Question

1. Assume that investment depends on both the interest rate and the level of GDP. We will call the effect of output on investment (loosely) the “accelerator” effect.

   1. Compare the multipliers for an adverse demand shock on Y with and without the accelerator effect using (i) the algebraic solution for the multiplier and (ii) IS and LM curves.

   2. Does the addition of the accelerator affect the direct, positive or negative feedback effects?

   3. Also show how the addition of the accelerator effect affects the IS an/or LM curves and, using the curves, the response of output to and increase in the money supply.

   4. Is there a condition under which the multiplier provides realistic results? If so, what is the condition?

   5. Please try to explain what the implications are if this condition is not met.

Answer 1