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This assignment does not use real world data; it involves solving a model similar to that in lectures.

We use the following terminology in this part: aggregate income Y and disposable income Y_D (= Y T ), consumption function C(Y_D), planned investment function I(R), government spending G, and taxation T = TY where T is the marginal tax rate; R% denotes the real interest rate in the economy. (Note, R is in percentage points, e.g. R = 2 means the interest rate is 2%. When doing calculations, the interest rate should not simply be inserted in decimal form. For example, if R = 2 then I(2) = 124 2 = 122.)

Consider a hypothetical economy where:

C(Y_D) = 12 + 0.75 (Y T)

I(R)=1241R

G=120

T=20%

1.Using the information above, write out the planned Aggregate Expenditure equa-tion. (Hint: Remember that this takes the form of AE = . . . .)

2.Write down an expression for the Investment-Savings (IS) Curve. (Hint: First use the AE equation to find an expression for equilibrium Y . Next, remember that the IS equation takes the form of r = ....)

3.Assume that inflation is zero, so that I = R. This economy's central bank follows a given Monetary Policy Rule: R = I = 0.025 Y + 0.0003 P , where P is the price level. Given this and the expression for the IS Curve, write down an expression for the Aggregate Demand Curve. (Hint: Remember that the AD Curve takes the form P = . . . .)

4.Suppose that the price level (P ) is 3333.33. What is the equilibrium value of aggre-gate income, Y ? (Hint: use the AD equation.)

5.What are the equilibrium values of the interest rate, R, and investment, I? (Hint: use the M P R or IS, and I(R) equations.)

6.Suppose that the price level (P ) falls to 500. What is the equilibrium value of aggregate income, Y ?

7.What are the new equilibrium values of the interest rate, R, and investment, I?

8.Discuss why the change in the price level has the identified impacts on Y , R and I.