2. Q1
Equilibrium level of aggregate demand (AD) occurs
when an economy’s real goods and capital goods
markets are in equilibrium.
Eqbm in goods market: Goods demanded = goods
supplied, IS Curve gives interest rate (i), income (Y)
combinations
Eqbm in capital market: Money supplied = money
demanded, LM curve gives i, Y combinations
That’s your initial equilibrium. Disturbance: Price
level (P) increases.
3. 1) CTD, TRANSITION TO NEW EQBM
P increase, real quantity of money falls
Money demand greater than supply, public sell
bonds, interest rate increases and new eqbm is
reached in capital goods market
But now i has gone up, investment (I) will fall and
eqbm AD must now occur at a lower Y and higher i.
Now… here’s the focus of this question, how does
the sensitivity of I to i influence the overall change
in Y?
Most of you too briefon this bit
4. BEST WAY IS TO COMPARE TWO EXTREMES
A: Imagine if I was hugely sensitive to i, then a
small increase in i would cause a massive fall in I
and thus a large drop in Y would be required to
reach equilibrium AD again.
B: If I didn’t really budge, then once the public sell
their bonds, that’s more or less the whole story.
Yes, i goes up, but the subsequent change in Y
would be very small.
The question did ask you to focus on this ‘in
particular’. So do that.
Now think, what would the AD curves look like for A
and B?
5. 2) AGAIN, ‘IN PARTICULAR’
If AD was shallower for A, then what does that tell
you about the IS curve for A?
6. 3) JUST ALGEBRA, PG65 TELLS YOU HOW
IS: Y = [c0+c1T + I(i, Πe) + G] / (1-c1)
LM: Y = M / P.L(i)
…and in AD eqbm, we know that Z = Y
Remember, IS and LM on i, Y space, AD on P, Y
Simply plug in the values you have been given and
rearrange to derive the IS curve.
Y = 2925 – 35000i …or more usefully…
i = 0.08357 – (Y/35000)
7. LM CURVE
We have H, we have c, we have θ
…and we know M = H/[c+θ(1-c)], so M is 125
Again, just sub this in to your Md equation:
Md/P = M/P = 125/P = 0.4Y-5000i
Rearrange to get:
i = [Y – (312.5/P)]/12500
8. NOW AD
IS & LM cross at one combination of i and Y
AD curve on space of P and Y, so let’s get rid of i
We know from LM expression that:
i = [Y – (312.5/P)]/12500 so sub into IS to get:
Y = 2925-35000[Y-(312.5/P)]/12500
Y = 769.7358 + 230.26/P
9. 3)II)
If Y = 1000 and our AD curve tells us that:
Y = 769.7358 + 230.26/P
then just plug in Y = 1000 to get P = 1
Then using either IS or LM to get i:
1000 = 2925 – 35000ii = 0.055
Now we know i, we can calculate price of bond
10. III) AND IV)
If you couldn’t do these, try again.
Any problems, come see me, though Nigel will post
answers on BlackBoard soon.