Yevada is a closed economy and is characterized by the following equations: Consumption: C = 5000...

Transcribed Image Text:

Yevada is a closed economy and is characterized by the following equations: Consumption: C = 5000 + 0.85(Y - T) - 500r Investment: I = 2000 - 600r Government spending: G = 1200 Taxes: T = 2200 Real money demand: (Md/P) = L(Y,i) = 0.65Y - 130i Expected inflation: pe = 0 Production function: Y = 3K1/32/3 Note: Interest rates, i and r, are expressed in percentage points, i.e., if r = 2.5, then r = 2.5%. Suppose the IS-LM model can used be to describe Utopia, and answer the following questions. Keep your answers to a minimum of THREE decimal points (for fractions). a) Derive the IS and LM equations for this economy. b) The supply of capital and labour in this economy are both equal to 6000; and the level of the nominal money supply is 11,118. Calculate the long-run or full-employment values of the output, consumption, investment, real interest rate, public saving, private saving, national saving, and price level. c) Now suppose the government is deciding on a new monetary policy regime. They are considering targeting the real interest rate equal to 3% or 5%. Assuming that the economy was initially at full-employment, with the real interest rate target, what are the new values of output, consumption, investment, real interest rate, public saving, private saving, national saving, and price level in the short-run? d) Suppose an economist criticizes the policy recommended in part (c) and claims that by aggressively altering the money supply the government will create high levels of inflation for many years to come and thereby discourage new physical capital investment. Another economist, also critical of this policy, says that the economist above AND the government are both wrong, he says this policy is very flawed and should only be used temporarily when the economy is hit by a bad business cycle shock. Use the IS/LM model to describe whether these criticisms are at all reasonable. Ensure to explain why each argument is or is not reasonable. (10 points) Yevada is a closed economy and is characterized by the following equations: Consumption: C = 5000 + 0.85(Y - T) - 500r Investment: I = 2000 - 600r Government spending: G = 1200 Taxes: T = 2200 Real money demand: (Md/P) = L(Y,i) = 0.65Y - 130i Expected inflation: pe = 0 Production function: Y = 3K1/32/3 Note: Interest rates, i and r, are expressed in percentage points, i.e., if r = 2.5, then r = 2.5%. Suppose the IS-LM model can used be to describe Utopia, and answer the following questions. Keep your answers to a minimum of THREE decimal points (for fractions). a) Derive the IS and LM equations for this economy. b) The supply of capital and labour in this economy are both equal to 6000; and the level of the nominal money supply is 11,118. Calculate the long-run or full-employment values of the output, consumption, investment, real interest rate, public saving, private saving, national saving, and price level. c) Now suppose the government is deciding on a new monetary policy regime. They are considering targeting the real interest rate equal to 3% or 5%. Assuming that the economy was initially at full-employment, with the real interest rate target, what are the new values of output, consumption, investment, real interest rate, public saving, private saving, national saving, and price level in the short-run? d) Suppose an economist criticizes the policy recommended in part (c) and claims that by aggressively altering the money supply the government will create high levels of inflation for many years to come and thereby discourage new physical capital investment. Another economist, also critical of this policy, says that the economist above AND the government are both wrong, he says this policy is very flawed and should only be used temporarily when the economy is hit by a bad business cycle shock. Use the IS/LM model to describe whether these criticisms are at all reasonable. Ensure to explain why each argument is or is not reasonable. (10 points)