Question

Suppose that you are given the following information about a particular economy C = 500 + 0.75(Y –T) Where C = consumption T = 1,000 T = taxes I = 750 – 25r I = investment G = 1,000 G = government spending M = 3,200 M = Money Supply P = 2 P = Price level (M/P)d = M/P = 0.5Y – 50r r = real interest rate in percent (i.e., 10 = 10%)

a)Using this information generate the equations for the IS and the LM curve (with Y and then r on the left hand side)

b)Using this information, calculate the short run equilibrium level of output (Y), interest rate (r), and investment (I).

c)Suppose that the long run full employment level is 5,000, and there is no government interference in the economy.

explain briefly (without diagrams) how the economy will adjust to the long run equilibrium (you can start by envisaging the SRAS-AD-LRAS framework and draw diagrams on scrap paper)

calculate the interest rate in the long run equilibrium Real balance (M/P) in the long run equilibrium Price level in the long run equilibrium

How would your answer to part (c) in question 2 above differ if the government decides to attain the full employment level of output though the use of fiscal policy (changing G)

Answer 1

(a) The IS equation is denoted by Y = C+I+G. We shall use above information to generate relevant IS equation:

The LM equation is denoted by M/P = kY-hr. Using above information, the LM equation is:

(b) Solving for the short run equilibirum level of output, interest rate and Investment by inserting LM equation into IS equation.

(c) We are provided that long run full employment level is 5,000, and there is no government interference in the economy. The short run level of output is 4600 which is smaller than full potential output. Also, the short run equilibrium rate is 14% which is greater than the provided 10% interest rate.

Since there is no government interference (means AD curve won't shift), the SRAS curve will make adjustments to reach full employment level. The SRAS curve will shift downwards to the right untill output reaches full employment level. In this process, the price level will decline which will cause real money supply to rise which will push downward pressure on the market interest rate (LM Curve shifts rightwards). The process continues untill output is at full employment level, prices have declined and interest rate have aligned to new equilibirum level i.e. from 14% to 10%.

(d) Using IS equation to find long run interest rate and Real money supply.

(e) The government can reach full employment level of output with expansionary fiscal policy. The expansionary fiscal policy will shift the AD curve upwards to the right. This will cause output to expand and reach full employment level, however such policy measure will cause inflation in the economy.