This preview shows pages 1–16. Sign up to view the full content.
This preview has intentionally blurred sections. Sign up to view the full version.
View Full DocumentThis preview has intentionally blurred sections. Sign up to view the full version.
View Full DocumentThis preview has intentionally blurred sections. Sign up to view the full version.
View Full DocumentThis preview has intentionally blurred sections. Sign up to view the full version.
View Full DocumentThis preview has intentionally blurred sections. Sign up to view the full version.
View Full DocumentThis preview has intentionally blurred sections. Sign up to view the full version.
View Full DocumentThis preview has intentionally blurred sections. Sign up to view the full version.
View Full DocumentThis preview has intentionally blurred sections. Sign up to view the full version.
View Full Document
Unformatted text preview: Chapter 2: Measuring the Economy lnaz‘rucitw‘a Mamet Chapter 2: Measuring the Economy Problem 1 A closed economy is an economy without international trade, while an open economy is an
economy that participates in international trade. The public sector refers to the portion of the economy controlled by the government, while the private sector refers to the portion of the economy controlled by households and ﬁrms. The government budget deﬁcit refers to yearly borrowing by the government, while government debt refers to the total accumulated borrowing that is owed by the government. Aggregate income, aggregate expenditure, and aggregate production are each equal in value and are each measured by GDP. Problem 2 See Section 4 in the text and equation 2.9. From equation 2.9, you can see that a larger budget deﬁcit, (TR +G)>T, will lead to a larger trade deﬁcit, NX<0, everything else being equal. Looking at Figure 2.4 in the
text, you can see that trade deﬁcits in the US tended to be larger in the mid 19805 when
the government budget deﬁcit was at its the largest. Given that the budget deﬁcit decreased dramatically and actually turned into a budget
surplus in the late 19905, we should have witnessed a decrease in the US. trade deﬁcit,
everything else being equal. However, once again looking at Figure 2.4, you see that the
trade deﬁcit actually increased during the late 19905. The only explanation must be a
change in one of the other variables in equation 2.9. The low private savings rate, S, in the US. is the most likely source of this decrease in net exports. (This will be discussed more
fully in Chapter 6.) Problem 3 We know that the trade deﬁcit is TD=G+TRT. So rewriting this equation we
can obtain G= TD + T — TR = 200—200+500=$500. The GDP accounting identity is Y=C+I+G+NX. So GDP equals
5,000+] ,000+500+600800=$6,300. Given that NX=$200, this country must also have a negative level of net foreign
investment of $200. Thus, this country is a net foreign borrower. C/Y=5,000/6,300= 79.4%.
l/Y=1,000/6,300= 15.9%. Chapter 2: Measuring the Economy Instructor’s Manual Problem 4 Stocks are variables that are measured at a particular point in time, while ﬂows are measure over a
period of time. Stock variables are useful in giving you a snapshot of the overall level of assets
and liabilities that have been accumulated over time. Flow variables allow you to investigate the
rates of change in these stock variables. Problem 5 Flow variables are measured with respect to time (thus they have a "per unit time" dimension),
while stock variables are measured at a point in time. Therefore, the stock variables are national debt and capital. The ﬂow variables are
Consumption, Gross Domestic Product, Net Domestic Product, the government budget deﬁcit,
transfer payments and interest payments on debt. Problem 6 a. From the GDP accounting identity, Y = C + I + G, it is possible to obtain the ﬁgure for
gross investment. Since we have numbers for GDP (Y), consumption (C), and government
spending (G), gross investment is I = Y  C  G = $5,000 — $2,600  $1,200 = $1,200. b. Net Investment is simply Gross Investment minus the Depreciation cost of maintaining the
existing capital stock. So, Net Investment = Gross Investment  Depreciation
= $1,200  (0.10)($10,000) = $200. c. The Net Domestic Product is obtained by subtracting depreciation costs from the Gross
Domestic Product. Thus,
NDP = GDP  Depreciation = $5,000  $1,000 = $ 4,000. d. The capital stock in any year is the capital stock inherited ﬁom the previous year plus new
investment that took place last year. We care only about net investment since a part of
gross investment is used to cover for the depreciation of the existing capital stock. Hence, Capital Stock in 2002 = Capital Stock in 2001 + Net Investment in 2001
= $10,000 + $200 = $10,200. Chapter 2: Measuring the Economy Instructor’s Manual Problem 7 The table below shows the capital stock for the years 19941999. GROSS CAPITAL STOCK DEPRECIATION .

