ECMA06_Tutorial_10_Solution.doc

6 Pages
59 Views
Unlock Document

Department
Economics for Management Studies
Course
MGEA06H3
Professor
Iris Au
Semester
Summer

Description
ECMA06 Tutorial #10 Answer Key Question 1 Part (a) • Disposable income, DI: DI = Y – T + TR DI = Y – 0.3Y + [20 – 0.075Y] = 20 + 0.625Y • C = C(Y): C = 0.8(20 + 0.625Y) C = 16 + 0.5Y • The AE function: AE = C + I + G AE = [16 + 0.5Y] + [20 – 50r] + 49 AE = 85 + 0.5Y – 50r • Setting Y = AE: Y = 85 + 0.5Y – 50r 0.5Y = 85 – 50r Y = 170 – 100r This is called the IS curve & you will learn it in ECMB06 • Note: Since we have two unknowns (Y & r), we cannot just solve for Y* and r* by setting AE = Y. We need one more equation that shows the relationship between Y & r, and this can be obtained from the money market equilibrium. • Money market equilibrium: MS = MD 30 = 0.25Y – 100r 0.25Y = 30 + 100r Y = 120 + 400r This is called the LM curve & you will learn it in ECMB06 • Solving for equilibrium Y and r: Equate the IS and LM: 170 – 100r = 120 + 400r 500r = 50 r* = 0.1 (10%) ⇒ Sub r = 0.1 into IS or LM: IS: Y* = 170 – 100(0.1) = 160 LM: Y* = 120 + 400(0.1) = 160 Part (b) Suppose G increases by 10, i.e., G = 59: • The new AE function: AE = [16 + 0.5Y] + [20 – 50r] + 59 AE = 95 + 0.5Y – 50r • Setting Y = AE to find the IS curve: Y = 95 + 0.5Y – 50r Y = 190 – 100r • Using the money market to find the LM curve: 30 = 0.25Y – 100r ECMA06 Tutorial #10 Answer Key 1 Y = 120 + 400r • Solving for equilibrium Y and r: Equate the IS and LM: 190 – 100r = 120 + 400r 500r = 70 r* = 0.14 (14%) ⇒ Sub r = 0.14 into IS or LM: IS: Y* = 190 – 100(0.14) = 176 LM: Y* = 120 + 400(0.14) = 176 Before: G = 49 After: G = 59 Change Y* 160 176 16 r* 0.1 0.14 0.04 I* 15 13 – 2 • Note: Expansionary fiscal policy (partially) crowds out investment because an increase in G leads to an increase in r, which raises the cost of investment. How do the changes in G, I and Y relate to the simple multiplier? 1 1 • The simple multiplier = 1 − c = 1 − 0.5 = 2 Y • ΔG = 10 and ΔI = – 2 ⇒ ΔAE = 0G + ΔI = 10 + (– 2) = 8. • ΔY = the multiplier × ΔAE 0 2 × 8 = 16, which is the change in Y*. Question 2 Part (a) Suppose there is a reduction in investment: Short run: • I ↓ ⇒ AE ↓ ⇒ AD shifts to the left to AD . • Point B is the short run equilibrium: 1 Y ↓ to Y P ↓ to P1 • Transmission mechanism: ⇒ When AE ↓ as a result of I ↓, firms find their inventories rise unexpectedly. ⇒ Firms try to lower inventories to their desired levels by lay off some of their workers to lower production (and the level of unemployment increases) and lowering prices. Long run: • Since the short-run level of output is below the full-employment level and the level of unemployment is higher than the long-ru1 level, there will be pressure for wages to fall. • Wages ↓ ⇒ AS shifts to the right to AS . • Point C is the long run equilibrium: Y ↑ back to Y FE P ↓ further to P2 ECMA06 Tutorial #10 Answer Key 2 • Note: It may take a long time for wages to fall since wages tend to be flexible upward but sticky downward. ECMA06 Tutorial #10 Answer Key 3 What should the government do? • Given it may take a long time for a reduction in wage to be realized, the government can use expansionary fiscal policy, which will shift the AD curve to the right, to offset the initial effect of a fall in investment on Y. • By doing so, the government can bring the economy back to its initial equilibrium (point A) fa
More Less

Related notes for MGEA06H3

Log In


OR

Join OneClass

Access over 10 million pages of study
documents for 1.3 million courses.

Sign up

Join to view


OR

By registering, I agree to the Terms and Privacy Policies
Already have an account?
Just a few more details

So we can recommend you notes for your school.

Reset Password

Please enter below the email address you registered with and we will send you a link to reset your password.

Add your courses

Get notes from the top students in your class.


Submit