Question

Monetary Policy in Keynesian Models of the Macroeconomy (a) The Keynesian consumption function is: C d = C¯ + c(Y − T) − γcr. Provide an intuitive explanation for this equation. Define all terms. (b) Consider the AD-AS model. Assume that an economy is initially in an equilibrium with output equal to potential output. Then suppose the central bank alters its policy reaction function so that for any given inflation rate and output gap it sets a lower real interest rate. Explain what effect this change in policy will have upon the short run and the long run in the AD-AS model. Describe how inflation and output change over time.

Answer #1

**(a)Ans:** The given Keynesian consumption
function is: C_{d} = C¯ + c(Y − T) − γcr

The above function says that consumption demand is a function
(C_{d}) that depends positively on disposable income (Y −
T). Y and T denotes income and Taxes respectively. C¯ is the fixed
amount of consumption. γcr is the retained earnings, depends
negatively on C_{d}.

**(b)Ans:** Considering the AD-AS model.

In the above diagram, e_{sr} is the short-run
equilibrium. Short run aggregate supply (SRAS) and Aggregate demand
(AD) intersect at this point. *Y*^{1} is
the current output and *PL*_{1} is the current
price level. Y1 is
greater than Y_{f}. Here, the economy is producing more
than full employment output. Hence, it has an inflationary gap.

Now check the diagram below for the long run impact.

Long run aggregate supply (LRAS) is always vertical. In economics, the long run is long enough to adjust all prices and achieve full employment output. When all prices have adjusted, the short-run output will also be the full employment output. Equilibrium occurs where all the three curves intersect each other.

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b) Write down the fiscal policy reaction by the government. What
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a. Suppose that the central bank does nothing. What will be the
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desired (targeted) inflation also 2%. Finally, suppose the
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a. Monetary Policy involves changing taxes and
government spending/ the design of currency/ exports/ the money
supply. In the United States, Monetary
Policy is implemented by the Federal Reserve/ President and
Congress/ Secretary of the Treasury/ states.
b. Contractionary Monetary Policy/ Lower prices/
Expansionary MonetaryPolicy/ Larger coins can be used to
address a Recessionary Gap; while Expansionary
MonetaryPolicy/ smaller coins/ Contractionary Monetary Policy/
higher prices can be used to address an Inflationary
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Suppose that investment and consumption expenditure change very
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implies for the slope of the IS curve and AD curve, and for the
relative effectiveness of monetary and fiscal policy in stabilizing
real output. Explain your results.

Suppose a central bank decides to conduct monetary
policy according to a rule for interest rates.
a) How does it choose the basic setting for the interest
rate within the rule?
b) How would it respond to a rise in the output gap (Y
−YP)?
c) How would the bank react to an inflation rate higher
than its target inflation rate?

) Explain expansionary monetary policy using
the following four macroeconomic models. Indicate what happens to
real GDP (Y), the components of real GDP (C, I, G, NX), and the
price level (P). Why are the answers different depending on the
model used?
Short Run: Closed Economy (IS/LM)
Short Run: Aggregate Demand/Aggregate Supply
Long Run: Closed Economy (S = I)
Long Run: Small, Open Economy (S – I = NX)

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.
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b) Find an expression for the LM curve and plot it.
c)...

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Labor Supply: Le = 11
Capital Supply: K=11
Production Function:
Y-10K.3(Le).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: Ld=
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Money Supply: M=360
Price Level: P=2
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Find an expression for the LM curve and plot it.
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Show your answer with the help of a diagram and explain the
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where the short-run...

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