199 _—
199
199
199
199 The second column is calculated as follows:
In 1995, for instance, capital stock = capital from 1994 + gross investment  depreciation cost. YEAR Problem 8 John’s balance sheet: ASSETS ‘ ‘ LIABILITIES Car: $20,000 Mortgage: $45,000
Credit Card: $2,000 Credit to Joan: $17,000
House: $50,000 Net Worth: $44,000 Joan’s balance sheet: ‘
Car: $1 1,000 Debit: $17,000
Jewelry: $2,000 Mortgage: $45,000
House: $50,000 Credit Card Debts: $700
Credit Card: $1,000 Net Worth: $1,300 The Brown family's balance sheet: ‘
Cars: $31,000 Mortgage: $90,000
Credit Card: $3,000 Credit Debts: $700 House: $100,000
Jewelry: $2,000 Net Worth: $45,300 Chapter 2: Measuring the Economy Instructor’s Manual Problem 9 3. GDP using the expenditure methodl
Y = value of ﬁnals goods and services = $5 + $80 = $85 b. Value added by ﬁrm A = $5 + $25 = $30.
c. Value added by ﬁrm B = $80  $25 = $55. d. Assume that all proﬁts go back to the households.
Proﬁts of ﬁrm A = Revenue from sales  Cost of inputs = $30  ($5 +$25) = $0.
Fim‘. B spends $30  $10 = $20 in wages. The problem is not speciﬁc about whether it
employs capital too. Supposing that it does not, then
Firm B's proﬁts2 = $80 — $20  $25 = $35.
Thus total proﬁts earned by hbuseholds from Firms A and B are $35. e. $25, the value of the goods that.me A sells to ﬁrm B.
Problem 10
a. GDP per capita seems to be the most appropriate measure to compare the well being of these two countries. b. GDP per capita is $133.33 in Country A. GDP per capita is $102.86 in Country B, so Country A is better off. 0. Country A produces 91.7% of the world’s output and Country B produces 8.3%. Problem 11 19941995 inﬂation was ((129.96126.35)/126.35)*100=2.86%.
19951996 inﬂation was ((132.37129.96)/129.96)*100=186%.
19961997 inﬂation was (135.32132.37)/132.37)*l00=2.22%. l Verify that you get the same answer using the value added and the income methods.
By the value added method, Y = Sum of value added = $30 + $55 = $85. By income method,
Y = Wages + Rent + Proﬁt = $30 + $20 + $35 = $85. 2 If we assume that the ﬁrm employs capital too and that the production function exhibits constant returns
to scale, these $35 are payments to capital so that Firm B makes zero proﬁt like Firm A. Chapter 4: The Theory of Aggregate Supply Instructor’s Manual Chapter 4: The Theory of Aggregate Supply Problem 1 A representational agent economy is one in which each individual has identical preferences. The
reason why economists make this assumption is that is simpliﬁes their models and their analysis
signiﬁcantly. The problem is that it excludes the investigations of many sorts of issues,
particularly distribution issues. For example, the effects that a speciﬁc policy might have on
income distribution cannot be evaluated within a representational agent model. Problem 2 The nominal wage is the actual money amount paid to a worker for each hour of work. The real
wage is the amount of goods and services that can be purchased with the proceeds from each hour
of work. It is the real wage that matters to households because, ultimately, households do not care
about the size of the numbers in their paycheck but about the amount of goods that they can buy
with their wages. Similarly, it is the real wage that matters to ﬁrms because that is the true
measure of a ﬁrm's cost of hiring labor. Problem 3 Diminishing returns refers to the fact that the additional amount of output produced by adding
additional amounts of labor falls as larger amounts of labor are added to production. In other
words, the marginal product of labor falls as the quantity of labor rises. Because the productivity
of additional units of labor falls as a firm hires more labor, ﬁrms will only be willing to hire more
labor if the real wage also falls. It is for this reason that the labor demand curve is downward
sloping. Problem 4 a. The substitution effect refers to the fact that as the real wage rises, leisure becomes more
expensive which, in turn, encourages households to work more hours. The wealth eﬂect
refers to the fact that as the real wage rises, households become wealthier and can afford to
work less and enjoy more leisure. b. The ﬁgure in Box 4.5 indicates that real wages have risen signiﬁcantly in the US. while
the employment rate (as a percentage of the population) has remained relatively constant.
