Université d'Orléans - Année universitaire 2008-2009 Faculté de Droit, Économie et Gestion Licence Economie Gestion (Mention Européenne) – semestre 2 Macroeconomics 17th April 2012

Exam #2

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Exercice 1 (12 points) After your studies in economics at the University of Orléans, you become adviser for the minister of economics. You role is to analyze the evolutions of the French economy, which can be characterized by the following equations: An economy has the following characteristics: C = 12000 + 0.6 Yd I = 10000 – 40000i G = 22000 T = 20000 Ms=50000 Md=0.6 Y -200000i + 15000 L=400Y with L the level of employment. The active population is 40 000 000.

1) Comment each equation. (1 point) 2) We know that the public deficit is equal to (G-T). What is the value of the public deficit for France? (0.5 points). Public deficit 2000.

3) Build the IS and LM relation (2 points) (IS): Y=-100000i + 80000 (LM): Y=333333,33i + 58333,33

4) Solve for equilibrium output and interest rate (1 point). Y=75000 i=5%

5) What is the level of public deficit in percentage of GDP (0.5 points) 2,66%

6) What is the level of employment and the unemployment rate? (1 point) 1

employment= 30 000 000 unemployment rate= 1 - 30 000 000 / 40 000 000 = 25 % 7) The European Central Bank is ready to help European governments to decrease unemployment. Without making any calculation, explain which type of policy can be chosen by the central bank in order to reach this goal? Show graphically the effect of such policy on the IS-LM graph. (1.5 points).

8) We now suppose that Ms=60000. Find the new equilibrium output and interest rate, the new level of employment and the unemployment rate. Calculate also the new public deficit in percentage of GDP. Comment. (1.5 points).

(LM) : Y=333333,33i + 75000 Y= 78846,15 i = 1,15 % L=31538461,5384615 u= 21,15 % public deficit= 2,54 % 9) Let's come back to the case where Ms=50000. The government wants to reduce public deficit. What kind of policies can be chosen? Show the effect of such policies using the IS-LM graph. (1.5 points)

10) We now suppose that G=21500. Find the new equilibrium output and interest rate. Calculate the new level of employment, the unemployment rate and the public deficit (in % of GDP). Comment in the light of what you obtained in question 8 (1.5 points).

(IS) : Y=-100 000i+78750 Y=74036,46 i = 4,71 % L=29615384,6153846 u = 25,96 % public deficit = 2.02 % The policy leads to a stronger reduction of public deficit but at the expense of a higher level of unemployment. We can notice that an expansionary monetary policy also lead to a reduction of public deficit (together with a fall of unemployment).

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Exercice 2: Effectiveness of fiscal policy (8 points) 1. We keep the same parameters than in the previous exercise. The only change is the function of money demand. C = 12000 + 0.6 Yd I = 10000 – 40000i G = 22000 T = 20000 Ms=50000 Md=0.6 Y + 15000

a) solve for equilibrium output and interest rate. (1 point) (LM) : Y=58333,33 Y=58333,33 i= 21,67 % b) The government decides to reduce public spending by 500. G is now equal to 21500. Find the new equilibrium. (1 point) Y=58333,33 i = 20,42 % c) Show graphically the two equilibrium and comment. (1 point) No effect of fiscal policy because LM is vertical (classic LM curve). 2. The money demand is now Md=0.6 Y - 300000i + 15000. a) solve for equilibrium output and interest rate. (1 point) (LM) : Y=50000i + 58333,33 Y= 76388,89 i = 3,61 % b) The government decides to reduce public spending by 500. G is now equal to 21500. Find the new equilibrium. (1 point) Y= 75347,22 i= 3,40 % c) Show graphically the two equilibrium and comment. (1 point) 3. Condition of effectiveness of fiscal policy (2 points) a) Calculate the evolution of GDP induced by the fall of public spending (from G=22000 to G=21500) : 3

- in the previous exercice (question 10) evol GDP= 75000-74036,46 = 963,54 - in question 1 evol GDP= 0 - in question 2 evol GDP= 76388,89 – 75347,22 = -1041,67 b) In the light of these results, explain how the money demand affects the effectiveness of fiscal policy (1.5 points). 1. The effectiveness of fiscal policy: Fiscal policy is completely inefficient when LM is vertical (when LM does not depend from the interest rate). The crowding out offset all the positive shift of the fiscal policy. The higher is the sensitivity of the demand for money to the interest rate, the higher is the effectiveness of fiscal policy. Demand for money is relatively more dependent from the interest rate than from the output. It means that any increase in the output has a lower impact on money demand, and thus on the interest rate. That’s why the crowding out effect is reduced.

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