Question

Consider an hypothetical economy characterized by the following equations (all variables as defined in class).
C = 700 + 0.95Y
I = 500 − 30i
G = 50
M*/P = 400
L(i, Y ) = 0.75Y − 30i
i) What is the equation for the IS curve? (4 marks)
ii) What is the equation for the LM curve? (4 marks)
iii) Solve for the equilibrium values of income (Y) and interest rates (i). (4 marks)
iv) Assume that the government engages in expansionary fiscal policy by increasing expenditure to G = 100. Solve for the new equilibrium values of income (Y) and interest rates (i). Illustrate your answer in a graph. (4 marks)
v) Assume that instead of the expansionary fiscal policy in part iv) above, that the Monetary Authority (The Central Bank) engages in expansionary monetary policy by increasing the money supply by 100 to Ms/P = 500. Solve for the new equilibrium values of income (Y) and interest rates (i) in this case. Illustrate your answer in a graph. (4 marks)
vi) Which of the policies from parts iv) and v) above would be the most effective expansionary policy? Explain. (2 marks)
vii) Say that the government engaged in both of the policies of parts iv) and v) simultaneously. Would this policy mix be more or less expansionary than the individual policies? Explain. (4 marks)
viii) Suppose that money demand in this economy was observed to be income insensitive so that it was now represented by L(i, Y ) = L(i) = 600 − 30i.
In this case, which of the policies from parts iv) and v) above would be the most effective expansionary policy? Explain your answer in terms of the concept of “crowding out”. (4 marks)
ix) Lastly, returning to the original model as in part i), suppose that investment was now determined to be interest insensitive such that it could be represented by I = 600.
In this case, which of the policies from parts iv) and v) above would be the most effective expansionary policy? Explain this answer in terms of “crowding out”. (4 marks)

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(i) The equation for the IS curve

Y = AE = C+I+G
C=700+0.95Y
I= 500-30i
G= 50
Y= 700+0.95Y+500-30i+50
Y = 1250+0.95Y-30i
30i = 1250 -0.95Y-Y
30i = 1250 – 0.05Y...

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