The following formula can be used to calculate equilibrium GDP:
Y = (a+IPlanned +G-MPC*T + NX)/(1-MPC). Recall that a is the constant in the consumption equation.
Use the following values to answer question 2.
C = 100 + .75(Y-T)
T = 200
G = 200
IPlanned = 250
Exports and imports depend upon the exchange rate as follows:
Exchange rate Exports Imports
1.5 100 100
1 150 50
1a. Calculate equilibrium GDP assuming that the exchange rate is equal to 1.5
b. Calculate equilibrium GDP assuming that the exchange rate is equal to 1.
c. Sketch the IS* curve. It is not necessary to use graph paper, but label all axes and show the coordinates of the curve clearly.
d. Suppose G = 300 rather than 200. Calculate equilibrium GDP for exchange rates of 1.5 and 1.
e. Sketch the new IS* curve on the same graph as in part c.
f. Suppose instead exports and imports depend upon the exchange rate as follows:
Exchange rate Exports Imports
1.5 100 100
1 200 25
Will this make the IS* curve steeper or flatter? Why?
2. Assume that money demand can be described by the following equation:
(M/P)d = .1*Y - 10*r
a. Assume that the money supply is equal to 130 and that the world interest rate, r*, is equal to 3. Sketch the LM* curve. It is not necessary to use graph paper, but label all axes and show the coordinates of the curve clearly. (Hint: what level of income is necessary for money supply to equal money demand?)
b. Assume that the world interest rate, r*, rises to 5. Sketch the new LM* curve, showing the coordinates of the graph.
c. Assume instead that the world interest rate, r*, equals 3, as in the beginning of the problem, but that the money supply is equal 150. Sketch the new LM* curve.
d. Bonus. Sketch the LM* curve in part c with the IS curve in part 1c. What is the equilibrium exchange rate?
3. In what year did the unemployment rate reach a peak during the Great Depression? What was the unemployment rate during that year?
4. The multiplier effect is the effect of changes in government spending on GDP. It occurs in a number of stages, as an increase in government spending first increases income, which then increases consumption, which further increases income and consumption and so on. Assume that the change in government spending is 100 and that the marginal propensity to consume is equal to .8. Calculate
i) the first change in consumption
ii) the second change in consumption
iiii) the third change in consumption
5. For each of the following, list whether the IS or LM curve shifts, and whether the curve shifts right or left. It is possible that more than one curve will shift. Assume a closed economy.
a. A tax decrease, assuming that the Fed keeps the money supply constant.
b. Savers and investors expect deflation.
c. Increased economic uncertainty causes businesses to reduce investment.
d. An increase in government spending, assuming that the Fed keeps output constant.
e. Bonus. The demand for money increases due to economic uncertainty.
6. For each of the following, list whether the IS* or LM* curve shifts, and whether the curve shifts right or left. It is possible that more than one curve will shift. Assume a small open economy with flexible exchange rates in parts a and b and a small open economy with fixed exchange rates in parts c-d.
a. An increase in the money supply
b. A rise in the stock market, which increases household wealth and consumption
c. A reduction in tariff rates due to a free trade treaty with other countries
d. A devaluation of the exchange rate.