ECON20401 Derive and plot the IS and LM curves of the economy

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ECON20401

SECTION A
Answer ALL Questions (60 marks)
1. Consider a closed economy that is characterized by the following equations:
Y=C+I+G

(1)

C =500 + 0.75(Y-T)

(2)

I = 375 - 25r

(3)

T = 500

(4)

G = 500

(5)

Ms=Md

(6)

Ms =1000

(7)

Md/P = L(r,Y) = 0.5Y – 50r

(8)

where Y is gross domestic product, C is private consumption expenditure, I is
investment expenditure, G is government expenditure, T is tax revenues, Ms is money
supply, Md/P is demand for real money balances, r is the interest rate (in % points),
and P is the aggregate price level.
A1. Derive and plot the IS and LM curves of the economy, expressing Y as a function
of r and assuming P is fixed at 1.0
[10 points]
A2. Calculate the short-run equilibrium values of Y and r assuming P is fixed at 1.0
and apply the values to your diagram.
[10 points]
A3. Derive and plot the aggregate demand (AD) curve of the economy using your
earlier calculations, expressing Y as a function of P, assuming P is flexible
[10 points]
A4. Calculate the long-run equilibrium values of r and P, assuming that the potential
level of output (Y*) is equal to 3500 monetary units. Use the IS/LM and AD/AS
models to illustrate graphically the short-run and long-run equilibrium, and to explain
how the economy moves from the short-run to the long-run equilibrium, if the two are
different. Finally discuss how this model matches the facts that we observe in
macroeconomic data.
[30 points]