Question 1:

a) The following represents the key equations for a closed economy:

M^d/P= 18+0.5Y-450(r+^e) Real Money Demand

C^d= 6+0.8(Y-T)-250r Desired Consumption

I^d= 33-200r Initial budget position

G=T Initial budget position

Write out the equations for the IS and LM curves for this economy, with the real rate of interest (r) on the left-hand side. Next, use these relationships to find the AD curve, written with real output (Y) on the left-hand side. Based on your model, describe briefly how, in the short run, real output (Y) would respond to a rise in expected inflation (^e) and why? How would output respond in the short run to a cut in taxes (T) and why?

b) You are given the following information: Government spending (G) is 15; the velocity of money (V) is 2; the price level (P) is one; and expected inflation is zero. Use this information to find real output (Y), the real interest rate (r) and the nominal money supply (M). Verify that your values of Y and r will give of C and I that are consistent with the national account identity.

c) Assume that the level of output you found in Part b is the economy's long-run full-employment level.

Now suppose that expected inflation (^e) rises from 0 to 1%. Find the short-run levels of Y and r. Next, calculate the long-run values of the price level (P). Describe briefly the process that drives the economy from the short to its long-run equilibrium. By how much has the price level changed and is that change consistent with the rise in ^e? In the long run, by how much has the real interest rate changed?