In a closed economy, the consumption function is C = 50 + 0.75(Y T ) where

Fantastic news! We've Found the answer you've been seeking!

Question:

In a closed economy, the consumption function is C = 50 + 0.75(Y − T ) where Y is real GDP and T is net taxes. The investment function is I = 350 − 50r where r is the real interest rate measured in percentage points. Government spending is G = 45 and net taxes are T = 60. The central bank uses an interest rate rule of the form r = −10 + 0.01Y + 3π where π is the inflation rate measured in percentage points. The expected inflation is always equal to the current rate of inflation.

Anticipating shortage of inputs, firms simultaneously reset prices. The inflation rate goes up to 4% instantly.

(i) Call the initial equilibrium point A.

(ii) Calculate the short-run equilibrium values for Y , r, π and i; call this point B.

(iii) Calculate the new long-run equilibrium values for Y , r, π and i when the economy is left by itself; call this point C.

(iv) Graphically show the point F on IS/MP and AS/AD where the economy would be if fiscal policy was used to return GDP back to its potential level.

(iiv) Describe the immediate response and the long-term adjustment of the economy, and show these processes on two connected IS/MP and AS/AD diagrams. Show on a separate pair of connected IS/MP and AS/AD diagrams. Explain all transitions using economic logic.