Question 4 (25 points) - Chapters 9 & 10/11
Utopia is a closed economy and is characterized by the following equations:
Consumption: C = 4000 + 0.80(Y - T)
Investment: I = 8000 - 250r
Real money demand: (Md/P) = L(Y,i) = 0.6Y - 1200i
Expected inflation: pe= 0
Production function: Y = 5.8 ´K1/2L1/2
Labour supply is equal to 11000
Note: Interest rates, i and r, are expressed in percentage points, i.e., if r = 6.15, then the real interest rate is interpreted as being equal to 6.15% (even though we use r = 6.15 in the formulas).
Suppose the IS-LM model can used be to describe Utopia, and answer the following questions. Keep your answers to a minimumof THREEdecimal points (for fractions).
a) Derive the IS and LM equations for this economy as functions of any unknown parameters. (4 points)
b) Suppose the long-run levels of capital and labour utilized in this economy are both equal to 10000; the government spends 3000 on goods and services and has a balanced budget; and the level of the nominal money supply is 30000. Calculate the long-run or full-employment values of the real interest rate, nominal price level, real money supply, and unemployment rate. (5 points)
Suppose a new leader Winnie Ford is appointed prime minister for life based on his promise to lower andkeep the unemployment rate at zero by changing government spending on goods and services by whatever amount is needed to achieve this goal. (The remaining parts of this question involve this new situation)
c) Is Prime Minster Ford able to achieve this goal in the short-run? Explain why or why not. If this goal is feasible in the short-run solve for the new short-run equilibrium levels of real output, real interest rate, real money supply, employment & the new level of government spending on goods and services. (8 points)
d) Is Prime Minster Ford able to achieve this goal in the long-run? Explain why or why not. If this goal is feasible in the long-run solve for the new long-run equilibrium levels of real output, real interest rate, real money supply, employment & the new level of government spending on goods and services. (8 points)
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