Question

A classical economy is described by the following equations: ?? = 150 + 0.8(? − ?) − 200?
?? = 150 − 80?
? = 0.6? − 150?

? = 1,500
?^e = 0.06
Government spending and taxes are equal where T = G = 100. The nominal money supply M = 4,550.

(a) What are the equilibrium values of the real interest rate, the price level, consumption, and investment?

(b) Suppose an economic shock increases desired investment by 30, so it is now ??

= 180 − 80?. How does this affect the equilibrium values of the real interest rate, the price level, consumption, and investment?

(c) During a recession, would classical economists suggest that the changes in monetary policy be used to improve economic conditions? Briefly explain.

Answer 1

The IS curve gives

Y = C + I + G = 150 + 0.8(? − ?) − 200?+150 − 80?+100

Y =150 + 0.8(? − 100) − 200?+150 − 80?+100

Y=400+0.8Y-80-280r

Y-0.8Y=320-280r

0.2Y=320-280r

Y=1600-1400r

The LM curve gives M/P = L = 0.6Y – 150i = 0.6Y – 150(r + ?e) = 0.6Y – 150(r + 0.06) = 0.6Y – 150r – 9.
M = 4550,

The IS curve is Y = 1600-1400r. Output must be at its full-employment level of 1500. From the IS curve, 1500 = 1600-1400r, or 14r = 10, so r = 0.07(approx)

Using this in the LM curve to find the price level gives M/P = 0.6Y – 150r – 9 or 4550/P = (0.6 *1500) – (150 ´ 0.07) – 9, so P = 4550/(900-10.5-0.07) = 4550/880.5 = 5.17

Then consumption is C = 150 + 0.8(? − ?) − 200?
= 150 + 0.8(1500-100) – 200(0.07) = 150+1120-14=1256(approx).

Investment is I = 150 − 80?=150-80(0.07)=150-5.6=144.4(approx).

b)

The IS curve gives

(I=180-80r)

Y = C + I + G = 150 + 0.8(? − ?) − 200?+180 − 80?+100

Y =150 + 0.8(? − 100) − 200?+150 − 80?+100

Y=430+0.8Y-80-280r

Y-0.8Y=350-280r

0.2Y=350-280r

Y=1750-1400r

M/P=0.6Y – 150r – 9 (from a)

Now, Y=1750-1400r : M=4550

4550/P=0.6Y-150r-9 ---------------------------------------(1)

IN CLASSICAL MODEL THE ECONOMY IS AT FULL EMPLOYMENT LEVEL SO THE EQUILIBRIUM LEVEL OF INCOME i.e. 1500 REMAINS THE SAME .

1500=1750-1400r

r=250/1400=0.18(approx.)----------------------------(2)

inserting (2) in equation (1)

4550/P=0.6(1500)-150(0.18)-9

4550/P=864

P=4550/864=5.27(aprrox)

C=150+0.8(Y-T)-200r

=150+0.8(1500-100)-200(0.18)

=150+1120-36

C=1234

I=180 − 80?

=180-80(0.18)
​​I=165.6

The reduction in consumption from 1256 (a) to 1234 in (b) is compensated(approximately due to rounding off) by an increase in Investment from 144.4(a) to 165.6(b). This leaves the aggregate demand unchanged in the classical system with no change in government expenditure and taxation.

c) A change in monetary policy will leave the real variables such as Y and r unchanged. A 10% increase in money supply will increase the Price level i.e. P by 10% leaving real variables unchanged. In the classical system, the quantity of money determines the price level and the level of nominal income. Therefore, we can say that the government won't suggest changes in monetary policy to pull the economy out of recession.