Question

2) Consider the following Keynesian model of the economy.
Consumption Function: C = 12 + .6 Y d,
Investment Function: I = 25 − 50 r,
Government Spending: G = 20,
Tax Collections: T = 20,
Money Demand Function: L d = 2 Y − 200 r,
Money Supply: M = 360,
Price Level: P = 2.

a) Find an expression for the IS curve and plot it.
b) Find an expression for the LM curve and plot it.
c) Find the short run equilibrium level of output and real interest rates.

Suppose that the government decides to stimulate the economy by increasing the level of government spending to G = 22.
d) Find an expression for the new IS curve.
e) Draw a graph of the new IS curve on the same diagram with the old IS curve and the old LM curve.
f) Looking at your graph, what do you expect will happen in the short run to output and real interest rates?
g) Verify your previous answers by computing the short run equilibrium level of output and real interest rates.

Suppose that the Federal Reserve Bank decides to stimulate the economy by increasing the money supply to M = 370. (For this problem assume that G = 20.)
h) Find an expression for the new LM curve.
I) Draw a graph of the new LM curve on the same diagram with the old IS curve and the old LM curve.
j) Looking at your graph, what do you expect will happen in the short run to output and real interest rates?
k) Verify your previous answers by computing the short run equilibrium level of output and real interest rates.

Answer 1