This seems to indicate that these two effects tend to offset each other, i.e., the substitution effect is approximately equal to the wealth effect, and that the long run labor supply curve
is close to being horizontal. 317 Chapter 4: The Theory of Aggregate Supply Instructor’s Manual Problem 5 A tax on labor income will discourage work and reduce the supply of labor. Both the quantity of
labor and the real wage will fall as a result. The reduction in the quantity of labor increases the
marginal product of labor because of diminishing returns. As the quantity of labor falls, there is a
movement along the existing production function and output falls. Problem 6 A tax on capital will reduce the amount of capital, which decreases the marginal product of labor
and the demand for labor. This reduction in the demand for labor will lower the quantity of labor
and the real wage. The production function will shift downward. At the same time, there is also a
movement along this new production function as the quantity of labor falls. Both of these effects
serve to reduce the level of output. Problem 7 The answer here is exactly the same as the answer to Problem 5 above. Problem 8 a. At t = .3 then I.S = (.7)(w /P).
At t = .2 then L3 = (.8)(w /P). b. At t = .3, setting LS = Ld you can solve for the value of the real wage which is
w / P = 2.39.
At t = .2, setting L5 = Ld you can solve for the value of the real wage which is
w / P = 2.23.
c. An increase in the tax rate, t, should reduce the labor supply curve, which will increase the real wage and decrease the quantity of labor. d. Att= .3, L3 = .717.
At t = .2, L3 = .446. e. The Laﬂer curve is a graph of tax revenue against the marginal tax rate. Looking at Box
4.4 in the text, you can see that there is a tax rate at which tax revenues are maximized. In
this example, an increase in the tax rate increases tax revenue, so the current marginal tax
rates must be below the tax rate that maximizes tax revenue. This example is not
consistent with supplyside arguments that in the real world current marginal tax rates are
above the revenue maximizing tax rate. 38 Chapter 4: The Theory of Aggregate Supply Instructor’s Manual Problem 9
a. The marginal product of labor is MPL = (l/2)L'”2.
b. WhenL= l, MPL=.5. When L = 2, MPL = .35.
When L = 3, MPL = .29. c. The labor demand curve is obtained by setting w / P = MPL, or w / P = (1/2)L'1/2.
This can be simpliﬁed to Ld = l/(4(w /P)2). d. Setting LS = Ld, the equilibrium values of the real wage and labor can be calculated as
w/P=‘/2andL= l, e. When L = 1, we can see from the production function that Y = 1. Problem 10 Real Business Cycle models assert that business cycles are created by changes in aggregate supply,
speciﬁcally random technology shocks. As a result, business cycles do not represent inefﬁcient
uses of resources but are simply an optimal response by ﬁrms and households to unavoidable
changes in the productivity of the economy. The attractiveness of RBC models is that they are
simple, intuitive, and mimic business cycles in the real world fairly well (see Figure 4. 7 in the
text). The problems with RBC models are twofold. First, it seems hard to satisfactorily explain all
business cycles as decreases in technology (see the discussions on the Great Depression later in the
text). Second, RBC models cannot explain involuntary unemployment, in which there are workers
who would be willing to work for a lower real wage but are still unable to ﬁnd work. In RBC
models, all unemployment is voluntary and occurs when workers move in and out of the labor
market in response to changes in real wages. 39 Chapter 5: Aggregate Demand and the Classical Theory of the Price Level Instructor’s Manual Chapter 5: Aggregate Demand and the Classical Theory
of the Price Level Problem 1 a. The value of the propensity to hold money, k, is calculated according to the relationship
k = M/PY and is shown in the table below. 1280"“ _1_981‘_ 198g“ 1983 1984 1985 0.152 ""'0.i4"1"”0.15'2' 0.153 0.145 0.155 b. Since k = M/PY, nominal GDP (PY) is a ﬂow and M is a nominal stock, k has units of
time.
c. Figure l below illustrates the timepath of the propensity to hold money, k. Although k ﬂuctuated a lot over the period, there is no discernible time trend. In fact, by eyeballing
the graph we can think of k as being approximately constant at 0.149. 0.156
0.154
0.152
0.150
0.148 0.146 0. 144
1980 1981 1982 1983 1984 1985 Figure 1: Propensity to hold money Problem 2 The quantity theory of money says that MD = kxPYD, where PYD is the nominal demand for
commodities and k is the marginal propensity to hold money. The intuition behind this equation
is that people hold a constant fraction of their nominal demand for commodities as money. The
quantity theory of money is a theory of aggregate demand because if the money market is in
equilibrium, i.e. MD = M3, then the quantity theory equation can be rewritten as P = Ms/(kYD).
