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ECMA06_Tutorial_10_Solution

# ECMA06_Tutorial_10_Solution - ECMA06 Tutorial#10 Answer Key...

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ECMA06 Tutorial #10 Answer Key Question 1 Part (a) Disposable income, DI: DI = Y – T + TR DI = Y – 0.3Y + [20 – 0.075Y] = 20 + 0.625Y C = C(Y): C = 0.8(20 + 0.625Y) C = 16 + 0.5Y The AE function: AE = C + I + G AE = [16 + 0.5Y] + [20 – 50r] + 49 AE = 85 + 0.5Y – 50r Setting Y = AE: Y = 85 + 0.5Y – 50r 0.5Y = 85 – 50r Y = 170 – 100r This is called the IS curve & you will learn it in ECMB06 Note: Since we have two unknowns (Y & r), we cannot just solve for Y* and r* by setting AE = Y. We need one more equation that shows the relationship between Y & r, and this can be obtained from the money market equilibrium. Money market equilibrium: MS = MD 30 = 0.25Y – 100r 0.25Y = 30 + 100r Y = 120 + 400r This is called the LM curve & you will learn it in ECMB06 Solving for equilibrium Y and r: Equate the IS and LM: 170 – 100r = 120 + 400r 500r = 50 r* = 0.1 (10%) Sub r = 0.1 into IS or LM: IS: Y* = 170 – 100(0.1) = 160 LM: Y* = 120 + 400(0.1) = 160 Part (b) Suppose G increases by 10, i.e., G = 59: The new AE function: AE = [16 + 0.5Y] + [20 – 50r] + 59 AE = 95 + 0.5Y – 50r Setting Y = AE to find the IS curve: Y = 95 + 0.5Y – 50r Y = 190 – 100r Using the money market to find the LM curve: 30 = 0.25Y – 100r Y = 120 + 400r ECMA06 Tutorial #10 Answer Key 1

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Solving for equilibrium Y and r: Equate the IS and LM: 190 – 100r = 120 + 400r 500r = 70 r* = 0.14 (14%) Sub r = 0.14 into IS or LM: IS: Y* = 190 – 100(0.14) = 176 LM: Y* = 120 + 400(0.14) = 176 Before: G = 49 After: G = 59 Change Y* 160 176 16 r* 0.1 0.14 0.04 I* 15 13 – 2 Note: Expansionary fiscal policy (partially) crowds out investment because an increase in G leads to an increase in r, which raises the cost of investment.
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ECMA06_Tutorial_10_Solution - ECMA06 Tutorial#10 Answer Key...

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