INTRO TO MACROECONOMICSExercise 7 Twitter: @RajEconwww.firstname.lastname@example.orgRaj.Chande@bristol.ac.uk
Q1 Equilibrium level of aggregate demand (AD) occurs when an economy’s real goods and capital goods markets are in equilibrium. Eqbm in goods market: Goods demanded = goods supplied, IS Curve gives interest rate (i), income (Y) combinations Eqbm in capital market: Money supplied = money demanded, LM curve gives i, Y combinations That’s your initial equilibrium. Disturbance: Price level (P) increases.
1) CTD, TRANSITION TO NEW EQBM P increase, real quantity of money falls Money demand greater than supply, public sell bonds, interest rate increases and new eqbm is reached in capital goods market But now i has gone up, investment (I) will fall and eqbm AD must now occur at a lower Y and higher i. Now… here’s the focus of this question, how does the sensitivity of I to i influence the overall change in Y? Most of you too briefon this bit
BEST WAY IS TO COMPARE TWO EXTREMES A: Imagine if I was hugely sensitive to i, then a small increase in i would cause a massive fall in I and thus a large drop in Y would be required to reach equilibrium AD again. B: If I didn’t really budge, then once the public sell their bonds, that’s more or less the whole story. Yes, i goes up, but the subsequent change in Y would be very small. The question did ask you to focus on this ‘in particular’. So do that. Now think, what would the AD curves look like for A and B?
2) AGAIN, ‘IN PARTICULAR’ If AD was shallower for A, then what does that tell you about the IS curve for A?
3) JUST ALGEBRA, PG65 TELLS YOU HOW IS: Y = [c0+c1T + I(i, Πe) + G] / (1-c1) LM: Y = M / P.L(i) …and in AD eqbm, we know that Z = Y Remember, IS and LM on i, Y space, AD on P, Y Simply plug in the values you have been given and rearrange to derive the IS curve. Y = 2925 – 35000i …or more usefully…i = 0.08357 – (Y/35000)
LM CURVE We have H, we have c, we have θ …and we know M = H/[c+θ(1-c)], so M is 125 Again, just sub this in to your Md equation:Md/P = M/P = 125/P = 0.4Y-5000i Rearrange to get: i = [Y – (312.5/P)]/12500
NOW AD IS & LM cross at one combination of i and Y AD curve on space of P and Y, so let’s get rid of i We know from LM expression that:i = [Y – (312.5/P)]/12500 so sub into IS to get: Y = 2925-35000[Y-(312.5/P)]/12500 Y = 769.7358 + 230.26/P
3)II) If Y = 1000 and our AD curve tells us that: Y = 769.7358 + 230.26/P then just plug in Y = 1000 to get P = 1 Then using either IS or LM to get i: 1000 = 2925 – 35000ii = 0.055 Now we know i, we can calculate price of bond
III) AND IV) If you couldn’t do these, try again. Any problems, come see me, though Nigel will post answers on BlackBoard soon.