PROBLEM SET 1 (PART 1)

(1) Consider the Keynesian cross model and assume that the consumption
function is given by:
C = 200 + 0.75(Y − T )
Planned investment (I) is 100, government purchases (G) and taxes (T)
are both 100.
(a) Graph planned expenditure as a function of income;
(b) Find the equilibrium level of income;
(c) If government purchases increase to 125, find the new equilibrium level
of income;
(d) What should be the level of G in order to achieve an income of 1600
in equilibrium?
(2) Consider the following general version of the Keynesian cross:
Y =C +I +G
C = a + b(Y − T )
I = c − dr
Assume that taxes (T) are not fixed but depend on income in the following
way:
T = T̄ + tY
where T̄ > 0 and 0 < t < 1 are parameters of the tax system.The param-
eter t is the marginal tax rate: if income rises by $1, taxes rise by t$1.
Furthermore, a > 0, 0 < b < 1, c > 0, d > 0.
(a) How does this tax system change the way consumption responds to
changes in GDP?
(b) In the Keynesian cross, how does this tax system alter the government-
purchases multiplier?
(c) Find the IS equation from this Kenesian cross mode. How does this
tax system alter the slope of the IS curve?
(3) Suppose that the money demand function is given by:
 d
M
= 1000 − 100r
P
where r is expressed in percent. The money supply is 1000 and the price
level is fixed at 2.
(a) Graph the supply and demand for real money balances;
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2 PROBLEM SET 1 (PART 1)

(b) Find the equilibrium interest rate;

(c) Now suppose that the money supply increases to 1200. Find the new
equilibrium interest rate;
(d) Suppose that the central bank wants to raise the interest rate to 7%,
what money supply should it set?