Problem
Consider a closed economy IS/LM model.
1. Consumption is C = 200 + 0.75(Y - T) and investment is I = 200 - 50r. G = T = 0. Solve for the IS curve (i.e. an equation for Y in terms of r).
2. Money demand is given by L = Y - 200r, the money supply is 1000 and the price level is P. Solve for the LM curve (i.e. an equation for Y in terms of r and P).
3. Find the equilibrium interest rate of r and the equilibrium level of income (i.e. solve for where the IS and LM curves cross).
[Hint: express equilibrium interest rate of r and the equilibrium level of income in terms of p]
4. The LRAS curve is Y* = 1000. What is the price level at which output is exactly equal to this?
5. Now the money supply increases to 1200. What is the new equilibrium level of income (i.e. solve the IS/LM problem again with M = 1200).
[Hint: express equilibrium interest rate of r and the equilibrium level of income in terms of p]
6. If prices remain at exactly the level you found in (4), what is the new level of income? Does the increase in money supply cause an expansion or contraction in income?
7. What would prices have to be so that income is exactly equal to Y* = 1000 again?