Consider a closed economy, described by the following equations: (1) C = 0.75YD

Question

Consider a closed economy, described by the following equations: (1) C = 0.75YD + 140 (2) YD = Y - T (3) T = 0.20Y (4) I = -2,000r + 400 (5) G = G* = constant (6) Y = C + I + G (7) MD /P = 2/3Y – 5,000r +750 (8) MS = M* = constant (9) MS = MD (10) P = 1

5- Following question 4-: assuming that money supply cannot change, explain what could be the policy of the Government in order to restore the initial equilibrium income (from question 2-). In addition, explain what are the expected consequences on the endogenous variables of the model; you will justify your reasoning using the (IS)-(LM) chart, without any computation

Explanation / Answer

There is no hint regarding previous / initial equilibrium.

If Fed cannot change money supply then they can restore equilibrium by adjusting money demand. Actually there are two parts of money demand one is depended on income (known as transaction demand for money and other part is depended on interest rate and that is known as speculative demand for money. If interest rate increases that will reduce the speculative demand for money since money supply is fixed transaction demand for money will increase to restore the initial equilibrium and through transaction demand for money income will also increases. Similar logic will be applied to restore change in transaction demand for money.

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