In a closed economy....C = XXXXXXXXXXY-T) (2)I = 375 - 25r (3)T = XXXXXXXXXXG = XXXXXXXXXXMs=Md...

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In a closed economy....C = XXXXXXXXXXY-T) (2)I = 375 - 25r (3)T = XXXXXXXXXXG = XXXXXXXXXXMs=Md (6)Ms = XXXXXXXXXXMd/P = L(r,Y) = 0.5Y – 50r
A4. Calculate the long-run equilibrium values of r and P, assuming that the potentiallevel of output (Y*) is equal to 3500 monetary units. Use the IS/LM and AD/ASmodels to illustrate graphically the short-run and long-run equilibrium, and to explainhow the economy moves from the short-run to the long-run equilibrium, if the two aredifferent [14 points].
A5. Suppose that the supply of money remains unchanged and that, in the short-run,the aggregate price level is fixed at 1.0. Suppose that the public wants to hold moremoney balances such that the money demand function changes to Md/P = Y–50r.Using the IS/LM and AD/AS models, explain what happens to equilibrium output and the equilibrium interest rate in the short-run, and equilibrium output and theequilibrium price level in the long-run [14 points].

David · Accepted Answer

In a closed economy....C =500 + 0.75(Y-T) (2)I = 375 - 25r (3)T = 500 (4)G = 500 (5)Ms=Md 
(6)Ms =1000 (7)Md/P = L(r,Y) = 0.5Y – 50r 
A4. Calculate the long-run equilibrium values of r and P, assuming that the potentiallevel of 
output (Y*) is equal to 3500 monetary units. Use the IS/LM and AD/ASmodels to illustrate 
graphically the short-run and long-run equilibrium, and to explainhow the economy moves from 
the short-run to the long-run equilibrium, if the two are different [14 points]. 
Answer: 
We are given Ms = 1000 and Md  = P(0.5Y-50r) 
At equilibrium, Ms = Md i.e. 
1000 = P(0.5Y-50r), implies P = 1000/(0.5Y-50r) 
In the long run, output (Y) = potential output (Y*) = 3500 
So P = 1000/(0.5*3500-50r) = 1000/(1750-50r) ………. (1) 
We are also given C =500 + 0.75(Y-T) (2)I = 375 - 25r (3)T = 500 (4)G = 500 
At equilibrium Y = C+ I+ G i.e. 
Y = 500 + 0.75(Y-500) + 375-25r + 500       [given T = 500] or 
Y = 500 + 0.75Y – 375 + 375 -25r + 500 or 
Y = 1000+0.75Y-25r or 
0.25Y = 1000 – 25r or 
r = 40 – 0.01Y 
In long run equilibrium, Y = potential output = 3500 
So long run equilibrium value of ‘r’ = 40-0.01*3500 = 5 
Substituting this value in (1), we get long run equilibrium value of price (P) = 1000/(1750-50*5) 
= 0.

In a closed economy....C = XXXXXXXXXXY-T) (2)I = 375 - 25r (3)T = XXXXXXXXXXG = XXXXXXXXXXMs=Md (6)Ms = XXXXXXXXXXMd/P = L(r,Y) = 0.5Y – 50r A4. Calculate the long-run equilibrium values of r and P,...

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