Question

1. Based on the following set of equations,

(1) AD=Y=Y*

(2) AD = C + G₀ + I

(3) C = C₀ + c1* YDIS

(4) Y^DIS = Y-T

(5) T=T₀ + tY

(6) I = I0 –er

0 <c1<1

0 <t<1

e>0

a)         Derive AD curve

b)         Draw AD curve

c)         Analyze, what will happen, if r (real interest rate) increases.

d)         Interpret coefficient e. Do you expect the value of this coefficient will be higher in the UK or Senegal?

e)         Based on point a), solve the equation for r variable.

f)         Based on point e), draw the function r = f(Y) (hint: r should be on the vertical axis, Y should be on the horizontal axis).

2. The real demand for money (Md = Md (nominal)/P) is expressed as a linear function:

(1) Md = kY-hr

(2) Ms = Md

a)         Explain the sign of coefficients k and h. What types of money demand do they refer to?

b)         Explain why there is no equation for the money supply.

c)         Using equation (1), express i as the function of Y (simply solve it for r variable).

d)         Draw the function obtained in point (c) on the same graph as in point 1.f).

3. Based on the graph you draw in point d), analyze the effect of the following events on the economy. Make sure to explain everything step-by-step.

EXAMPLE a) The central bank increases the money supply.

Ms increases => interest rate decreases => investment increases =>Y increases

On the graph: LM shifts to the right; at the new equilibrium point, Y increases, interest rate decreases.

b) The government increases taxes.

c) The government increases government spending.

d) MPC increases.

e) the tax rate decreases.

Answer 1