The document discusses macroeconomic equilibrium when there is a price level increase. It explains how the equilibrium level of aggregate demand is determined by the intersection of the IS curve in goods markets and LM curve in capital markets. The sensitivity of investment (I) to the interest rate (i) influences how much the equilibrium level of income (Y) must change to restore equilibrium aggregate demand when the price increase causes i to rise.

1. INTRO TO MACROECONOMICS
Exercise 7 Twitter: @RajEcon
www.rajchandeteaching@blogspot.com
Raj.Chande@bristol.ac.uk

2. 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.

3. 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

4. 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?

5. 2) AGAIN, ‘IN PARTICULAR’
 If AD was shallower for A, then what does that tell
you about the IS curve for A?

6. 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)

7. 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

8. 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

9. 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 – 35000ii = 0.055
Now we know i, we can calculate price of bond

10. III) AND IV)
 If you couldn’t do these, try again.
 Any problems, come see me, though Nigel will post
answers on BlackBoard soon.

11. 4) THE DOLLAR INDEX SINCE 1969