From this equation, we can see that there is a negative relationship between P and YD. The
intuition behind the downward sloping aggregate demand curve is that an increase in the price
level reduces the real value of the money supply. As real money balances fall, the real demand
for commodities also decrease. 49 Chapter 5: Aggregate Demand and the Classical Theory of the Price Level Instructor’s Manual Problem 3 There should be a strong positive relationship between the money supply and the price level, and
as a result a positive relationship between money growth and inﬂation. However, looking at the
quantity equation you see that this relationship is not necessarily a perfect relationship if there is a
change in one of the two other variables in the quantity equation. First, changes in k, the
marginal propensity to hold money, affect the relationship between the money supply and the
price level. An increase in k lowers the price level if the money supply is held constant. Second,
a change in Y, or real GDP. changes the relationship between the money supply and the price
level. An increase in Y also reduces the price level holding the money supply constant. Problem 4 Nominal variables are variables that are measured in monetary units and, as a result, have not
been adjusted for changes in the price level over time. Real variables are variables that are
measured in units of commodities and as a result are not distorted by changes in the price level.
The proposition of money neutrality says that increases in the money supply will lead to
proportional increases in all nominal variables but will not affect real variables. In other words,
changes in the money supply only lead to proportional changes in the price level and those
variables measured in prices. Problem 5 One of the implications of perfectly competitive markets is that prices will be perfectly ﬂexible in
these markets. If markets are not perfectly competitive and individuals have some control over
setting prices, then prices most likely will not be perfectly ﬂexible. As a result, in a response to
an increase in the money supply it may not be the case that the price level will increase
proportionally. Looking at the quantity theory you see that if the money supply rises without a
proportional increase in the price level, one of two real variables must adjust to maintain
equilibrium, either it or Y. This would violate the proposition of money neutrality in that changes
in the money supply would affect real variables. Problem 6 fidgniamge refers to the revenue that a government generates by printing and issuing money.
Many governments ﬁnd themselves with severe budget problems. For example, many less
developed countries have accumulated large amounts of foreign debt and loan payments. At the
same time. many of these same countries have a very poor tax base from which to raise revenue.
As a result, countries that have experienced a hyperinﬂation are typically countries that have had
no other alternative but to meet their obligations through printing up large amounts of money,
which produces high levels ofinﬂation. 50 Chapter 5: Aggregate Demand and the Classical Theory of the Price Level Instructor’s Manual Problem 7 The price level is countercyclical in the classical model. Given that changes in output can only be
created by changes in aggregate supply, when aggregate supply and output increase the price
level must fall. While prices have been countercyclical over certain periods 0fU.S. history,
prices were strongly procyclical during the Great Depression when both prices and output fell
substantially. The classical model is unable to explain this procyclical movement in prices. Problem 8 a. An increase in natural resources would increase labor demand and aggregate supply. As
a result of the increase in labor demandl the quantity of labor would rise and real wages
would rise. As a result of the increase in aggregate supply the price level would fall and
aggregate output would rise. b. A reduction in the money supply would only affect nominal variables and not real
variables according to the proposition of money neutrality. There would be no change in
the real wage, but nominal wages and the price level would both fall by 20%. Aggregate
demand falls but aggregate supply remains unchanged so that aggregate output remains unchanged.
c. Same answer as in part a.
Problem 9 A large increase in labor force participation created by more women entering the labor force
would result in a large increase in labor supply. Real wages would fall and the quantity of labor
would rise. As a result, aggregate supply would rise, which would reduce the price level and
increase output. If both the price level and the real wage fall, it must be the case that nominal
wages fell as well and by more than the decrease in the price level. Problem ll) If we impose market clearing on the classical aggregate demand equation by equating aggregate
demand YD to aggregate supply YE, we obtain the Quantity Equation of Money: Ms kYE '
This equation tells us what factors inﬂuence the average price level. Preferences affect the price
level through the propensity to hold money, k. Although the classical theory assumes that the
propensity to hold money is constant over time, as Figure 59 in the text shows, it has changed a
lot over the years. Technology affects the price level through the fullemployment output level
YE, with a higher output leading to lower prices. Finally, as an example of endowments, we could think of the number of people in the economy. A shrinking labor pool would imply a shrinking
real economy, and this would raise the price level. P: 51 Chapter 5: Aggregate Demand and the Classical Theory of the Price Level Instructor’s Manual None of these factors can be considered as having hadany important consequence for prices
in the US. history. In fact, as Figure 57 in the text demonstrates, the inﬂation rate in the US.
