Question

You are given the following information for a closed economy in a general equilibirum context.

C^d = 5000 + 0.8Y - 80,000r , I^d = 1000 - 45,000r.

M^d/P = 0.9Y - 4000i ,  π ^e = 0.05, G = 450, Y-bar= 1000, and M = 3000.

a) Calculate the general equilibrium values of the real interest rate and the price level.

b) Explain what general equilibrium means in the IS-LM framework and how it is attained.

c) What kind of a shock has the Covid-19 pandemic crisis led to in the economies?

Answer 1

Ans- given the following information-

Cd = 5000 + 0.8Y – 80,000r , Id = 1000 – 45,000r

Md/P = 0.9Y -4000i , πe = 0.05, G=450, , M=3000.

Where,

Cd : consumption demand

Id: = Investment demand

Md: Money demand, M: Money supply

P: Price level, πe: Expected inflation

r: real interest rate, i: nominal interest rate

Y: output or GDP,

a) We have the equilibrium condition in goods market

Y = AD

Where, AD = Cd + Id +G

So, Y = Cd + Id +G

Put the values of Cd, Id, and G

Y = (5000 + 0.8Y – 80,000r) + (1000 – 45,000r) + (450)

Y = 6,450 + 0.8Y -125,000r

Y – 0.8Y = 6,450 -125,000r

0.2Y = 6,450 – 125,000r

To find real interest rate (r)

125,000r = 6,450 – 0.2Y

In the short run  

So,

Put

Using fisher Effect which says that, Nominal interest rate(i) = real interest rate(r) + expected Inflation(πe)

So, i = r + πe

i = 0.05 + 0.05

i = 0.10 or 10% i.e. nominal interest rate

We have the money market equilibrium

Nominal Money demand (Md) = Nominal Money supply(M)

Given, Md/P = 0.9Y-4000i

Put Md = M = 3000, i=0.10 (found above) and     i.e. short run equilibrium

b) In the IS-LM framework, general equilibrium means the combination level of Output or GDP(Y) and the level of nominal interest rate(i) at which both the goods market (i.e. Y=AD) and the money market (i.e. Md = M) are in equilibrium in the short run and hence the economy in equilibrium in the short run.

How it is attained-

In the goods market, Y=AD i.e. the equilibrium condition

Where, AD = Cd + Id +G

And hence, Y = Cd + Id +G

By substituting Cd, Id and G function we get the IS equation which shows the combinations of interest rate(i) and output(Y) at which goods market is in equilibrium or real balance is attained.

Where,

c: Marginal propensity to consume

t: tax rate on individual income

b: responsiveness of change in Investment due to change in i

In the money market, Md(money demand) = M(money supply)

Where, Md is a function of Y and i

By substituting Md and M function we get the LM equation which shows the combinations of interest rate(i) and output(Y) at which money market is in equilibrium.

By solving IS and LM equations for i and Y we get general equilibrium.

c) Covid-19 affected both the Aggregate demand and Aggregate supply of the economy i.e. the aggregate demand of the economy sharply reduced due to the job losses of the individuals after shut down of the industries announced by the govt. Nationwide lockdown announced by the govt. caused the industries to shut down and thus many individuals either lost their jobs or got cut in their salaries.Due to this the aggregate demand of the economy reduced.

Due to the shut down of the industries, the aggregate supply of the economy also affected.

hence, the covid-19 pandemic caused both the supply and demand shock in the economy except for the necessary goods. these types of shock causes IS curve to shift leftward and thus the output(Y) of the economy reduces and also causes to shift LM leftward due to the decrease in money demand.