Question

IS/LM: Use the same setup as #1, but now Investment spending is a function of the real interest rate: I = 10000 – 50000r. Government purchase are now $1200b (makes for nicer numbers).

Money demand in the economy is MD= (0.01Y – 800r)P + o. Assume the current money supply is $1400b, the price level/CPI is 100, and there are no money demand shocks to worry about (o = 0).

a) Derive the IS curve and the LM curve for this economy, and calculate the level of GDP and the real interest rate.

b) Suppose the Fed increases the money supply to $2000b. For now, assume that the level of GDP stays the same. Use the money demand equation and the current level of GDP to find the new interest rate in the economy. Briefly describe why the Fed’s increase of the money supply changes the interest rate.

c) Derive the new LM curve based on the higher money supply. Adopting our usual “different interest rate at the same level of GDP” thinking, how would you describe this change in the LM curve graphically? 4b and 4c are the “initial shock” part of our 3-part IS-LM story.

d) Based on the new LM curve, calculate the new level of GDP and interest rate in the economy, and draw an IS-LM graph that shows the before and after. Label both intersections, but no need to label intercepts or worry about scale too much.

e) Use our 3-part story to explain why the interest rate change you found in 4c is different from the change in 4b. Discuss the 3-part story, including the arrows in your graph, and you should see the answer.

Answer 1

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