Question 1: [55 marks]

When we derived money demand function in class, we assumed that money demand

depends on income and interest rate. Consider an economy that its money demand does not

depend on income and is only a function of interest rate.

M

d

=

L

(

i

)

Suppose that the economy is an open economy that is on a exible exchange rate system.

1. Draw the money demand and supply curves with money demand and supply on x-axis

and interest rate on y-axis. [3 marks]

2. Show what happens to money demand and supply curves if income changes. [2 marks]

3. Derive the

LM

curve. [5 marks]

4. Derive the

AD

curve. [5 marks]

5. In response to the COVID-19 crisis, suppose that the government of the

ABOVE

ECONOMY

increases transfer payments to help people struggling during the COVID-

19 pandemic.

(a) Show the short run eects of this policy using the

Five-Figures Diagram

we drew in class; goods market, money market, the

IS

-

LM

curves, the interest

parity condition curve, and the

AS

-

AD

curves. Explain your answer. [8 marks]

(b) How about the eects of this policy in the medium run? Assume that before

and after the changes, the economy is still in a recession (i.e. its output is below

its natural level). To answer this question, draw the

Two-Figures Diagram;

the

IS

-

LM

curves and the

AS

-

AD

curves. Explain your answer. [5 marks]

(c) Do you think this policy is su cient to compensate for damage done to the

economys production and consumption of goods and services during the epi-

demic? Explain your answer. [2 marks]

6) In response to the COVID-19 crisis, suppose that the foreign government increases

investment in new hospitals. Show the short run eects of this foreign policy on the

ABOVE ECONOMY

using the

Five-Figures Diagram

we drew in class; goods

market, money market, the

IS

-

LM

curves, the interest parity condition curve, and the

AS

-

AD

curves. Explain your answer. [10 marks]

7. Suppose that the central bank of the

ABOVE ECONOMY

lowers its target for the

overnight rate and buys government bonds to provide support to the economy during

the COVID-19 pandemic.

2

(a) Show the short run eects of this policy using the

Five-Figures Diagram

we drew in class; goods market, money market, the

IS

-

LM

curves, the interest

parity condition curve, and the

AS

-

AD

curves. Explain your answer. [8 marks]

(b) How about the eects of this policy in the medium run? Assume that before

the changes, the economy was at the natural level of output. To answer this

question, draw the

Two-Figures Diagram;

the

IS

-

LM

curves and the

AS

-

AD

curves. Explain your answer. [5 marks]

(c) The more the central bank buys, the lower the interest rates that the govern-

ment has to pay on new borrowing, and the more the government can borrow.

Does this mean the government can spend as much as it wants and protect the

economy from damage done by the virus? Explain your answer