Question

IS: Y = 7000 + 2.5*G – 1.5*T – 500*r

LM: r = [Y – 5*(MS/P)]/500

1. The AD curve of this economy, as a function of G, T, MS and P is
[HINT: Note that you’ll get rid of the “500” in the denominator of the LM curve since when you plug r from the LM curve into the IS curve, you’ll have 500/500, which equals 1. Solve for Y]

(a) Y = 7500 + 2.5*G – 1.5*T + 5*MS/P
(b) 7000 + 2.5*G – 1.5*T + 5*MS/P = 0
(c) Y = -3500 – 1.25*G + 0.75*T – 2.5*MS/P

(d) Y = 3500 + 1.25*G – 0.75*T + 2.5*MS/P

Answer 1

The correct answer is (d) Y = 3500 + 1.25*G – 0.75*T + 2.5*MS/P

Given: Y = 7000 + 2.5*G – 1.5*T – 500*r ------IS curve

r = [Y – 5*(MS/P)]/500 --------------LM Curve

AD curve shows the combination of Y and P at which Both Goods and Money market is in equilibrium.

Hence We have to find Y in terms of P and considering G , T and MS be exogenous variables. We have:

Y = 7000 + 2.5*G – 1.5*T – 500*r

and r = [Y – 5*(MS/P)]/500

=> Y = 7000 + 2.5*G – 1.5*T – 500*r = 7000 + 2.5*G – 1.5*T – 500*[Y – 5*(MS/P)]/500

=> Y = 7000 + 2.5*G – 1.5*T - [Y – 5*(MS/P)]

=> Y = (1/2)(7000 + 2.5*G – 1.5*T + 5*(MS/P))

=> Y = 3500 + 1.25G - 0.75T + 2.5(MS/P)----------AD Curve equation.

Hence, the correct answer is (d) Y = 3500 + 1.25*G – 0.75*T + 2.5*MS/P