Consider the economy of Hicksonia. The consumption function is given by C = 300

Question

Consider the economy of Hicksonia. The consumption function is given by C = 300 + 0.70(Y -T) The investment function is I = 300- 30r Money demand is given by (M/P)^d= Y- 100r The money supply M is 1200 and the price level P is 3. Government expenditure is 100 and taxes are 150. Find the equilibrium interest rate r and the equilibrium level of income Y. Suppose that government purchases are raised from 100 to 150. How much does the IS curve shift? Suppose instead that the money supply is raised from 1200 to 1500. How much does the LM curve shift?

Explanation / Answer

Y = C + I + G

Y = 300 + 0.70*Y - 0.70*150 + 100 + 300 - 30r

0.30Y = 595 - 30r

Y = 1,983.33 - 100r

and

1200/3 = Y - 100r

Y = 400 + 100r

Solving 2 equations

Y = 1,191.66

and r = 7.91%

b Shift in IS = 1/1-MPC*change in G = 1/1-0.7*50 =166.66

c, Shift in LM = 1500/3 - 1200/3 = 300

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