Question

2. Assume that households’ consumption function is given by C(Y − T) = 50 + 0.75(Y − T), that firms’ investment function is I(r) = 150 − 10r, government spending is G = 150, and the tax bill T = 200.

(a) What is the Marginal Propensity to Consume (“MPC”)?

(b) What is the equilibrium level of real GDP, in the goods market, if the real interest rate is 5%? (Plug in r = 5 for 5%, rather than 0.05 This is an assumption about the way we scale the coefficients in the investment function.)

(c) Solve for the equation of the IS Curve (“Investment-Savings”). How will this equation change if government spending increases to 200? The money supply is MS = 3000 and the price level is P = 4. Money/liquidity demand is given by Md/P = L(r, Y ) = Y − 50r.

(d) Solve for the equation of the LM Curve (“Liquidity-Money”).

(e) Based on your answers to the previous two questions, what are the equilibrium levels of the real interest rate and real GDP? (G is back to 150.)

(f) Assume now that P is unknown. Solve for the equation of the Aggregate Demand curve (“AD”)