Economics 358 Assignment 1 -Explain the meaning of IS curve

Economics 358 Assignment 1 (version A)

This assignment has a maximum total of 100 marks and is worth 20 percent of your total grade for this course. You should complete it after completing your course work for Units

2 through 5. Answer each question clearly and concisely.

1. Explain the meaning of IS curve. Why does it have a negative slope? What factors determine the flatness or steepness of the IS curve? (10 marks)

2. Use the IS-LM graph to determine the effects on the equilibrium level of income (output) and the interest rate of the following:

(a) an increase in government spending, and

(b) an increase in taxes.

Why do income and the interest rate move in the same direction? (15 marks)

3. How is the IS curve altered by introducing international trade? What is the effect on IS curve of a rise in international trade? (15 marks)

4. Define the Marshall-Lerner condition. What are the likely effects of devaluation during a recession when supply elasticities are high? (10 marks)

5. Explain the J-curve phenomenon. Consider an economy with a fixed exchange rate with a fixed price level. What is the effect of depreciation on equilibrium income and trade balance in the first six months after depreciation? (10 marks)

6. Define uncovered interest parity. What is the relationship among the forward exchange rate, the spot exchange rate, and the interest rate? Suppose the (1-year) interest rate on bank deposits is 2% in Canada and 1.75% in United States. If the (1-year) forward US$–C$ exchange rate is C$1.25per US$ and the spot rate is C$1.2 per US$, will the C$ depreciation or appreciation against the US$ over one year, and by how much?(15 marks)

7. Define the real exchange rate. Suppose that the cost of the market basket in Canada is PCA = $200. Fill in the missing elements of the table below. (Hint: Use a spreadsheet application such as Excel.)(10 marks)

Country

(currency measured

in FX units)

Per $,

EFX/$ Price of market basket

(in FX) Price of Canadian basket in FX

(PCA times EFX/$) Real exchange rate, ?

Brazil (real) 2.7884 555

Cyprus (Cy£) 0.45 80 1.125

India (rupee) 52.3456 12,025

Mexico (peso) 12.0222 1,810

S. Africa (rand) 7.2320 850 1446.6

Zimbabwe (ZW$) 90,680 3,400,000

8. Consider the following economy. Suppose the real exchange rate is fixed and equal to one. The consumption (C), investment (I), government spending (G), taxes (T), exports (X), and imports (Q) are given by:

Z = C + I + G + (X–Q)

C = 120 + 0.85(Y–T)

I = 250

G = 600

X = 0.2Y*

T = 50 + 0.25Y

Q = 30 + 0.1Y

where Y is the domestic income and Y* is the income of the principal trading partner. Assume Y* = 800.

a. Based on the above information, derive the planned aggregate expenditure as a function of Y (Hint: derive the ZZ curve – aka the AE curve). Sketch the Keynesian cross diagram of the above economy and indicate the equilibrium level of income (output). (5 marks)

b. Calculate the equilibrium level of income. (5 marks)

c. Calculate the amount of taxes collected when the economy is at equilibrium level of output. Is the government running a surplus or deficit, and by how much?

(2.5 marks)

d. Calculate the value of net exports when the economy is at equilibrium level of output. (2.5 marks)