Instructor: Guisinger Spring 2014 Econ 2102.11 6(f) (1) Set I= 320 in the investment equation (I= 352 - 400r) to obtain 320 = 352 - 400rwhich implies 400r= 32. Therefore, the real interest rate must be r= 0.08 to attain I= 320. (2) In long-run equilibrium, output equals its full-employment level, so Y= 1400. Therefore, Y =C + I + Gimplies 1400 = C+ 320 + 350, so C= 730 in long-run equilibrium when I= 320 and G= 350. (3) In long-run equilibrium with I= 320 and G= 350, Y= 1400 and r= 0.08. Set 730 in the consumption function C= 388 + 0.4(Y -T) - 600rto obtain 730 = 388 + 0.4(1400 - T) - (600 ´ 0.08). Therefore, 0.4T= 388 + 560 - 48 - 730 = 170, which implies T= 425 to attain the level of consumption in part (2) in long-run equilibrium with I= 320 and G= 350. (4) In long-run equilibrium, Y= 1400 and r= 0.08, so L= 1750 + 0.75Y- 8750(πe) = 1750 + (0.75 ´ 1400) - [8750 ´ (0.08 + 0.02)] = 1925. Since M/P = L= 1925, we have M= 1925 ´ P. To attain P= 6 in long-run equilibrium with I= 320 and = 350, the nominal money supply must be M= 1925 ´ 6, so M= 11,550.
4. Classical economists argue that using fiscal policy to fight a recession doesn’t make workers better off. Suppose, however, that the Keynesian model is correct. Relative to a policy of doing nothing, does an increase in government purchases that brings the economy to full employment make workers better off? In answering the question, discuss the effects of the fiscal expansion on the real wage, employment, consumption, and current and future taxes. How does your answer depend on (a) the direct benefits of the government spending program and (b) the speed with which prices adjust in the absence of fiscal stimulus? ANSWER: An increase in government purchases shifts the IScurve up and to the right and the ADcurve up and to the right to return the economy to full employment, instead of waiting for the price level to fall to get there. The advantage of doing so, according to Keynesians, is that full employment is restored quickly, whereas if the price level must adjust, it may take a long time for full employment to be restored. In the short run, the fiscal expansion does not affect the real wage, since it is an efficiency wage. However, it increases employment and it increases current and future taxes to pay for the higher government spending. The effect on consumption is ambiguous, with the rise in output raising consumption, while the rise in taxes reduces consumption. In the long run, at full employment, the lasting effects of the fiscal expansion are to decrease consumption, because of the higher real interest rate and the