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MGEA06H3
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Iris Au
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Economics for Management Studies

MGEA06H3

Iris Au

Summer

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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)
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