Question

TUHATV 3. Consider a closed economy of Balticland that can be described by the following functions: All values C, 1, and G are in billions of USD. Consumption expenditure: C = 110 + 0.5(Y-T) Investment expenditure: 1g = 1,100 - 58r, where r = 2.5% Government expenditure: G = 550 Lump-sum constant taxes: T = 550 (a) Find the equilibrium Y, C and lg

Answer 1

(a)

When r = 2.5,

Ig = 1,100 - 58 x 2.5 = 1,100 - 145 = 955

In equilibrium, Y = C + Ig + G

Y = 110 + 0.5 x (Y - 550) + 955 + 550

Y = 1,615 + 0.5Y - 275

0.5Y = 1,340

Y = 2,680

C = 110 + 0.5 x (2,680 - 550) = 110 + 0.5 x 2,130 = 110 + 1,065 = 1,175

(b)

Y = 100 + 0.5 x (Y - 550) + 955 + 550

Y = 1,605 + 0.5Y - 275

0.5Y = 1,330

Y = 2,660

(c)

100 + 0.5 x (Y - 550) + 1,100 - 58r + 550 = 2,680

0.5Y - 275 - 58r = 930

0.5 x 2,680 - 58r = 1,205

1,340 - 58r = 1,205

58r = 135

r = 2.33%

(d)

Target real interest rate found in (c) is higher than given interest rate of 2.5%, so central bank has to increase interest rate by decreasing money supply. This can be done by increasing the DR and is known as contractionary monetary policy.