Economics 2220A-570

Review Questions#2

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Ideally, set aside a time block of 2 hours at the maximum for these review questions (You may be able to finishthem faster) so that you can finish all questions without interruption.

Bring your worked solutions to the Nov 3 class. If you want to show them to me, please do so during the break and after class. I will be happy to have a look and to make correction if necessary.

1.Drive the IS curve from the Keynesian Cross Diagram of Y = AE = C+I+G, and I = I0 - bi, for the two different cases i) where investment is perfectly inelastic with respect to interest rate, and ii) where investment is reasonably elastic with respect to interest rate.

i)When b =0ii)When b is non-zero

Keynesian Cross Diagram Keynesian Cross Diagram

IS CurveIS Curve

2.Derive different slopes of LM curves for varying elasticity of real money demand curves.

Hint: md = k Y – h i + u , and assume k=1 for simplicity; and draw LM for varying values of h.

1)When h approaches zero, which means that real money demand is perfectly inelastic/elastic with respect to interest rate(Please, circle one for an answer, and then proceed to the derivation of the LM curve).

2)When h is between zero and infinity, which is the case of normal or standard downward sloping LM curve.

3)When h approaches infinity, which means that real money demand is perfectly inelastic/elastic with respect to interest rate (Please, circle one for the answer and proceed to graphical derivation of LM curve)

3.All five sub-questions are cumulative here.

1).Graphically derive the LM curve from the real money supply curve and two ‘standard’ or ‘normally-shaped’ downward-slopingreal money demand curvescorresponding to two different levels of national income Y.

Real Money Supply-Demand SettingLM Curve

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2) Draw the above derived LM in the following panel, and combine the above LM curve and the given standard IS curve. Show the equilibrium national income and interest rate, Y* and i* , which satisfy the equilibrium condition for both goods and money markets.

IS-LM Curves

3) Can you get/recall the mathematical expression of the equilibrium equation for Y* for the standard IS-LM curves of Case 1?

Assume that Y = C+ I + G; C = C0 + c1(Y-T0) ; I = I0– bi ; G = G0 in the goods market; and

M/P = k Y – h i + u for the money market.

Y* =

4) Suppose that now the government increases its expenditure G, what will happen to the IS curve, Y* and i*?

Illustrate the changes in the following IS-LM curves (as derived at Question 2) ).

Use the answer to Question 3), and give the mathematical expressions for the distance of shift of IS curve, and changes in Y* and i* respectively.

IS-LM Curves

5)First, repeat/draw the above graphs– money demand and supply, LM curve, and a given IS curve- from Question 1) once again in the following panels(as the following question is a continuation/cumulative of the above question);

Second, assume now that the due to a sudden‘financial market instability’people would like to move away from financial investment and just to hold more of real money balances (Hint:The real money demand increases, which is a positive value of random monetary shock in the money market). Now, illustrate what will happen to real money demand and LM curves.

Real Money Supply-Demand SettingLM Curve

By drawing the above LM curves- original and shifted-, explain what happens to Y* and i*.

IS-LM Curves

6)This is again a cumulative question to Question 4).

First, draw the above graphs from Question 4)once again on the following panels( the next question is a continuation of the above question).

Nowsuppose that the monetary authoritydoes not want to have the changes in i* in response to the aforementioned ‘random increase in real money demand’, as shown in Qestion 4), and wants to keep interest rate at the initial level. Thus the monetary authority is engaged in the ‘interest rate pegging policy’. Illustrate what would the monetary authority do with MS, and ms? What will happen to LM curves? Now to save space, we put the given IS curve in the second panel.

Real Money Supply-Demand SettingLM Curve (and IS curve)

4. (New Questions) Suppose that people have a voracious appetite for money and thus the real money demand is perfectly elastic with respect to interest rate: Illustrate your answer with some brief and to-the-point written explanation.

1)Derive the LM curve for this case from the corresponding real money demand curve:

Money Supply and Demand SettingLM Curve

i

2) Draw the specific LM curve derived above in the following panel, and combine it with the given‘standard/normal’IS curve.

Nowillustrate the degree of effectiveness of the expansionary money policy( MS) on the national income in this case: Is it not effective/somewhat effective/or highly effective? And why is it so?

IS-LM setting

3) Draw the specific LM curve derived above in the following panel, and combine it with the given ‘standard/normal’ IS curve.

Now illustrate the degree of effectiveness of the expansionary fiscal policy(G) on the national income in this case: Is it not effective/somewhat effective/or highly effective? And why is it so?

IS-LM setting

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