Question 4 (25 points) - Topics 8, 9 & 10

Utopia is a closed economy and is characterized by the following equations:

Consumption: C = 1510 + 0.95(Y - T) - 510r

Investment: I = 2000 - 900r

Government spending: G = 2400

Taxes: T = 2200

Real money demand: (Md /P) = L(i = r + e , Y) = 0.5Y - 200i

Expected inflation: e = 0 Production function: Y = 5K1/3L 2/3

Note: Interest rates, i and r, are expressed in percentage points, i.e., if r = 5.50, then r = 5.5%.

Suppose the IS-LM model can used be to describe Utopia and answer the following questions. Keep your answers to a minimum of THREE decimal points (for fractions).

a) Derive the IS and LM equations for this economy. (4 points)

b) The supply of capital and labour in this economy are both equal to 4000; and the level of the nominal money supply is 9600. Calculate the long-run or full-employment values of real output, consumption, investment, real interest rate, public saving, private saving, national saving, and price level. (8 points)

c) Now suppose the government of Utopia is deciding on a new monetary policy regime. They are considering targeting the real interest rate. It is considering either setting it real interest rate target at 1.75% or 2.20%. Assuming that the economy was initially at full-employment, for each real interest rate target what are the new values of real output, consumption, investment, real interest rate, public saving, private saving, national saving, and price level in the short-run? (8 points)

d) The central bank cares about both the rate of inflation and the unemployment rate and would prefer neither to be large. Given these considerations explain in words whether they prefer one of these interest rate targets over the other and why. (5 points)