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Supplementary Solution Manual for Midterm II

<Q.5 of Chapter 5>

a. IS relation: (negative) relation between Y and i obtained from the equilibrium condition in the
goods market

Y = C + I + G = 200 + 0.25(Y − 200) + 150 + 0.25Y − 1000i + 250

Y = 1100 − 2000i

b. If 5%, equilibrium output: Y = 1100 − 2000 × 0.05 = 1000
M
c. Note that the equilibrium condition in the money market is P
= Y L(i). The question supposes
that the real money demand function is more concretely given as Y L(i) = 2Y − 8000i so that
M
the equilibrium condition in the money market becomes P
= 2Y − 8000i. If 5%, the real money
supply in the case of equilibrium in the money market would be:
M
= 2 × 1000 − 8000 × 0.05 = 1600
P
d. – Equilibrium consumption: C = 200 + 0.25(Y − T ) = 200 + 0.25(1000 − 200) = 400
– Equilibrium investment: I = 150 + 0.25Y − 1000i = 150 + 0.25 × 1000 − 1000 × 0.05 = 350
– Y = C + I + G = 400 + 350 + 250 = 1000; yes, it is the same as the equilibrium output
obtained in (b).

e. In case the central bank implements an expansionary monetary policy by cutting the rate to
i = 3%:

– Equilibrium output: Y = 1100 − 2000 × 0.03 = 1040 (from the IS relation in (a))
– Equilibrium consumption: C = 200 + 0.25(Y − T ) = 200 + 0.25(1040 − 200) = 410
– Equilibrium investment: I = 150 + 0.25Y − 1000i = 150 + 0.25 × 1040 − 1000 × 0.03 = 380
– Y = C + I + G = 410 + 380 + 250 = 1040; yes, it is the same as the equilibrium output
obtained from the IS relation above.
M M
– Equilibrium P
: From (c), we have P
= 2Y − 8000i = 2 × 1040 − 8000 × 0.03 = 1840
M
⇒ All of Y , C, I, and P
increased due to the expansionary monetary policy.

f. In case of expansionary fiscal policy that raises G = 400:

– Equilibrium output:

Y = C + I + G = 200 + 0.25(Y − 200) + 150 + 0.25Y − 1000i + 400

Y = 1100 − 2000i
Y = 1400 − 2000 × 0.05 = 1300

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The former can be W W 1 rearranged into P = 1 − u — which is the wage-setting relation — and the latter into P = 1+m — which is the price–setting relation. P = 1+m = 1. as expected.05 c.25 × 1300 − 1000 × 0. When m = 10%.952 (since m = 5%) b.09 = 9% 1+m 1. On the other hand. – Equilibrium consumption: C = 200 + 0.8% 1+m 1. un = 4. W = P (1 − u) is given in the question as a specific functional form of the wage function W = P e F (u. 1 1 u=1− =1− = 0.8% and u0n = 9% 2 .25(1300 − 200) = 475 – Equilibrium investment: I = 150 + 0.05 = 0. it is the same as the equilibrium output obtained above. m0 = 0.05. z). we have P = 2Y − 8000i = 2 × 1300 − 8000 × 0. C. W 1 1 a.05 = 425 – Y = C + I + G = 475 + 425 + 400 = 1300. we know the price function P = (1 + m)W . M M – Equilibrium P : From (c).1.1 where m = 0.048 = 4.3 of Chapter 7> 3.25(Y − T ) = 200 + 0. and P increased due to the expansionary fiscal policy.25Y − 1000i = 150 + 0.05 = 2200 M ⇒ All of Y . From the two relations. <Q. we obtain the equilibrium condition in the labor market as 1 1−u= 1+m from which the natural rate of unemployment is derived as 1 1 u=1− =1− = 0. I.