2) Part A) The following equations characterise a hypothetical economy. MD = 100 +Y ? 50r (Money Demand) M5 = 100 (Money Supply) C = 400 + 0.2YD (Consumption Function) I = 80 + 0.5Y ? 10r (Investment Function) G=100 T=100 I. II. III. IV. (Government Expenditure) (Taxes) Calculate the equilibrium level of Income and the interest rate. Describe your solution with a graph. Calculate the equilibrium level of consumption and investment. [Hint: Solve consumption and Invest equations based on solutions to the IS LM system of equations] Assume the government spending increase to 200. Calculate the Fiscal policy multiplier [Hint: Change in Y divided by change in G] Replace the 'Money Supply' in the above system of equations with the 'Real Money Supply' equation ie (Ms =100/P). Now calculate the Aggregate Demand (AD) equation based on the above system of equations. If the Aggregate Supply (AS) equation is Y = 1120, based on the Aggregate Demand equation you got for part IV calculate the equilibrium Y and equilibrium P. Also, Do you notice something unusual about the shape of the AS curve? Comment brie?y. 2) Part B) Consider the system of equations given in part A. Suppose the government increases public spending from 100 to 200 with no change in taxes. I. II. III. Calculate the new equilibrium level of Y, under the assumption that the central bank adjusts M5 to keep interest rate constant at r = 22.4 Calculate the new equilibrium level of Y, under the assumption that the central bank keeps money supply constant at M5 = 100 Compute the Fiscal policy multiplier for part I and II and discuss how for fiscal policy to be effective interest rates need to be prevented from rising. 3) Part A) In the IS-LM model, if Investment demand becomes completely unresponsive to the interest rate, then both monetary and fiscal policy become less effective. Is this statement true or false? Brie?y explain your answer using diagrams. [Hint: recall the diagrammatic derivation of the IS curve, if investment becomes unresponsive to interest rate what happens to the shape of the IS curve] 3) Part B) Brie?y answer the following questions.
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