Due Friday, 5 Nov 1999, 4pm
Given the Bank's policy, what would happen in the very short run (before
general
equilibrium is restored) to output and the real interest rate? What must happen
to the LM curve and the price level to restore general equilibrium?
Cd = 100 + 3/4 (Y - T) | Desired Consumption |
Id = 0.1Y - 1,500r | Desired Investment |
T = (1/3)Y | Taxes (government revenue) |
G = 170 | Government Spending |
M/P = Y - 10,000r | Real money demand |
M = 250 | Nominal money supply |
(a) Let P=2. Derive the IS and LM equations and show that the short-run
equilibrium is characterized by r=4% and Y=525. What is the budget surplus
or deficit?
(b) Suppose the long run (full employment) output level is Yfe=800, describe (qualitatively or otherwise) how the economy can attain its long-run equilibrium without policy intervention. What happens to prices, wages and interest rates along the transition?
(c) How can monetary policy be used to reach the full-employment output? How can fiscal policy be used to reach full-employment output?
(d) If you were responsible for Economic Planning in this country, would you use fiscal or monetary policy to move the economy to its full-employment level of output? Why?
IMPORTANT: The following question need not be done for Assignment #3.
Desired consumption and investment are given by:
Taxes and government expenditure are given by:
The real money demand is:
The money supply M = 9890 and the expected inflation pie = 0.10.
(a) Derive the equations for the IS and LM curves and show them on a graph.
(b) If the full-employment output is Yfe = 1000, what are the
equilibrium values of r, P, C and I?
(c) Suppose there is a surprise increase in M to 12,650, what will be the
short run equilibrium values of Y, r, C and I? What will happen in the
long-run?
[Hint: Prices are sticky in the short run, since Keynesian].
MPK = (r+d) pK
Since the price of capital goods is assumed not to change over the business cycle, MPK is acyclical since its behaviour over the business cycle depends on the beahviour of the real interest rate.
However, if one contends that capital is "fixed" to some degree, its behaviour will exhibit certain cyclical tendencies. For example, if more labour is employed in a "boom", the MPK could rise (given fixed K) and so MPK could be seen to vary procyclically.
In the short run (point F), Y falls and the real interest rate is unchanged. In the long run, to restore general equilibrium (point G), prices will have to fall so that the LM curve shifts to the right (to LM2) until it intersects with the FE line and the new IS curve. So, prices have fallen by more than if the money supply had not changed, real interest rate has fallen, and output is back at the full-employment level.
The IS curve is given by equilibrium in the goods market:
Id = Sd implies 0.1Y - 1500r = 0.5Y - 270
is the equation for the IS curve.
[Alternatively, you could use the AS=AD method : Y = Cd + Id + G . This gives the same equation for the IS curve as found using Id = Sd above.]
The LM curve is found by equating real money supply with real money demand:
Hence,
is the equation for the LM curve.
The short run equilibrium is given by the intersection of the IS and LM curves. Equating r given by each of IS and LM, we get
The budget surplus is T - G = 5.
One argument in favour of using monetary over fiscal policy to move the economy to full-employment output is that monetary policy favours investment, while fiscal policy does not (via the effect on r). Investment is important in determining a country's long run productive capacity.
That being said, the question gives little indication as to why the economy has found itself at its original point. Determining this reason is important in choosing the best policy. For example, if IS shifted back due to a fall in consumer confidence, fiscal policy could be favoured. Note also that in restoring the economy to full employment by increasing the money supply, policy makers are implicitly choosing a NEGATIVE real interest rate. Because of the effects this might have on the asset market (ie. it raises the demand for money to extremely high levels), using monetary policy could be an unwise policy choice in the context of this economy.