Principles of Macroeconomics - Assignment [Dr.

Tanweer Ul Islam]

Macroeconomic Problems
Based on Mankiw, Principles of Macroeconomics, 9th ed.
May 17, 2025

Instructions:

ˆ Answer all questions. Show all your calculations and reasoning clearly.

ˆ State any assumptions you make.

ˆ Partial credit will be awarded for correct methodology even if the final numerical
answer is incorrect.

ˆ Round final numerical answers to two decimal places where appropriate, unless
specified otherwise.

Question 1: Monetary Policy, Inflation, and the Open

Economy (40 points)
Consider a small open economy described by the following equations:

ˆ Real GDP (Y): 5,000 units

ˆ Consumption (C): C = 200 + 0.75(Y − T )

ˆ Investment (I): I = 1000 − 50r

ˆ Government Purchases (G): 1,200 units

ˆ Taxes (T): 1,000 units

ˆ World real interest rate (r∗ ): 4% (i.e., r = 0.04)

ˆ Money Demand (M d /P ): L(Y, i) = 0.8Y − 2000i, where i is the nominal interest

rate.

ˆ The Fisher Equation holds: i = r + π e , where π e is expected inflation.

ˆ Initially, the central bank has set the money supply (M) such that expected inflation
(π e ) and actual inflation (π) are both 2% (i.e., 0.02).

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Principles of Macroeconomics - Assignment [Dr. Tanweer Ul Islam]

ˆ The commercial banking system has a required reserve ratio (rr) of 10% (0.10)
and banks hold no excess reserves. The public holds no currency (currency-deposit
ratio, cr = 0).

(a) Initial Equilibrium (15 points):

(i) Calculate the initial equilibrium values for private saving (Sp ), public saving
(Sg ), national saving (S), investment (I), net exports (NX), and the trade
balance.
(ii) Calculate the initial real money demand (M d /P ).
(iii) Given that π e = 0.02 and the banking system parameters, what must be the
initial monetary base (B) set by the central bank to achieve this inflation
target? (Hint: First find M, then B).

(b) Monetary Shock and Short-Run Price Stickiness (15 points): Suppose
the central bank unexpectedly conducts open market operations, purchasing bonds
equivalent to 50 units of monetary base. In the very short run, assume prices (P)
are sticky and expected inflation (π e ) remains at 2%.

(i) What is the new money supply (M’) immediately after the OMO?
(ii) Given sticky prices and unchanged expected inflation, what is the new nominal
interest rate (i′ ) that clears the money market?
(iii) Is the new nominal interest rate consistent with the world real interest rate and
initial expected inflation? If not, explain the disequilibrium in the context of
a small open economy with perfect capital mobility. What is likely to happen
to the nominal exchange rate (assuming flexible exchange rates)?

(c) Long-Run Adjustment (10 points): In the long run, prices adjust fully, and
expected inflation adjusts to actual inflation. The economy returns to the world
real interest rate r∗ = 0.04.

(i) What will be the new long-run inflation rate (π ′ ) and price level (P’) relative to
its initial level P0 if the change in monetary base from part (b) is permanent?
(You can express P’ as a multiple of P0 ).
(ii) How does this outcome differ from a closed economy scenario?

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Principles of Macroeconomics - Assignment [Dr. Tanweer Ul Islam]

Question 2: Economic Growth and Policy (30 points)

Consider an economy described by the Solow growth model. The aggregate production
function is Y = K 0.4 (LE)0.6 , where Y is total output, K is total capital, L is the labor
force, and E is the efficiency of labor. The labor force (L) grows at a rate n = 0.01 per
year. The efficiency of labor (E) grows at a rate g = 0.02 per year. The capital stock (K)
depreciates at a rate δ = 0.04 per year. The saving rate (s) is 28% (i.e., s = 0.28).
Let k = K/(LE) be capital per effective worker and y = Y /(LE) be output per
effective worker.

(a) Steady State (15 points):

(i) Express the production function in per effective worker terms, i.e., find y =
f (k).
(ii) Write down the equation for the change in capital per effective worker (∆k).
(iii) Calculate the steady-state level of capital per effective worker (k ∗ ), output per
effective worker (y ∗ ), and consumption per effective worker (c∗ ).

(b) Golden Rule (10 points):

∗
(i) Calculate the Golden Rule level of capital per effective worker (kgold ) that
maximizes consumption per effective worker.
(ii) What savings rate (sgold ) would be required to reach this Golden Rule steady
state?
(iii) Is the current saving rate (s=0.28) leading to more or less capital accumulation
than the Golden Rule level? Briefly explain the policy implications if the
government wants to move towards the Golden Rule.

(c) Growth Rates (5 points): In the steady state you calculated in part (a), what
are the growth rates of:

(i) Output per worker (Y/L)?

(ii) Total output (Y)?

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Principles of Macroeconomics - Assignment [Dr. Tanweer Ul Islam]

Question 3: Unemployment and National Income Ad-

justments (30 points)
(a) Labor Market Dynamics (15 points): An economy has a labor force (L) of 20
million people. In any given month, the rate of job separation (s) is 0.5% (0.005),
and the rate of job finding (f) is 9.5% (0.095).

(i) Calculate the natural rate of unemployment (u) and the number of unemployed
people in this economy.
(ii) Suppose a new government policy successfully improves the efficiency of job
matching, increasing the rate of job finding (f) to 11.5% (0.115) without affect-
ing the rate of job separation. What is the new natural rate of unemployment
and the new number of unemployed people?
(iii) If, simultaneously with the policy in (ii), a structural shift in the economy (e.g.,
rapid automation in a major sector) increases the rate of job separation (s)
to 0.7% (0.007), what would be the resulting natural rate of unemployment?
Compare this to the initial rate and explain the net effect of these simultaneous
changes.

(b) National Income Accounting Adjustments (15 points): Consider the fol-
lowing data for an economy (in billions of dollars):

ˆ GDP: 8,000
ˆ Factor payments from abroad: 250
ˆ Factor payments to abroad: 350
ˆ Depreciation (Consumption of Fixed Capital): 900
ˆ Indirect Business Taxes (e.g., sales tax): 700
ˆ Subsidies to businesses: 100
ˆ Corporate Profits: 1,200
ˆ Social Insurance Contributions (employer and employee): 800
ˆ Net interest paid by government and consumers: 300 (Assume all government
interest is part of G and not transfer)
ˆ Dividends: 400
ˆ Government and business transfer payments to individuals: 1,000 (e.g., social
security, welfare)
ˆ Personal Interest Income (received by individuals from all sources): 500
ˆ Personal Taxes: 1,500

Calculate the following, showing your steps:

(i) Gross National Product (GNP)

(ii) Net National Product (NNP)
(iii) National Income (NI) (using the NNP approach)
(iv) Personal Income (PI)

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Principles of Macroeconomics - Assignment [Dr. Tanweer Ul Islam]

(v) Disposable Personal Income (DPI)

Assume that ”Net interest paid by government and consumers” in national income
accounting refers to the portion of interest payments not already included in other
components like investment or consumption of services, and is typically subtracted
when moving from NI to PI (or added if it’s net interest received by households
*from government/business*). For PI calculation from NI, treat ”Net interest paid
by government and consumers” as net interest received by persons *not* from
production (like government bond interest). For simplicity with the provided data,
we will use this value when adjusting NI to PI as Personal Interest Income is broader.
Reconcile any standard definitional ambiguities with clear statements of how you
are using the data provided. Mankiw’s text sometimes simplifies these identities.
We aim for a detailed flow.

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