Responding to Economic Fluctuations Additional Homework Problems ECON 3133 Dr. Keen Answers 1. a.In the year of the shock, the price level, being a predetermined variable, will stay at 1. Therefore, the real money supply will also stay constant and be MS/P = 900/1 = 900. To calculate the new value of GDP and the new level of interest rates, derive the equations of the IS and LM curves, and then find the coordinates of the point where they intersect. Nothing has happened to shift the IS curve. Therefore, as before, IS: R = 1.178 – 0.000188×Y. Due to money demand shock, the equation of the LM curve changes. The new equation of the LM curve is LM: R = 0.00007915×Y – 0.45. Therefore, when G = 1200, MS= 900, and P = 1, Y = 6,093.9547 and R = 0.0323. b. In the year of the shock the economy moves from point A to B, and then, in subsequent years, it moves from point B to C. c.In the long run, GDP will return to its potential level, which is Y* = 6,000. That is, Y = 6,000. Substituting Y = 6,000 in the IS equation gives R = 0.05. Next, substituting Y = 6,000 and R = 0.05, and in the (new) LM equation gives P = 1.0591.