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Macrotheory 2011 WT - Problem Sheet 07 Answers

# Macrotheory 2011 WT - Problem Sheet 07 Answers

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10/08/2012

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Department of EconomicsProfessor Heiko Fritz
Macrotheory(ECON 712)
WT 2011 – Problem sheet 7
Problem 1
Consider an economy running a proportional income tax system in which the goodsmarket is described by the behaviourial functions below:Private consumption C(Y)= 200 + 0.25∙(Y T)Lump sum tax T= 200Private investment I(Y,r)= 150 + 0.25∙Y 1,000∙rGovernment purchases G= 250Likewise the monetary sphere of the economy is described by the following functions:Money demandL(Y,r)= 2Y 8,000rMoney supply M= 1,600a. Derive the IS relation.Planned aggregate expenditure E = C + I + GConsumption C: C(Y) = 200 + 0.25∙(Y 200)
C(Y) = 150 + 0.25∙Y=> E(Y,r)= 150 + 0.25∙Y + 150 + 0.25∙Y – 1,000∙r + 250= 550 + 0.5∙Y – 1,000∙rThe IS function holds for all combinations of r and Y for which the goods market is inequilibrium. Goods market equilibrium requires E = Y=> Y = 550 + 0.5∙Y – 1,000∙rSolving for Y yields Y = 1,100 2,000∙r

b. Derive the LM relation.Equilibrium in the money market requires M = LEquilibrium can then be written as1,600 = 2∙Y – 8,000∙rSolving for Y yields Y = 800 + 4,000∙rSolving for r yieldsr= -0.2 + (1/4,000) ∙Yc. Solve for equilibrium real output.Substitution of the expression of the LM function into the IS function yields:Y = 1,100 – 2,000∙(-0.2 + (1/4,000) ∙Y)
Y = 1,000d. Solve for the equilibrium interest rate.Substitution of the equilibrium real output into the LM function yieldsr= -0.2 + (1/4,000) ∙1,000 = 0.05 (or 5%)e. Solve for the equilibrium values of C and I and verify the value you obtained for Y byadding up C, I, and G.C (Y = 1,000) = 200 + 0.25∙(1,000 – 200) = 400I(Y,r) = 150 + 0.25∙1,000 – 1,000∙0.05 = 350Planned aggregate demand = C + I + G = 400 +350 + 250.
Problem 2
When money demand is perfectly elastic with respect to the interest, there is nocrowding out. True or false? Explain.True.Perfectly elastic money demand with respect to the interest rate means that the moneydemand function is horizontal. Individuals (most notably commercial banks) are preparedto hold any amount of money supplied at the going interest rate. While sounds veryhypothetical, this may occur when there is much uncertainty about the future economicdevelopment. An increase in money supply would then increase the liquidity in thecommercial bank. The commercial banks, however, would not be interested inincreasing loans to the private non-banks due to uncertainty about, for instance, thequality of their loan portfolio or the ability of potential borrowers to repay the loans.When the money demand function is horizontal, the LM function is horizontal too.The mechanism of crowding out usually works is as follows. The government increasesgovernment purchases which stimulates planned aggregate expenditure and equilibriumproduction and income. In the money market this leads to a shift of the money demandfunction to the right. If money demand is downward sloping this increases the equilibriuminterest rate and decreases private investment demand. Thus the decrease in private