Question

We investigate the effect on the economy of a negative shock to consumer confidence. Assume that the behavior of the economy is given by the following equations:

Goods Market:

Y = C + I + G (Goods Market equilibrium)

C = Z + 0.5(Y − T) (Consumer Demand)

I = 60 − 50r (Investment Demand)

G = T = 100 (Government Budget)

Money Market:

M/P = L(Y, r + e) (Money Market Equilibrium)

L(Y, r + e) = 0.1Y − 50(r + e) (Real Money Demand)

M = 100 (Money Supply)

Labor Market: Y bar = 200

Variable Z is an index of consumer confidence: a positive Z means that consumers are optimistic about the future, a negative Z means that they are pessimistic. We assume initially that Z = 0. The shock we wish to consider in this exercise is a sudden drop in consumer confidence: Z < 0.

1. Derive the IS curve for any Z.

2. Plot the IS curve. How does the IS curve shift in response to changes in confidence?

3. Derive the LM curve.

4. Assume the economy has been at the long-run equilibrium for a long time with Z = 0 and e = 0. Compute the corresponding output, real interest rate and the price level.

5. Assume now that confidence Z suddenly drops from 0 to -5. Show what happens to the economy in the short run and in the long run on a graph with IS, LM and FE curves. Explain what happens to output, interest rates and the price level? (Graphically only)

6. Using the IS, LM and FE curves, compute the output, interest rate and the price level

a. In the short run

b. In the long run

Answer 1