Question

A. Consider the following equations for a little closed economy; the role of the Government is neglected. C = 40 +0.80Y I = 70 - 2001 1) Calculate the national income (V) 2) Determine the equilibrium income when the interest rate is 10%, then 5%. Comment the results. Draw a graph to illustrate 3) What will happen if investment behaviours are changing and becoming = 80 - 200i 4) What kind of change would have involved a movement along the curve? B. In the country X, the velocity of money is constant. Real GDP grows by 5 percent per year, the money supply grows by 14 percent per year, and the nominal interest rate is 11 percent. What is the real interest rate?

Answer 1

A) C = 40 + 0.8Y

I = 70 - 200i

a) At equilibrium, Y = C + I

Y = 40 + 0.8Y + 70 - 200i

0.2Y = 110 - 200i

b) If interest rate is 10% (0.1), then equilibrium income is 0.2Y = 110 - 200 (0.1)

0.2Y = 110 - 20

Y = 550 - 100 = 450

If interest rate is 5% (0.05), then equilibrium income is 0.2Y = 110 - 200 (0.05)

0.2Y = 110 - 10

Y = 550 - 50 = 500

When rate of interest falls, investment level rises.

Interest 60 I nostment

c) If Investment changes to I = 80 - 200i

Then equilibrium income would be Y = 40 + 0.8Y + 80 - 200i

0.2Y = 120 - 200i

Y = 600 - 1,000i

d) Change in rate of interest cause movement along investment - interest rate curve.

B) Quantity theory of money says that: Change in Money supply * Change in Price level = Change in Velocity of money * Change in real GDP

Money supply = 14% = 0.14

Real GDP = 5% = 0.05

Change in velocity of money is constant

0.14 * Price level = 0.05

Price level = 35.71%

As change in price (Inflation rate) is 35.71%

Nominal Interest rate = Inflation rate + Real Interest rate

11% = 35.71% + Real Interest rate

Real Interest rate = 35.71% - 11% = 24.71%