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Homework 8

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Homework 8

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renato.moreira6089
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Homework 8

Macroeconomics I, UC3M

Question 1: Consider the IS-LM model. Assume the central bank reduces the money
supply.

a. What happens in the money market? How does this affect the LM curve?

b. How do interest rates and output change in the short run?

c. Assume, the economy was growing before at its natural rate. How does the policy
affect unemployment?

d. Compare the short-run responses of output and interest rates to those in the long-run.

Question 2: Consider the following economy:

Y =C +I +G
C = 120 + 0.5[Y − T ]
I = 100 − 10r
G = 50, T = 40
 M D
= Y − 20r
P
M = 600, P = 2

a. Draw the IS curve resulting from the above model.

b. Draw the LM curve resulting from the above model.

c. What is equilibrium output and the real interest rate in the economy?

Question 3: Consider two closed economies in the short run with fixed prices. Suppose
two economies are identical except in the sensitivity of money demand to the interest rate.
Suppose government spending increases. Compare the responses of output and the real
interest rate between the two economies.

Question 4: In the IS − LM model, we assume that investment is a decreasing function


of the interest rate. One may also think that consumption is a decreasing function of the
real interest rate.

1
a. Consider the model described by the following equations:

Y =C +I +G
C = c0 + c1 (Y − T ) − c2 r with 0 < c1 < 1, c2 > 0
I = d1 − d2 r with d2 > 0

Solve for output in terms of r, parameters (c0 , c1 , d1 , d2 ) and exogenous variables (G, T ).

b. Discuss how d2 affects the sensitivity of output to r.

Question 5: Consider an economy where:

Y =C +I +G
C = 10 + 0.5[Y − T ]
I = 30 − 5r
L(Y, r) = Y − 40r
G=T =0
M = 100
P =2

a. Derive the short-run equilibrium real interest rate and output.

b. Assume, the short-run price level rises exogenously to P = 5. Recalculate the short-run
equilibrium.

c. Derive the Aggregate demand curve.

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