Question

Suppose the economy is operating at full potential in the following IS-LM-PC model: C 200+0.25*Y I-150 0.25*Y-1000 i G = 150 T-200 i-0.05 a) Solve for the equilibrium level of output. What is the level of potential output? b) Solve for the equilibrium values of C and I c) Suppose in period t+1 there is an increase in consumer confidence to 0.5 and an increase in taxes to 300. Solve for the new equilibrium levels of Y, C and I inflation rate in period t+1? in period t+2? Solve for the nominal interest rate that will return the economy to d) Solve for and explain the effect of the increase in consumer confidence on the e What policy must the central bank implement to return output back to its potential potential and the new equilibrium levels of Y, C and I under this policy

Answer 1

a) Equilibrium level of output :

GDP = C+I+G+NX

GDP = 200 + 0.25Y + 150 + 0.25Y - 1000(0.05) + 150

GDP = 450 + 0.50Y

Y = 450 + 0.50Y

Y = 450/0.5 = 900

As it is given that the economy is operating at full potential, thus Y = 900 is the level of potential output as well.

b) Put Y = 900 in C and I

Equilibrium level of C: C = 200 + 0.25(900) = 425

Equilibrium level of I : I = 150 + 0.25(900) - 1000(0.05) = 325