.Solve the following with clear answers.

Question

Part 1: In class we built the IS-LM model using graphical representations. Below see if you can derive the formation of the model algebraically: C = 0.5(Y -T) T = 2000 I = 3,000 - 250r G = 3,000 Md/P = 0.5Y - 500r Ms/= 2,000 P=2

(a) Write a formula for the IS curve (Y as a function of r alone). Remember IS is based on demand.

Y=C+I+G

Y=0.5(Y -T) + 3,000 - 250r +3,000

Y= 0.5(Y -2000) + 3,000 - 250r +3,000

Y-0.5Y=1000+3000+3000-250r

0.5Y=7000-250r

(b) Write a formula for the LM curve (Y as a function of r alone). Remember LM is based on money market equilibriums. Hint: substitute out M/P.

Md/P = 0.5Y - 500r

Ms/= 2,000

P=2

Md/P=Ms/P

0.5Y - 500r =2,000

0.5Y=2000-500r

Y=4000-1000r

(c) Sketch and label the two curves on a graph (d) What is the short run equilibrium values of Y, r and national savings?

Part 2:

(a) Using the same information from Question 1, what is the government expenditure multiplier?

(b) Based on the multiplier found in (a) how much would GDP increase buy if government spending increases by 1,500 (ignore money demand effects (no change in r)).

(c) Use the IS-LM model from question 1, how much is the short run equilibrium if Government spending increases by 1,500 (consider money demand effects)? Sketch a graph of these results. (d) What monetary policy could be implemented in order for the government stimulus to have its full multiplier effect (don't have to give a numerical answer just a policy)? (hint: think of what you would want to do with the LM curve)

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