chapter_9_answers - 1 Use the IS-LM model to determine the effects of each of the following on the general equilibrium values of the real wage

# chapter_9_answers - 1 Use the IS-LM model to determine the...

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1 1. Use the IS-LM model to determine the effects of each of the following on the general equilibrium values of the real wage, employment, output, the real interest rate, consumption, investment, and the price level. a. A reduction in the effective tax rate on capital that increases desired investment. Answer: I d r; MPK f , τ ( ) If ↓τ , then the investment schedule shifts to the right. Adjustment story: at r o the level of desired savings is less than the level of desired investment. That is equivalent to saying the following Y < C d + I d + G i.e., the Goods Market is not in equilibrium at r o . Explain adjustment in the goods market in terms of movements along desired savings and desired investment. (Note that we are assuming that prices of the goods are not changing) at r o : Y < c d + I d + G consumers save less and firms invest more when the interst rate it low
2 r eliminates the excess demand for goods over the supply by c d & I d until Y = c d + I d + G adjustment along the savings schedule: r S d = Y C d G adjustment along the investment schedule: r r + d ( ) p k = uc ⇒ ↓ I t = K K t + dK t Now we can write out the IS function explicitly IS r, Y; y f e , W , G , T , MPK f , τ If ↓τ then the IS curve shifts up, i.e., to the right. Note that when we consider changes in r and Y, then we are contemplating movements along the IS curve! When an exogenous variable changes, we are considering what happens to the equilibrium interest rate for a given level of output, Y . Asset Market Equilibrium: Recall our money demand function M d = PL Y, r + π e ( ) In equilibrium M s = M d M s = PL Y, r + π e ( ) M s P = L Y, r + π e ( )
3 Now we can graph this relationship Money supply changes: P shifts the money supply curve to the left Adjustment Story : at r 1 the quantity of money demanded exceeds the quantity of money supplied. As money holders sell some of their nonmonetary assets so they can hold more money in their portfolios, the price of nonmonetary assets is driven down. This raises the real interest rate on nonmonetary assets. As r rises the quantity of money demanded falls (movement along a negatively sloped money demand curve), until equilibrium is reached. Show with the money demand equation .
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5 b. The expected rate of inflation rises. Answer: If ↑π e then real money demand falls, i.e., shifts back. Adjustment Story : at the old interest rate, the supply of money exceeds the quantity of money demanded. Agents purchase nonmonetary assets, driving their prices up and their real returns (the real interest rate paid on the asset) down. As the real interest rate falls, individuals find the nonmonetary asset less and less attractive relative to money. Eventually the interest rate will fall so low that the excess supply of money and the excess demand for nonmonetary assets are zero.