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Solution - Assignment 4

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103 views

Solution - Assignment 4

Uploaded by

christine uwiringiyimana
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© © All Rights Reserved
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ECN 282: Macroeconomic Analysis

Xinchan Lu
Assignment 4

This assignment covers the material from Chapters 13 and 14. Total point is 100. This
assignment will be due on Monday, November 4, 2024, at 5 pm.
Part 1. IS-LM Model
1. [30 points] The following equations describe an economy:
C = 300 + 0.5(Y – T)
I = 100 – 2i
G = 100
T = 150
L = 0.5Y – 18i
M = 7,000
where C is consumption, i is the interest rate as a percentage, I is investment, G is government
expenditure, T is lump-sum taxes, Y is income, L is demand for real balances, M is the nominal
money supply,
(a) [10 points] Derive the IS and LM equations for the economy assuming that the price level is
given by P = 20.
(b) [10 points] Solve for the equilibrium levels of (i) interest rate, (ii) income, (iii) consumption,
and (iv) investment.
(c) [5 points] If the target income is equal to $900, how much increase in the government
expenditure is needed for the economy to achieve this goal?
(d) [5 points] If the target income is equal to $900, then by cutting taxes to which level will the
economy achieve this goal?
2. [10 points] Suppose the LM curve for a macroeconomy is given by Y = 2,500 + 100i, where Y
is income and i is the percentage of interest rate. In addition, the economy’s real money demand
is given by L = kY – hi, where L stands for liquidity, and k and h are positive constants. The
quantity of nominal money supply M = 1,500 and the price level P = 2. Based on the above
information, find the values of (i) k and (ii) h that are consistent with the money market
equilibrium.
Part 2. Short-run Fluctuations: Shift of Curves
3. [25 points] Consider what happens, according to IS-LM model, in the short run to the interest
rate (r) and income (Y) in each of the following circumstances. For each scenario, (1) shift the
appropriate curve to the new equilibrium in the IS-LM graph, and (2) indicate the resulting
change to each variable.
(a) The government increases taxes.
(b) The central bank decreases money supply.
(c) After the intervention of a new high speed computer chip, many firms decide to upgrade their
computer systems.
(d) A wave of credit card fraud increases the frequency with which people make transactions in
cash.
(e) A best seller titled Retire Rich convinces the public to increase the percentage of its income
devoting to saving.

Part 3. Fed’s Policy Instrument – Money Supply or Interest Rate?


4. [15 points] The Fed is considering two alternative monetary policies: (1) holding the money
supply constant and letting the interest rate adjust (i.e. LM curve), and (2) adjusting the money
supply to hold the interest rate constant (i.e., MP curve). Using the IS-LM model, determine
which policy will better stabilize output under different conditions?
(a) [5 points] Assume all shocks to the economy arise from exogenous changes in the demand for
goods and services (i.e., IS shocks). Illustrate a contractionary shock to the economy that shifts
the IS curve by -$4 trillion for any given interest rate (r). In the diagrams below, first, shift the IS
curve to indicate this shock. Then, move the equilibrium point E1 to the new equilibrium point
E2, and indicate the new equilibrium level of income (Y) for each policy.
(b) [5 points] Assume all shocks to the economy arise from exogenous changes in the demand for
money (i.e., LM shocks). Assume a negative shock to the demand for money that shifts LM curve
by +$4 trillion for any given interest rate (r). In the diagrams below, first, shift the LM (MP)
curve to indicate this shock. Then, move the equilibrium point E1 to the new equilibrium point
E2, and indicate the new equilibrium level of income (Y) for each policy.

(c) [2.5 points] Which policy allows for a more stable output response to a shock that arises from
a change in the demand for goods and services?
(d) [2.5 points] Which policy allows for a more stable output response to a shock that arises from
a change in the demand for money?

Part 4. Aggregate Demand


5. [20 points] Macro Island is well described by the IS-LM model. Government purchases are
100, the money supply is 600, and the government runs a balanced budget (i.e., G = T). People
always save a quarter of their disposable income. The demand for investment goods is given by I
!
= 200 – 25r, and the demand for real money balances is given by ( " )# = Y – 20r.

(a) [10 points] Derive the IS and LM equations assuming the price level is 2.
(b) [5 points] Solve for equilibrium interest rate and income.

(c) [5 points] Derive the aggregate demand (AD) curve for the economy.
4. (a)

(b)

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