Question

Consider the economy of Wiknam. The consumption function is given by f. With the initial values for monetary and fiscal policy, suppose that the price level falls from 5 to 3. What happens ? What are the new equilibrium interest rate and level of income? C = 250+ 0.6(Y-T). The investment function is The LM curve shifts to the by about 383.33. I = 100-20r. What are the new equilibrium interest rate and level of income? The money demand function is M = Y-20r. newTE % Round answers to two places after the decimal where necessary new Y= g. How do the monetary and fiscal policy changes in parts d and e impact aggregate demand? The increase in the government purchases causes aggregate

Answer 1

a. For the IS curve,

Y = C+I+G

or, Y = 250+0.6(Y-100)+100-20r+100

or, 0.4Y = 390-20r

or, Y = 975-50r

Now, plotting the value of r from 0 to 8, we can get, the IS curve in the diagram below.

b. Similarly, for the LM curve,

(M/P)_d = Y-20r

or, (2,875/5) = Y-20r

or, Y = 575+20r

Now, plotting the value of r from 0 to 8, we can get, the LM curve in the diagram below.

Interest rater IS 9 LM 8 -7 -6 5.7 E 5 -4 3 2 1690 700 0 100 200 300 400 500 600 800 900 1000 Output Y

c. From the above diagram, equilibrium is attained at point E (here IS = LM),

where equilibrium output Y = 690

and equilibrium interest rate r = 5.7

d. If G increases from 100 to 150, then $\Delta$ G = 150-100 = 50

Now, value of multiplier = 1/(1-mpc) = 1/(1-0.6) = 1/0.4 = 2.5 (here mpc=0.6)

Increase in Y ($\Delta$Y) = $\Delta$ G*multiplier = 50*2.5 = 125

Thus, the IS curve will shift to the right by 125

New IS curve is Y=1100-50r

For equilibrium, IS curve = LM curve

or, 1100-50r=575+20r

or, 70r = 525

or, r= 7.5

and Y = 575+(20*7.5) = 725

Then, new equilibrium output Y = 725

and new equilibrium interest rate r = 7.5

e. If money supply decreases from 2,875 to 2,500,

then, LM curve is given by (M/P)_d = Y-20r

or, Y = 500+20r

Comparing the new LM curve with old one,

the LM curve will shift to the left by 75.

Now, for equilibrium, IS = LM

or, 975-50r = 500+20r

or, 70r = 475

or, r = 6.8

and Y = 500+(20*6.8) = 636 (approx)

f. If price level falls from 5 to 3,

then, LM curve is given by (M/P)_d = Y-20r

or, 2,875/3 = Y-20r

or, Y = 958.33 + 20r

Comparing the new LM curve with old one,

the LM curve will shift to the right by 383.33,

Now, for equilibrium, IS = LM

or, 975-50r = 958.33+20r

or, 70r = 16.67

or, r = 0.24

and Y = 975-(50*0.24) = 963

g. From d and e,

The increase in government purchase caused aggregate demand to increase.

and the decrease in money supply caused aggregate demand to decrease.