Question

An economy is described by the following equations:

C = 1,600 + 0.6(Y – T) – 2,000r

I^P = 2,500 – 1,000r

G = 2,000

NX = 50

T = 2,000

The Bank of Lotusland, the central bank, has announced that it will set the real interest rate according to the policy reaction function found in the table below:

Inflation rate, π	Real interest rate, r
0.00	0.02
0.01	0.03
0.02	0.04
0.03	0.05
0.04	0.06

a. Find an equation relating planned aggregate expenditure to output and the real interest rate.

PAE= ? + ?Y - ?r

b. For each of the rates of inflation given below, find autonomous expenditure and short-run equilibrium output in Lotusland.

Inflation rate, π	Real interest rate, r	Autonomous expenditure	Equilibrium output
0.00	0.02	?	?
0.01	0.03	?	?
0.02	0.04	?	?
0.03	0.05	?	?

Using the data above, graph the AD curve.

c. Repeat parts a and b, assuming that government purchases have increased to 2,100. How does an increase in government purchases affect the AD curve?

New PAE = ? + ?Y – ?r

For the rates of inflation given, find autonomous expenditure and short-run equilibrium output in Lotusland after the increase in government purchases.

Inflation rate, π	Real interest rate, r	Autonomous expenditure	Equilibrium output
0.00	0.02	?	?
0.01	0.03	?	?
0.02	0.04	?	?
0.03	0.05	?	?

Using the data above, graph the new AD curve.

The increase in government purchases shifts the AD curve right by ? units at each inflation rate.

Answer 1