Problem 1:
Expenditure multiplier, autonomous spending, and LM curve are estimated of an economy, as given below:
- Expenditure multiplier: 2.5
- Autonomous planned spending function:Ap= 5000 - 200rand
- LMcurve: Y = 6000 + 300r
- Where Y is GDP, r is the market interest rate, which include risk premium and term premium andApis the autonomous planned spending. Using the above information:
a. Derive the equation for IS curve. Show both IS curve and LM curves for interest rates between 0 and 10 in a graph.
b. Find equilibrium interest rate and equilibrium GDP using the above information.
c. Suppose the Central Bank introduces a policy to buy junk private bonds to reduce risk, which results in the reduction of risk premium and term premium by 1.5% and 0.5% respectively. Now draw the LM curve and IScurve again taking into account the reduction of risk premium and term premium rates for interest rates between 0 and 10.
d. Using the above IS and LM curve (with the reduction of risk premium and term premium rates), calculate equilibrium GDP and equilibrium market interest rate.