𝐶 = 0,6(𝑌 − 𝑇)

𝐼 = 900 − 50𝑖

𝐺 = 700,

𝑇 = 875 2 (𝑀/𝑃)^𝑑 = 0,25𝑌 − 62,5𝑖

(𝑀/𝑃) = 400

where C = consumption, Y = GDP, T= taxes, G = government spending, (𝑀/𝑃)^𝑑= real money demand balance and (𝑀/𝑃) = real money supply balance.

1. What is the equation of the IS curve?
2. What is the equation of the LM curve?
3. What are the equilibrium values of the real interest rate and real GDP?
4. What is Keynesian Multiplier
5. What is the impact of an increase in government spending on GDP and the rate of
of interest?
6. What is the impact on national savings and the government budget balance of
this increase?

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”)

Please see the details:

ws curve: 𝑊/𝑃= 𝑃^𝑒/𝑃((40/100) + 𝑧 − 10𝑢)
production function: 𝑌 = 2𝑁
job insurance generosity: 𝑍 = 60/100
labor force: 𝐿 = 500
profit margin: 𝑚 = 1
and whose demand is characterized by the equations:
consumption: 𝐶 = 40 + 0.1(𝑌 − 𝑇)
investments:𝐼 = 14 − 20𝑖
government spending: 𝐺 = 40
taxes: 𝑇 = 40
expected inflation: 𝜋𝑒 = 0
Nominal Currency Stock: 𝑀̅ = 1000
actual cash demand: 𝑀^𝑑/𝑃 = 𝑌 − 120𝑖

2. What is the equation of the aggregate supply curve (AO)?
3. What is the equation of the IS curve?
4. What is the equation of the LM curve?
5. What is the equation of the aggregate demand curve (AD)?
6. What is the medium-term equilibrium?
7. Suppose the central bank increases the stock of money to 𝑀̅ = 2000 no effect on expected inflation. What will be the short-term and medium-term effect of this policy change on price level, GDP and real interest rate? Illustrate graph your answer.
8. Returning to 𝑀̅ = 1000. Suppose the government raises its spending to G = 500. What will be the short-term and medium-term effect of this policy change on
the price level, GDP and the real interest rate?

Balanced Budgets: Suppose that the government passes a balanced budget law.

This law - known in popular media as pay-as-you-go - requires the government to

meet any increase in government spending with an increase in taxes i.e. G "= T ".

This question will analyze the consequences of this law on the macro economy

under classical assumptions.

Consider the following Economy

Y = C + I + G

C = c0 + c1(Y - T)

I = I0 - I1r

G = _G

T = _ T

a) An increase in government spending and taxes represent a change in the demand for output. Under classical assumptions supply creates its own demand. Therefore, what is the impact of a change in taxes and government speding on output?

b) What market do you expect to be affected by a change in government speding under a balanced budget rule?

c) Assume that government increases spending to fund social security, which implies that taxes go up by an equal amount, what effect will this have on the real interest rate?

d) How does your answer depend on the marginal propensity to consume?