has followed the rate of money creation quite closely. Problem 11 in the classical model, aggregate output is completely determined by changes in aggregate
supply. As a result, the aggregate demand for output is determined solely by the amount of
output that is supplied. Surpluses and shortages of output are not possible in the classical model
because prices are perfectly ﬂexible. As a result, supply does determine, or "create," its own
demand and the classical model is consistent with Say’s Law. Problem 12
a. The marginal product of labor is MPL = 3L“. Setting the real wage equal to the
marginal product, the labor demand curve is
w / P = 3L“,
which can be rewritten as LD = 9/((w / P)2).
b. Using equation 5.4 in the text, the aggregate demand curve is P = lZ/YD.
0. Setting LS = LD and solving for the equilibrium wage, w /P = 1.65 and L = 3.31. d. Equilibrium output is YE : 66.31)"2 = 10.9. c. From the aggregate demand curve P = l2/10.9 = 1.1.
Problem 13
a. The marginal product of labor is MPL = AL'm. Setting the real wage equal to the marginal product of labor, w / P = AL”, I
w / P which can be rewritten as LD = (A/ (w / P))3"2.
b. Setting L5 = L” and solving for the equilibrium wage, w / P = l and L = 1. Aggregate
output is Y = 3.
c. Using equation 5.4 in the text, the aggregate demand curve is P = lS/YD. Given Y = 3
then P = 5.
d. When A = 4 then setting LS = LD, the equilibrium wage is now w /P = 2.30 and L = 2.30. Aggregate output increases to Y = l2(:2.30)1’/3= l5.84. The aggregate price
level falls to P = l5/(15.84) = .95. 52 Chapter 5: Aggregate Demand and the Classical Theory of the Price Level Instructor’s Manual Problem 14 a. Set the real wage equal to the marginal product to obtain LD = 16/((w / P)2). Set labor
supply equal to labor demand to obtain w / P = 2 and L = 4.
Y = 8(4)“2 = 2. P = MS/kY = 16. b. The real wage, labor, and output all remain unchanged. When the money supply rises to
MS = 120, the price level also rises so that P = Ms/kY = 20, which is also a 25% increase. c. The 25% increase in the money supply lead to a proportional increase in the price level
but did not affect real variables such as Y or L. As a result, these results are completely
consistent with the proposition of money neutrality. Problem 15 The production function for this economy is Y = L, while the representative agent's utility
function is U = Iog(Y) + Iog(IL). a. The simplest way to solve this problem is to maximize the representative agent's utility
subject to the economy's production function, i.e.,
Max U = log Y+ log (IL)
subject to Y = L
This can be rewritten as a problem of maximizing the function U = log Y + log (IlO,
by substituting for L from the production function into the utility function. The ﬁrst order
condition for the optimal choice of Y is 8U 1 1 t l
—=————=0 => Y =—.
aY Y 1 — Y 2
Thus 1/2 units of output are produced in equilibrium.
b. Equilibrium employment is obtained from the production function; it is l/2 unit.
c. If the labor market is perfectly competitive, the equilibrium real wage paid to workers will be equal to the marginal product of labor. Since the marginal product of labor is
always one, the equilibrium real wage (w /P)* is also equal to 11. Hence, if the price level is P=$6, the equilibrium nominal wage is W* = PX (w / P) * =$6. d. If money supply is $20 and the propensity to hold money k = 1, from the quantity
equation of money, the price level is P = M / (k Y *) = $40. Problem 16 A class discussion is helpful here. ‘ Recall from Chapter 4, that the labor demand curve is perfectly elastic at the real wage w/ P = 1. Hence
the labor supply curve must intersect the labor demand curve at w/ P = 1. 53 Chapter 9: The Demand for Money and the LM Curve Instructor’s Manual Chapter 9: The Demand tor Money and the LM Curve Problem 1 As real balances rise, the marginal utility of money falls. As a result, interest rates must fall in
order to encourage the holding of larger levels of real balances, which generates a downward
sloping money demand curve. Problem 2
YMAX is the maximum possible income of a household if it chooses to hold all of its wealth in
interestbearing corporate bonds: YMAX — ﬂ + 3L,
P P
where W/P is the household’s real wealth, w/P is the real wage rate, and L is the amount of labor
supplied during a typical week.
