Question

13. Suppose that the economy of Wonderland is described by the following equations: 1. ii. Planned consumption: Planned investment: Planned government expenditure: Planned net export: Income taxes: vi. Inflation rate: vii. Nominal interest rate: (Note: r is the real interest rate) C = 1600+0.6(Y-T) I= 2500-1000r G= 2000 NX = 130 T= 2000 n = 0.01 i = 0.04 a. What is the short-run equilibrium output for Wonderland? Please show your calculation. b. Briefly explain how the central bank of Wonderland can increase the real interest rate through the monetary policy. In your answer, please state a tool that the central bank can use to change the money supply and explain how this tool can work.

Answer 1

Is curve :- (Locus of output market equilibrium (Y, i) points)

Y = C + I + G + NX

Y = 1600 + 0.6(Y-T) + 2500 – 1000r + 2000 + 130

Now real interest rate = nominal interest rate – inflation rate

= > r = 0.04 – 0.01 = 0.03

Short run equilibrium is yielded by the IS curve equation which is basically the locus of Savings = Investment condition of equilibrium,

or alternative for of the above as output is equal to the sum of consumption ; investment , government expenditure and net exports ; this is the form we use in our answer;

Therefore; Y = 6230 + 0.6Y – 0.6*2000 -1000r

= > 0.4Y = 6230 – 1200 – 1000r

= > O.4Y = 5030 – 1000*0.03 = 5030 – 30 = 5000

= > Y = 12500

The central bank of Wonderland can increase real interest rate thorugh monetary policy by increasing the speculative demand for money by decreasing money supply. Basically when the money supply or the liquid assets in circulation are lowered by the central bank given tat purchasing power or transaction demand for money has remained same , then the “price for borrowing money “ goes up . i.e., accessibility to loans becomes dearer thus the interest rates goes up higher as people are wiiling to give more interest on borrowed funds since there is a relative lower amount of available loanable funds as compared to earlier. One of the tools that the central bank uses to achieve this is “Open Market Operations(OMO)” . Here the central bank shall sell bonds to commercial bank which would result into more money deposited with the central bank and less money available with banks and hence in the market, thus meeting its objective