Question

Goods Market: Money Market: C=50 +0.8(Y-T) M/P=490 I=120-400r L(r,y)=-5y-100r G=110 T-50 a. What are the IS and LM equations? Calculate and show graphically the equilibrium output and interest rates? b. Suppose there is an increased risk in the financial markets changing money demand by 50 units (add or subtract 50 from money demand). Calculate the SR and LR. c. If the Federal Reserve wanted to stabilize the economy while at the SR equilibrium what policy would they need to conduct? Show this graphically and calculate how large of a policy they would need to conduct d. If the Government wanted to stabilize the economy while at the SR equilibrium what three policies could they conduct? Show this graphically and calculate how large of each of the policies would need to be. How different are these policies from what would have been suggested from the Fiscal Multipliers that were learned in introduction to macro?

Answer 1

(a).

Given, 0-8 (Y-) &, c= 50+ 0 = 120 G 490 M. Р - 400 r 43, y) = 0.58 -100% In Goods mbt. At egn. Y = AD Y = c + I + G 0 % + 100 + 110 = = 50+ 0 8Y - 40 + 120-400 ei +11o 0.2Y = 240 - 400 r 1200 2000 Y = 1200 2000 r So, IS Equation In Money mbt , &, At egn. 2 0.5Y d MS Р - loon = 490 Y = 980 + 200 r so, Y = 980 + 200 r & 2) LM Equation & Therefore, from egno Egh interest rate (2) output (y) 0.1 (10 %). &, qm 1000

LM (10%)r* E IS 0 Y* (1000)

(b). If the demand for money increases (falls) then, the LM curve will shift to the left (right).

Case - Increase in Money Demand by 50 units :-

Suppose because of some reason, if people loss confidence in bonds then, the demand for money increases at the same level of income and the same rate of interest.

As a result, the demand curve for money shifts upward and to the right. As a result, the equilibrium rate of interest rises (from 10% to 15%) for the same level of income. Consequently, the LM curve shifts upward and to the left (from LM to LM') which leads to fall in output from (1000 to 910 units).

LM LM P LRAS' LRAS (15%) r' (10%)r* ↑ P * SRAS SRAS P* IS AD O Y' y* (910) (1000) AD Y' y* (910) (1000) Y