The price of a bond, PB, enters the variable YMAX through wealth, W, since
w = M + PBB. ' Therefore, an increase in the price of bonds will increase the household's wealth, everything else
remaining the same, and hence increase YMAX. The household's wealth increases because an
increase in price of bonds increases the value of corporate bonds that the household already owns. Therefore, the bond price increase will shiﬁ the budget line to the right, in a parallel fashion. Problem 3 The velocity of circulation is the number of times a year that the average dollar bill circulates in the
economy and is measured in fractions of l/years. The propensity to hold money is the fraction of a
year’s nominal income held as money and is measured in fractions of a year. For example, if
k=1/5 of a year's income, then v=5, which means that the average bill changes 5 times a year. Problem 4 See Box 9.2 in the text. In the data there is a cllose positive relationship between the nominal
interest rate and Velocity, just like the utility theory of money demand predicts. This compares
favorably to the predictions of the quantity theory, which assumed that velocity was constant and
that there should be no relationship between interest rates and velocity. Chapter 9: The Demand for Money and the LM Curve Instructor’s Manual Problem 5 ln the utility theory of money demand, it is the nominal interest rate that determines the level of
money demand. The nominal interest rate is the opportunity cost of holding real balances because
the nominal interest rate incorporates notjust the lost real return of holding money as opposed to
holding bonds but also incorporates inﬂation that decreases the real value of money holdings. Problem 6 in the classical model, the real interest rate is determined in the capital market, where saving
supply and investment demand determine the equilibrium real interest rate. In the new—Keynesian
model, it is the nominal interest rate that is matters. The nominal interest rate is the opportunity
cost, or price, of holding money and is determined by equating money supply with money demand. Problem 7 In response to an increase in the money supply, nominal interest rates in the money market will fall.
This is consistent with the real world behavior of interest rates in response toFederal Reserve
policy, which will be discussed more fully in Chapter 10. Problem 8 In the classical model, changes in the money supply have no real effects because of money
neutrality. Changes in the money supply only lead to changes in the price level. As a result of an
increase in the money supply, the real interest rate remains unchanged but the nominal interest rate
should increase as inﬂation increases. This is not consistent with what happens in the real world,
where increases in the money supply lead to decreases in nominal interest rates. This is a big
problem with the classical model’s explanation of interest rates. Problem 9 Usually money demand increases during the Christmas season because of the large increase in
purchases. This increase in money demand will put upward pressure on nominal interest rates. To
offset this, the monetary authority should increase the money supply to keep interest rates at their
current level. Problem 10 The LM curve is upward sloping because an increase in output increases money demand, which in
turn increases the equilibrium interest rate. See Figure 9.4 in the text. 94 Chapter 9: The Demand for Money and the LM Curve Instructor’s Manual Problem 11 According to the classical model, money neutrality holds and there is no relationship between the
level of nominal variables and the level of real variables. As a result, the nominal interest rate has
no eﬂ‘ect on real output and the LM curve is a vertical line. In the utility theory of money demand,
nominal interest rates do have an effect on the real demand for money balances and as a result
money neutrality does not hold and the LM curve is upward sloping. Problem 12 A decrease in the price level increases the real supply of money. This increase in the real money
supply reduces nominal interest rates. The LM curve shifts to the right towards lower nominal
interest rates for a given level of output. See Figure 9.5 in the text. Problem 13 A proportional increase in both the price level and the money supply leaves the real money supply
unchanged. As a result, there is no change in the money market, no change in nominal interest
rates, and no change in the LM curve. ' Problem 14 Setting Md/P = MS/P, the LM curve is Y = 500 + 200i. Notice that there is a positive relationship
between interest rates and output in the money market. 95 Chapter 9: The Demand for Money and the LM Curve Instructor’s Manual Problem 15 To derive the LM curve, ﬁrst let us ﬁnd the demand for money. Instead of obtaining the ﬁrstorder conditions from the utility maximization exercise, we will make things simpler by setting the slope
of the indifference curve (the MRS between M/ P and Y) equal to the slope of the budget line. (3’0
*2.
1 M P _ M D _ _
—~ — Y*=— 72—1: =(16)“Y.
6 P 3U p
é’Y T
Slope of the indifference Slope of the
curve is the Marginal budget line is the
Rate of Substitution. rate of interest. Having obtained the money demand function above, set money demand equal to money
supply, and ﬁx the price: MD = IllS = A7, P = 1—). Simplify the equation by expressing i as a
ﬁmction of Y, the (constant) money supply and the (constant) price level: i=—1—[£j Y‘"
6 P This is the equation of the LM curve. Note that it slopes upward, as it should. 96 ...
View Full
Document
 Fall '08
 Serra
 Macroeconomics

Click to edit the document details