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MGEA06H3 (157)
Iris Au (146)
Lecture

# ECMA06_Tutorial_10_Solution.doc

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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
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