Econ 512 Intermediate Economics

YiLi Chien Spring 2006

Homework Assignment 3 Answer

Question 1 (20 pts) : Suppose prices are sticky in the short run, but fully flexible in the long run (Keynesian model). The economy is initially in the long-run equilibrium. Now suppose that a change in government regulations allows banks start paying interest on checking accounts. (Recall that the money stock is the sum of currency and demand deposit, including the checking account) a. How dose this change affect the demand for money? Interest-bearing checking account makes holding money more attractive. This increases the demand of money. b. What happen to the velocity of money? The increase in money demand is equivalent to a decrease in the velocity of money. Recall the quantity equation M = kY P 1 Where k = . For this equation to hold, an increase in money balance for a given V amount of output means that k must increase, that is, velocity falls. Because interest on checking account encourages people to hold money, dollars circulate less frequently.

c. If the Fed keeps the money supply constant, what will happen to the output in the short run and long run? Show your results in a graph. If the Fed keep the money supply the same, the decrease in velocity shifts the AD curve downward. In the short run, when price are sticky, the economy output reduces from point A to point B. In the long run, prices are fully flexible, output is back to trend (point C) and the change in money supply only affects the price level.

LRAS

P 1

SRAS

P 1

C AD2 Y2

AD1 Y

d. Should the Fed keep the money supply constant in response to this regulatory change? Why or Why not? The decrease in velocity causes the aggregate demand curve to shift downward. The Fed could increase the money supply to offset this decrease and thereby return the economy back to the equilibrium point A.
Question 2 (25 pts): In the Keynesian cross, assume that the consumption function is given by

C = 200 + 0.75(Y T ) Planned investment is 100; government purchases and taxes are both 100. a. Graph planned expenditure as a function of income. Planned expenditure is E = C (Y T ) + I + G E = 200 + 0.75(Y 100) + 100 + 100 = 0.75Y + 325
E Y=E

E=0.75Y+325

325

Y * = 1300

b. What is the equilibrium level of income? To find the equilibrium income level, set Y = E :
Y = 0.75Y + 325 Y = 1300

c. If government purchases increase to 125, what is the new equilibrium income? What is the government purchase multiplier? If government expenditure increases to 125, then planned expenditure changes to E = 0.75Y + 350 . Equilibrium income increases to Y = 1400 . Therefore, increase in government purchases of 25 leads to an increase in income by 100. This implies the government purchase multiplier is 100/25=4. d. What level of government purchases is needed to achieve an income of 1600? A level of 1600 income represents an increase of 300 over the original level of income. Since the government purchase multiplier is 4, that means the government purchase must increase by 300/4=75 (to the level of 175) so that the income level can increase to 1600.
Question 3 (30 pts): Consider the impact of an increase in thriftiness in the Keynesian cross. Suppose the consumption function is

C = C + c(Y T ) Where C is a parameter called autonomous consumption and c is the MPC. a. What happen to equilibrium income when the society become more thrifty as represented by decline of C ? Show your result in a graph. If society become more thrifty, meaning that for any given level of income people save more and consume less. ( C decreases), the equilibrium income falls as shown in the following graph.

Y=E
E1 = C 1 + c(Y T ) + I + G E2 = C 2 + c(Y T ) + I + G

Y2

Y1

b. What happen to equilibrium saving? Equilibrium saving remains unchanged. The national income identity tell you that saving equal to investment, or S=I. In the Keynesian-cross model, we assume the desire investment is fixed. This assumption implies that investment is exactly the same in the new equilibrium as it was in the old equilibrium. c. Why do you suppose the result called the paradox of thrifty? The paradox of thrifty is that even though thriftiness increases, saving is unaffected. Increase thriftiness only reduced your income, hence in Keynesian world, thriftiness is a vice not a virtue. d. Does this paradox arise in the classical model of chapter 3? Why or why not? In the classical model in the chapter 3, the paradox of thrifty does not arise. In that model, output is fixed (since capital and labor are fixed), hence a decrease in consumption lead to a increase in total saving. As shown the following graph, the saving function shifts to the right. As a result, interest rate is lower and investment and saving are higher. Thus, in the classical model the paradox of thrifty dose not exist.

S1

S2

r1 r2

I(r) S,I

Question 4 (25 pts): Consider the following model of the economy:

Aggregate Expenditure:
C = 170 + 0.6(Y T ) T = 200 I = 100 40r G = 350

Money: Md = 0.75Y 60r P Ms = 600 P a. Derive the expressions for IS curve and LM curve. IS curve is derived by equating planned expenditure with income Y =C + I +G Y = 170 + 0.6(Y 200) + 100 40r + 350 Y = 1250 100r LM curve is derived by equating money demand and money supply Md Ms = P P 0.75Y 60r = 600 Y = 800 + 80r b. Find the value of real income and the real interest rate in an IS-LM equilibrium.

The interception of IS and LM curve is the equilibrium interest rate and real income. 1250 100r = 800 + 80r r = 2.5 Y = 800 + 2.5*80 = 1000

c. Suppose the government expands the money supply. Illustrate the effects on GDP and the interest rate on a graph of the IS and LM curves. Clearly label the axes, the curves and the points of intersection before and after the change in the money supply. Expanding money supply LM curve shifts to the right form LM 1 to LM 2
The interest rate drops from r1 to r2 and output increase from Y1 to Y2 (Since decreasing in interest rate increases investment and hence output increases) Besides, since output increases, the money demand increases so that the interest rate did not drop into r3 .

LM 1 LM 2

r1 r2 r3 IS Y1 Y2 Y

d. Suppose that the investment function is independent of the interest rate and is given by the expression I= I . The government expands the money supply.
0

Since the investment is given by 0 I , the expenditure function is independent of interest rate. Hence, changing the interest rate does not affect good market equilibrium. The IS curve is a vertical line. Expanding money supply LM curve shifts to the right form 1 LM to 2 LM The interest rate drops from 1 r to 3 r and output unchanged at 1 Y The output does not change because changing in interest rate has no effect on investment and hence no effect on equilibrium output. In addition, there no

effect on changing in money demand so the interest rate drops more compared to the answer in part c.

IS

LM 1 LM 2

r1

r3

Y1