Question 3 (25 points) - Chapters 10 & 11/12

Utopia is a closed economy and is characterized by the following equations:

Consumption: C = 3500 + 0.90(Y - T) - 9000r

Investment: I = 12000 - 8000r

Government spending: G = 10000

Taxes: T = 15333

Real money demand: (M^d/P) = L(Y,i) = 0.55Y - 3000i

Expected inflation:p^e = 0.02 ( or 2%)

Production function: Y = 25K^1/3L^2/3

Note: Interest rates, i and r, are expressed in decimal points, i.e., if r = 0.075, then r = 7.5%.

Suppose the IS-LM model and by relation the AS/AD model can used be to describe Utopia and answer the following questions. Keep your answers to a minimum of THREE decimal points (for fractions).

1. Derive the IS and LM equations for this economy. Hint: Write the LM curve as a function of the unknown M & P. (4 points)

1. Derive the AD curve for this economy. (2 points)

1. The supply of capital and labour in this economy are both presently equal to 4000; the nominal price level is presently equal to 1.00 and the economy is presently in long-run equilibrium. Calculate the long-run or full-employment values of real output, consumption, investment, real interest rate, public saving, private saving, national saving, and the current level of the nominal money supply. (8 points)

1. Now suppose the government of Utopia believes that the stock of both labour and capital will grow by four percent. Holding all other government policy variables fixed, what should the central bank do withmonetary policy if they hope to maintain a fixed price level moving forward? Suppose instead they hope to obtain a rate of inflation of two percent moving forward, then what should the central bank do? (6 points)

1. Using a single AS/AD diagram and explain in words why the central bank would share its beliefs (expectations) with agents in the economy. That is, explain in words what would happen to the economy in the short run if the central bank held these beliefs AND sought their goal with respect to the rate of inflation, but they did not share these expectations and/or goal with the public. Explain whether this is a good or bad outcome for society. (5 points)