Sometimes understanding of ISLM becomes clearer when one works through the algebra. This question is designed to promote such understanding. Consider Country A, a closed economy characterized by the following relationships: C = 200 + 0.5YD I = 70- 5r G = T = 100 MD = 500 + Y – 15i where YD, disposable income, is equal to income less taxes, Y-T, and r and i are the real and nominal interest rates expressed in percent. Country A is ruled by a fierce dictator who abhors price movements, so assume prices are not allowed to change in this economy, i.e., that i = r. a) Assume that the Central Bank of Country A sets the nominal interest rate at 4% (r=4) and keeps it at that level. Find consumption, investment and output in equilibrium. b) What money supply is consistent with a real interest rate of 4 percent? Given this money supply, show that saving equals investment. c) Assume Y=600 and plot money demand as a function of the nominal interest rate (put MD on the x-axis and i on the y-axis). Plot a second money demand function assuming Y=450. Assume the Central Bank sets the money supply at 800. What is the equilibrium real interest rate if Y=600? If Y=450? (Do the relative levels of these interest rates make sense to you?)
Sometimes understanding of ISLM becomes clearer when one works through the algebra. This question is designed to promote such understanding. Consider Country A, a closed economy characterized by the following relationships:
C = 200 + 0.5YD
I = 70- 5r
G = T = 100
MD = 500 + Y – 15i
where YD, disposable income, is equal to income less taxes, Y-T, and r and i are the real and nominal interest rates expressed in percent. Country A is ruled by a fierce dictator who abhors price movements, so assume prices are not allowed to change in this economy, i.e., that i = r.
a) Assume that the Central Bank of Country A sets the nominal interest rate at 4% (r=4) and keeps it at that level. Find consumption, investment and output in equilibrium.
b) What money supply is consistent with a real interest rate of 4 percent? Given this money supply, show that saving equals investment.
c) Assume Y=600 and plot money demand as a function of the nominal interest rate (put MD on the x-axis and i on the y-axis). Plot a second money demand function assuming Y=450. Assume the Central Bank sets the money supply at 800. What is the equilibrium real interest rate if Y=600? If Y=450? (Do the relative levels of these interest rates make sense to you?)
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