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Unformatted text preview: Chapter 11 Aggregate Demand II 103 tion and because income falls. Investment rises because of the lower interest rates and partially offsets the effect on output of the fall in consumption. If the Federal Reserve wants to keep output constant, then they must increase the money supply in order to reduce the interest rate and increase output back to its original level. The increase in the money supply will shift the LM curve down and to the right. Output will remain at its original level, consumption will be lower, investment will be higher, and interest rates will be lower. 3. a. The IS curve is given by: Y = C ( Y T ) + I ( r ) + G . We can plug in the consumption and investment functions and values for G and T as given in the question and then rearrange to solve for the IS curve for this econ omy: Y = 200 + 0.75( Y 100) + 200 25 r + 100 Y 0.75 Y = 425 25 r (1 0.75) Y = 425 25 r Y = (1/0.25) (425 25 r ) Y = 1,700 100 r. This IS equation is graphed in Figure 1111 for r ranging from 0 to 8. b. The LM curve is determined by equating the demand for and supply of real money balances. The supply of real balances is 1,000/2 = 500. Setting this equal to money demand, we find: 500 = Y 100 r . Y = 500 + 100 r . This LM curve is graphed in Figure 1111 for r ranging from 0 to 8. c. If we take the price level as given, then the IS and the LM equations give us two equations in two unknowns, Y and r . We found the following equations in parts (a) and (b): IS : Y = 1,700 100 r . LM : Y = 500 + 100 r . LM IS Y 1,700 1,100 500 6 8 r Interest rate Income, output Figure 1111 Equating these, we can solve for r : 1,700 100 r = 500 + 100 r 1,200 = 200 r r = 6. Now that we know r , we can solve for Y by substituting it into either the IS or the LM equation. We find Y = 1,100. Therefore, the equilibrium interest rate is 6 percent and the equilibrium level of output is 1,100, as depicted in Figure 1111. d. If government purchases increase from 100 to 150, then the IS equation becomes: Y = 200 + 0.75( Y 100) + 200 25 r + 150. Simplifying, we find: Y = 1,900 100 r . This IS curve is graphed as IS 2 in Figure 1112. We see that the IS curve shifts to the right by 200. By equating the new IS curve with the LM curve derived in part (b), we can solve for the new equilibrium interest rate: 1,900 100 r = 500 + 100 r 1,400 = 200 r 7 = r . We can now substitute r into either the IS or the LM equation to find the new level of output. We find Y = 1,200. Therefore, the increase in government purchases causes the equilibrium interest rate to rise from 6 percent to 7 percent, while output increases from 1,100 to 1,200. This is depicted in Figure 1112....
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This note was uploaded on 10/04/2011 for the course ECON 101b taught by Professor Staff during the Spring '08 term at University of California, Berkeley.
 Spring '08
 Staff
 Interest Rates

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