price level is 8 crowns/bushel of wheat and domestic money supply is 30 florins.

(a) What is the domestic price level? What is the fundamental value of nominal exchange rate? (b) Suppose that domestic country fixes the exchange rate at 6 crowns/florins. Is its currency overvalued undervalued / neither? What would happen to central bank's stock of official reserve assets if it maintains the exchange rate of 6 crowns/florins? What would be the impact of this policy on its trading partner?

(e) Now suppose that the domestic country wants a money supply level that equalizes the fundamental value of exchange rate and the fixed rate of 6 crowns/florins. What level of domestic money supply achieve this goal? Explain the relationship between money supply, interest rate and nominal exchange rate?

(d) What policy option may the domestic central bank ask its trading partner to exercise before it has taken any action itself to resolve the problem in part (b).

(e) Draw diagram(s) indicating all points.


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