Question

Solved parts a-e, need the rest.

1. Suppose the economy can be defined as the following:

Consumption Function: 3000+0.6*(Y-T)

Investment Function: 600-50r

Government Expenditure = 500; Tax = 500

Net Export = 300–30r

M = 10000

Money Demand Function: L(Y,r) =5Y–2500r

a) Derive the IS curve.

IS: r = 51.25 - .005Y

b) Derive the LM curve

LM: r = .002Y-4*(1/P)

c) Suppose P = 10, compute the equilibrium interest rate and output.

(e.g. If you compute r = 2.46, treat this as 2.46%)

r^∗=14.357, Y^∗=7378.571

d)Graphically illustrate the solution for part d, you should have four graphs: graph with the AD curve, the IS-

LM diagram, the Keynesian Cross (market of goods and services) and the theory of Liquidity Preference (market of real money balance).

Impact of Fiscal Policy

e)Suppose government spending increases to 700. Redo (a-d).

IS: r =53.75-.005Y, r^∗=15.071, Y^∗=7735.714

f)Compute the size of crowding out effect.

Crowding out size = _____________

g)Show how this increase of government expenditure affecting the graphs you draw on part (e)

(Don't need this one)

Special case

i)Suppose everything is the same, except now the LM curve is independent to interest rate, more specifically, LM : Y = 8000. Compute the equilibrium interest rates and outputs before and after the increase in government spending.

Before: r^* = ____, Y^* = _____

After:r^* = ____, Y* = _____

j) What is the size of the crowding out effect?

Crowding out size = _______

Answer 1