Question

Consider the following Keynesian (short-run) model along with the Classical (long-run) model of the economy.

Labor Supply: L^e = 11

Capital Supply: K=11

Production Function: Y-10K^.3(L^e)^.7

Depreciation Rate: &=.1

Consumption Function: C=12+.6Yd

Investment Function: I= 25-50r

Government Spending: G=20

Tax Collections: T=20

Money Demand Function: L_d= 2Y-200r

Money Supply: M=360

Price Level: P=2

Find an expression for the IS curve and plot it.

Find an expression for the LM curve and plot it.

Find the short run equilibrium level of output and real interest rates.

Find an expression for the AD curve. (Hint: The aggregate demand function is found by setting the IS curve equal to the LM curve to eliminate r while leaving the price level P unconstrained. So start by LM curve with an unconstrained P, then replace r with the IS expression you got in part a.)

Find an expression for LRAS curve.

What are the long run equilibrium values of output, prices, and interest rate?

(Hint: remember in the long-run, Y is equal to production function. Plug the long-run value of Y in AD function and solve it for P. Plug the value of Y in IS and solve it for r.)

Suppose that the economy is initially located at the short-run equilibrium found in (c). With the aid of appropriate diagrams (IS-LM and AD-AS), carefully explain what the dynamic adjustment will be as the economy adjusts from the short run equilibrium (c) to the long run equilibrium (f).

Suppose that fiscal policy makers have decided to undertake a policy intervention in which government spending is changed so that the economy moves to the long run output level without impacting prices. (i.e. prices stay at P=2).

What level of G will achieve this target? (Hint: first, plug the target Y into the LM and get r, then plug the Y and r into the expenditure equation and impose the goods market clearing condition (Y=PE) and get G.)

Answer 1

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