Semester 2, 2012 ECON204 Macroeconomic Analysis Tutorial 4, Week 6 Questions 1. Consider the...

Question

Semester 2, 2012 ECON204 Macroeconomic Analysis Tutorial 4, Week 6 Questions 1. Consider the following model of the economy: Wages are determined by the following equation W = Pe (2.5 -10u). Price is determined by the following equation P=2W Production function Y=N. Labour force is fixed L=100 Consumption function C=10+0.5(Y-T) Investment function I =12+0.3Y-100 i Government spending G=4 Taxes T=10 The central bank is using the following Interest Rate Rule: it = in + 2(P-PT) Where PT=10 a. Derive the AS relationship for this economy.
	
Document Preview: Semester 2, 2012 
ECON204 
Macroeconomic Analysis 
Tutorial 4, Week 6 
Questions 
 
1. Consider the following model of the economy: 
Wages are determined by the following equation W = Pe XXXXXXXXXX10u).  
Price is determined by the following equation P=2W 
Production function Y=N. 
Labour force is fixed L=100 
Consumption function C=10+0.5(Y-T) 
Investment function I =12+0.3Y-100 i 
Government spending G=4 
Taxes T=10 
The central bank is using the following Interest Rate Rule: it = in + 2(P-PT) 
Where PT=10 
 
a. Derive the AS relationship for this economy. What are the natural rate of the 
unemployment and natural level of output? 
b. Derive the IS relationship for this economy. 
c. Derive the AD relationship for this economy. 
d. What are the medium run values of P, Y and i? 
e. Analyse qualitatively what will happen to the economy in the short run and the 
medium run if the central bank decides to increase its price target from 10 to 
20? Assume that the expected price for the next period is equal to the current 
price 
 
2. Spending shocks and the medium run 
Using the AS-AD model where the central bank uses an interest rate rule with a price 
level target show the effects of an increase in consumer confidence on the position of 
the AD, AS, IS, and LM curves in the medium run. Then show the effect on output, 
the interest rate, and the price level in the short run and in the medium run. Assume 
that before the changes, the economy was in the medium run equilibrium. 
 
Note: If C(YD)=c0 + c1 YD, an increase in consumer confidence can be modelled as an 
increase in c0. 
 
3. Dynamics and the AS-AD model 
Consider the following model of the economy:

AS: Pt =	 d (Yt-Yn)

IS: Yt = b - c it +eG-fT 
Interest Rate Rule: it = in + a(Pt-PT) 
where a, b, c , d, e and f are positive parameters. 
a. What is the AD relation in this economy? 
b. Suppose PT =1, Yn=100, b=101, c=100, e=2, f=1, G=T=0 
What are the medium run values of P, Y and i? 
c. If G increased to 1,...

David · Accepted Answer

Answer to 1: 
a. 
We have W = Pe(2.5-10u) and P = 2W 
This implies P = 2Pe(2.5-10u) 
u  = 1- (N/L) = 1- (Y/100), substituting this value of ‘u’ above, we get AS relation as: 
AS: P = 2Pe[2.5-10*(1-(Y/L)] = 5Pe-20*[1-(Y/100)]  or 
P = 5Pe+20[(Y/100)-1] 
Natural level of output is that level of output at which all persons (i.e. whole of labor force) 
are employed. So natural level of output = 100 
b. IS relation: Y = C+I+G 
Y = 10+0.5*(Y-10)+12+0.3Y-100i+4 or 
Y = 10+0.5Y-5+12+0.3Y-100i+4 or  
0.2Y = 21-100i, implies IS relation: Y = 105-500i 
c. 
For AD relationship, substitute interest rate rule in AD equation i.e. 
Y = 105-500*[in+2(P-10)] = 10105-500in-10000P 
So AD relationship: Y = (10105-500in) -10000P 
d. 
For medium run values, Y would be at its natural level. So medium term output Y = 100 
Substituting this in AD equation above to get medium term value of price i.e. 
100 = 10105-500in-10000P, implies P = 1.0005-0.05in 
And finally medium term values for interest rate it = in+2(1.0005-0.05in-10) = in+2.001-
0.10in-20 = 0.9in-17.999
e. if central banks decides to increase its price target from 10 to 20, it is likely to follow 
expansionary monetary policy. Due to expansionary monetary policy, real money supply 
will increase (assuming there is no change in the price level in the short run) and as a 
result, in short run, interest rate would fall in the economy and economy’s output would 
expand. In the medium run, increase in money supply would cause price level to increase 
and as a result real money supply would start falling. Due to fall in real money supply, the 
LM curve will start shifting back to its initial position. So in the medium run, there would be 
no change in the economy’s output and interest rate. The following analysis implies that 
money is neutral in the system as it has no real effect. 
Answer to 2:

Semester 2, 2012 ECON204 Macroeconomic Analysis Tutorial 4, Week 6 Questions 1. Consider the following model of the economy: Wages are determined by the following equation W = Pe (2.5 -10u). Price is...

Solution

Answer To This Question Is Available To Download

Related Questions & Answers

Submit New Assignment