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EC2102 Topic 7 - Solution Sketch

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73 views2 pages

EC2102 Topic 7 - Solution Sketch

Uploaded by

sqhaa
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We take content rights seriously. If you suspect this is your content, claim it here.
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Topic 7 – Solution Sketch

Wong Wei Kang

1.

a. IS curve:
Y = C d + Id + G
Y = α + βY – βT – ηr + σ – λr + G
(η + λ) r = – (1 – β)Y + α + σ + G – βT
!!! !!!!!!!"
𝑟= − 𝑌+
!!! !!!

LM curve:
!
= 𝜇𝑌 − 𝜈(𝑟 + 𝜋 ! )
!
!
𝜈𝑟 = 𝜇𝑌 − 𝜈𝜋 ! −
!
! ! !!
𝑟= 𝑌− 𝜋 +
! !!

b & c.

An increase in α

Intuitively, an increase in α is an increase in autonomous consumption. Consequently, Sd =


Y – Cd – G falls. The Sd curve shifts to the left because Sd falls at any given level of interest
rate r. At the initial interest rate, there is an excess demand for loanable funds. This leads to
an increase in the price of loanable funds r to clear the goods market at any Y, causing the IS
curve to shift upwards.

Algebraically, α appears in the intercept of the IS curve. An increase in α leads to a larger


intercept, which means that the IS curve shifts upwards graphically.

An increase in πe

1
Intuitively, an increase in expected inflation leads to an increase in the nominal interest rate i,
where i = r + πe. A higher opportunity cost of holding money causes real money demand
L(Y, i) to fall at any r. So the real money demand function shifts to the left. Intuitively,
people reduce their money holding because expected inflation erodes the purchasing power of
money holding. When people reduce their money demand, they basically use money to buy
non-monetary assets, causing the price of non-monetary assets to rise. Consequently, the
interest rate on non-monetary asset falls, making monetary assets more attractive and
restoring equilibrium in the asset market. The fall in interest rate occurs at any given output
level, which means that the LM curve shifts downwards.

Algebraically, πe appears in the intercept term of the LM curve, with a negative sign in front.
This means that a higher πe causes the vertical intercept to be smaller, which means a
downward shift in the LM curve graphically.

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