Recall the following equations which describe an IS­LM economy: C(Y­T)= C1+b*(Y­

Question

Recall the following equations which describe an IS­LM economy: C(Y­T)= C1+b*(Y­T) I(r) = I1 ­ d*r G = G1 , T = T 1 Md= L1+e*Y­f*r r e a l M s = MP Suppose the economy is described by the following equations: C(Y T)=40+0.7*(Y T) I(r) = 300 30r G = T = 150 Md = 0.3Y 5r real Ms = 50 P Sob=0.7,d=30,e=0.3,f=5, andL1=0. Note that we now use the real money supply, or real money balances, which is the nominal money supply divided by the price level. These equations give the following IS and LM curves: IS: r = 9.5 1 Y 100 LM: r=0.06Y 10 P

1. What is the marginal propensity to save?

2. If p = 10, use IS and LM to find equilibrium GDP, then find equilibrium consumption and investment.

3. Describe one scenario in which autonomous investment could change.

4. Derive the AD curve. Do this by solving for price.

5. Which assumption do economists make which results in a vertical AS curve?

6. Which assumption do economists make which results in an upward­sloped AS curve? Describe one reason why this assumption might be true in the real world.

7. Draw the IS, LM, and AD curves described above. Include an upward­sloped AS curve. Be sure to label equilibrium Y and r with their exact values. Don’t worry about finding the exact value of p.

8. Name one exogenous and one endogenous variable in the IS­LM­AD­AS model.

9.

Recall your drawing for question #10. Now draw what happens when government spending increases by 10 (i.e., draw the proper curve shifts). Label the exact numerical change in equilibrium GDP. Use the following government spending multiplier:

MGISLM =

1/(1b+ de f )

Explanation / Answer

Q1. Consumption function is written as follows -

C(Y-T) = C1 + b*(Y-T)

In this equation,

b = marginal propensity to consume

The given consumption function is as follows -

C(Y-T) = 40 + 0.7*(Y-T)

b or marginal propensity to consume = 0.7

Calculate marginal propensity to save -

Marginal propensity to save = 1 - Marginal propensity to consume

                                         = 1 - 0.7

                                         = 0.3

The marginal propensity to save is 0.3

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