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Unformatted text preview: ECON 202, SPRING 2009 Malhar Nabar Answer Key #4 Posted: April 22 (extension) Note : There are &ve questions in total. You may consult with other students, but please turn in your own individual answer sheet with the names of all group members listed on the front page. 1. ( OLD MIDTERM QUESTION ) ISLM model ( Forty points ) ISLM model An economy is described by the following equations: Consumption: C = 50 + 0 : 5( Y & T ) Investment: I = 200 & 500 r Government expenditure: G = 100 Tax revenue: T = 100 Demand for Real Money Balances: L ( r; Y ) = 0 : 5 Y & 1000 r Supply of Real Money Balances: M P = 150 Potential / capacity output: Y = 500 a. (Twelve points) Please write down the equations for the IS and LM curves (i.e. the expressions for the relationship between r and Y that describe, respectively, the goods and money market equilibria). The IS curve represents combinations of ( r; Y ) for which the goods market is in equilibrium: Y = C + I + G ) Y = [50 + 0 : 5( Y & 100)] + [200 & 500 r ] + 100 ) Y = 300 + 0 : 5 Y & 500 r ) : 5 Y = 300 & 500 r The IS curve is given by: 500 r = & : 5 Y + 300 It is more convenient to express the relationship between r and Y as Y = 600 & 1000 r (1) The LM curve represents combinations of ( r; Y ) for which the money market is in equilibrium: M P = L ( r; Y ) ) 150 = 0 : 5 Y & 1000 r The LM curve is given by 1000 r = 0 : 5 Y & 150 It is convenient to express this as Y = 300 + 2000 r (2) 1 b. (Twelve points) Suppose that the economy is in an equilibrium consistent with full employ ment. Calculate the equilibrium values of output, the real interest rate, consumption. If the economy is in an equilibrium consistent with full employment, output Y = Y = 500 . Substituting for output in (1) we can back out the real interest rate r = 0 : 1 or 10% . Consumption: C = 50 + 0 : 5( Y & T ) = 50 + 0 : 5(500 & 100) = 250 . c. (Twelve points) Suppose that the price level doubles due to an adverse shock that hits the economy. Provide an example of a shock that could have this e/ect on economywide prices. Calculate the new values of the real interest rate and output in the short run. An example of such a shock is a sudden increase in oil prices and energy costs which a/ect prices across the economy. If the price level doubles, real money balances M P will fall to exactly half the initial level. The new level of real money balances is M P = 75 : The LM curve is M P = L ( r; Y ) ) 75 = 0 : 5 Y & 1000 r which may be reexpressed as Y = 150 + 2000 r (3) Solving (1) and (3), we can back out the ( r; Y ) combination for which both the goods and money markets are in equilibrium simultaneously. 600 & 1000 r = 150 + 2000 r ) r = 0 : 15 or 15% Substituting the real interest rate back into the LM curve (3) we can solve for the short run value of output: Y = 450 : d. (Four points) Suppose that there is no policy response to the adverse shock. Calculate the long run values of the real interest rate and investment....
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This note was uploaded on 06/15/2010 for the course ECON 202 taught by Professor Nabar during the Spring '08 term at Wellesley College.
 Spring '08
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