Problem 5

Consider an economy specified by the following:

Y = PE = C + I + G + NX (Income identity)

C = 300 + 0

.8YD (Consumption)

I = 200 – 1,500R (Investment)

NX = 100 – 0

.04Y – 500R (Net exports)

MD = (0

.5Y – 2,000R) (Money demand)

Also assume that government spending G = $200, the tax rate t = 0

.2, and the money

supply MS = $550 (and assume the price level is constant at P = 1)

.A

. What is the IS curve?

B

. What is the LM curve?

C

. What are the values of income (Y) and the interest rate (R) when the IS-LM model is in equilibrium?

Problem 6

Following upon problem 5, now imagine that consumption is given as:

C = 300 + 0

.8YD – 1,000R

And as above:

Y = PE = C + I + G + NX (Income identity)

I = 200 – 1,500R (Investment)

NX = 100 – 0

.04Y – 500R (Net exports)

MD = (0

.5Y – 2,000R) (Money demand)

And that as before government spending G = $200, the tax rate t = 0

.2, and the money

supply MS = $500 (and assume the price level is constant at P = 1)

.A

. Under these assumptions, what is the IS curve?

B

. What are the values of income (Y) and the interest rate (R) when the IS-LM model is in equilibrium?

C

. How does this new IS curve compare to your original IS curve from problem #5? That is, is your new IS curve flatter or steeper? Given your answer, would you suspect that monetary policy would be more (or less) effective in the current model versus the original model? Briefly explain

.