Calculate the equilibrium level of income and the interest

Question

Q1. A) The following equations characterise a hypothetical economy.

M_D = 100 + Y - 50r (Money Demand)

M_S = 100 (Money Supply)

C = 400 + 0.2Y_D   (Consumption Function)

I = 80 + 0.5Y 10r (Investment Function)

G = 100 (Government Expenditure)

T = 100  (Taxes)

I. Calculate the equilibrium level of Income and the interest rate. Describe your solution with a graph.

II. Calculate the equilibrium level of consumption and investment. [Hint: Solve consumption and Invest equations based on solutions to the IS LM system of equations]

III. Assume the government spending increase to 200. Calculate the Fiscal policy multiplier [Hint: Change in Y divided by change in G]

IV. Replace the 'Money Supply' in the above system of equations with the 'Real Money Supply' equation i.e. (M_S = 100/P). Now calculate the Aggregate Demand (AD) equation based on the above system of equations.

V. If the Aggregate Supply (AS) equation is Y = 1120, based on the Aggregate Demand equation you got for part IV calculate the equilibrium Y and equilibrium P. Also, Do you notice something unusual about the shape of the AS curve? Comment briefly.

B) Consider the system of equations given in part A. Suppose the government increases public spending from 100 to 200 with no change in taxes.

I. Calculate the new equilibrium level of Y, under the assumption that the central bank adjusts Ms to keep interest rate constant at r = 22.4

II. Calculate the new equilibrium level of Y, under the assumption that the central bank keeps money supply constant at M_S = 100

III. Compute the Fiscal policy multiplier for part I and II and discuss how for fiscal policy to be effective interest rates need to be prevented from rising.

Q2. A) In the IS-LM model, if Investment demand becomes completely unresponsive to the interest rate, then both monetary and fiscal policy become less effective. Is this statement true or false? Briefly explain your answer using diagrams. [Hint: recall the diagrammatic derivation of the IS curve, if investment becomes unresponsive to interest rate what happens to the shape of the IS curve]

B) Briefly answer the following questions:

a) Why is the Aggregate Demand curve downward sloping? (No math needed, economic intuition/reasoning is enough. You can do the math if it helps you explain better)

b) Under what circumstances could the aggregate demand curve be completely vertical? [Hint: recall the derivation of the AD curve)

c) Briefly explain (using the IS-LM framework) how the relationship between fiscal policy and crowding out is largely dependent on the interest elasticity of the LM curve.

Q3. There may exist a inverse relationship between inflation and unemployment in the short run but in the long run there is no relationship between inflation and unemployment and the economy has a tendency to move closer to the Natural rate of Unemployment"

Explain the above statement in detail. Draw the requisite diagrams.

Q4. A) What is 'Classical Dichotomy'? What is the neutrality of money? Are the two related? If so, how are they related? What are the major economic and political conclusions of 'Classical Dichotomy'?

B) Do Classical Dichotomy and Neutrality of money exist in the Keynesian model? (Use the AD-AS or 1S-LM models for the purpose of analysis). How do the economic and political conclusions of the Keynesian model differ from those of the classical model on account of this? Explain your answer in detail.

[Hint: Explain the major changes in assumptions about the labour and money markets that lead to the lack of existence of the classical dichotomy and money neutrality in the Keynesian model and how they relate to economic and political conclusions of the Keynesian model]