Question

3. Suppose that prices are completely rigid, so that the nominal and the real interest rate are necessarily equal. Money-market equilibrium is therefore given b L(r,Y). a. Suppose that government purchases increase, and that the central bank adjusts the money supply to keep the interest rate unchanged. i. Does the money supply rise or fall? ii. What happens to consumption and investment? b. Suppose that government purchases increase, and that the central bank adjusts the money supply to keep output unchanged. i. Does the money supply rise or fall? ii. What happens to consumption and investment? c. Suppose that government purchases increase, and that the central bank keeps the money supply unchanged. i. Does the interest rate rise or fall? ii. What happens to consumption and investment?

Answer 1

Increase in government purchase increases budget deficit, which increases government borrowing, increasing interest rate in absence of intervention. Higher government purchase increases output.

(a)

(i) To keep interest rate unchanged, money supply has to increase, which will lower interest rate until it returns to original, lower level.

(ii) Higher money supply increases output, consumption and investment.

(b)

(ii) To keep output unchanged, money supply has to decrease, which will increase interest rate, causing investment to fall and output to fall until it returns to original, lower level.

(ii) Lower money supply decreases output, consumption and investment.

(c)

(i) If money supply is unchanged, interest rate will rise (as explained at beginning of solution).

(ii) Higher interest rate decreases output, consumption and investment.