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A NSWERS TO A SSIGNMENT 2 Section I: Multiple Choice Questions 1. C 2. C 3. C 4. B 5. B 6. D 7. A 8. B 9. B 10. B 11. A 12. D Section II: Short Answer Questions Question 1 a) The IS curve connects all (r,Y) pairs that represent equilibria in the goods market. By definition, planned expenditure is: E = C + I + G + GX – IM Substituting in all the equations given in the question we have: E = A + MPE*Y The term A is decomposed into two terms: the baseline level of autonomous expenditure and the term that depends on r: A = = A 0 – ( I r + X ε ε r )r The goods market is in equilibrium when planned expenditure (or aggregate demand) is equal to real GDP (or national income): Y = E Combining all these equations we get the IS curve: Y = A 0 /(1-MPE) – ( I r + X ε ε r )r/(1-MPE)

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The LM curve gives you all pairs (i,Y) that represent equilibria in the money market. The demand for real money balances is: M D /P = L 0 + L y Y - L i (r + π e ) The supply of nominal money by the central Bank is M. The money market is in equilibrium when M D = M. Using this and solving for M we get the LM curve: Y = (1/L y ) *(M/P - L 0 ) + (L i /L y )*(r + π e ) The economy is in SR equilibrium when the IS and LM curves intersect. See Fig.1 ( Note : if you get a question like this you do not have to do more calculations than those above ).
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