10 Macroeconomics English Edition Don Bush After-school Exercises with AnswersCHAPTER 10MONEY INTEREST AND INCOMEAnswers to Problems in the TextbookConceptual Problems1 The model in Chapter 9 assum

er as the sensitivity of aggregate demand to interest rates increases.

b. If the money supply increases, the LM-curve shifts to the right. This means that for any given interest rate, there is now a higher level of income at which the money market is in equilibrium. As a result, the IS-curve shifts to the right as well, since for any given interest rate, there is now a higher level of income at which the goods market is in equilibrium. This leads to a higher equilibrium level of income and a lower equilibrium interest rate.

3. The liquidity preference theory of interest rates assumes that the demand for money is a function of the interest rate and that the supply of money is fixed. As a result, the interest rate adjusts to equate the demand for money and the fixed supply of money. The IS-LM model, on the other hand, assumes that the demand for money is a function of income and the interest rate, and that the supply of money can be adjusted by the central bank. As a result, the interest rate adjusts to equate the demand for money and the supply of money, which is now endogenous.

4. The loanable funds theory of interest rates assumes that the supply of savings and the demand for investment determine the interest rate. As a result, an increase in government borrowing crowds out private investment and raises the interest rate. The IS-LM model, on the other hand, assumes that the demand for money and the demand for goods both affect the interest rate, and that government borrowing can affect both of these demands. As a result, an increase in government borrowing can either raise or lower the interest rate, depending on its effect on these demands.

5. The Fisher effect states that an increase in expected inflation leads to an increase in the nominal interest rate, leaving the real interest rate unchanged. This is because lenders will demand a higher nominal interest rate to compensate for the expected loss of purchasing power due to inflation. The Keynesian liquidity trap occurs when the nominal interest rate is so low that people prefer to hold money rather than invest it, even though they expect inflation to be positive. In this case, the central bank cannot stimulate the economy by lowering the nominal interest rate, since it is already close to zero. Instead, it may have to resort to unconventional policies such as quantitative easing or negative interest rates.

Problems:

1. If the government increases its expenditures by $100 billion, assuming no change in taxes, and if the marginal propensity to consume is 0.75 and the marginal tax rate is 0.2, then the increase in equilibrium income is:

ΔY = 1/(1-MPC-MPT) * ΔG ΔY = 1/(1-0.75-0.2) * 100 = $400 billion

2. Suppose the IS curve is given by:

Y = 1000 - 50r

and the LM curve is given by:

M/P = 500 + 20Y - 100r

a. Find the equilibrium interest rate and income.

At equilibrium, the goods market and the money market are both in equilibrium, which means that:

Y = 1000 - 50r = (500 + 20Y - 100r)/P

Solving for Y and r, we get:

Y = 900/(3P/4-10) r = 10 - 3Y/20

Substituting Y into the second equation, we get:

r = 6/(4P/3-1)

Equating the two expressions for r, we get:

900/(3P/4-10) = 6/(4P/3-1)

Solving for P, we get:

P = $120

Substituting P back into the expressions for Y and r, we get:

Y = $180 billion r = 5%

b. Suppose the government increases its expenditures by $100 billion. Find the new equilibrium interest rate and income.

The new IS curve is given by:

Y = 1100 - 50r

The new equilibrium interest rate and income can be found in the same way as before:

Y = 1100 - 50r = (500 + 20Y - 100r)/P

Solving for Y and r, we get:

Y = 1000/(3P/4-10) r = 10 - 3Y/20

Substituting Y into the second equation, we get:

r = 6/(4P/3-1)

Equating the two expressions for r, we get:

1000/(3P/4-10) = 6/(4P/3-1)

Solving for P, we get:

P = $135

Substituting P back into the expressions for Y and r, we get:

Y = $190 billion r = 5.5%

c. How does the increase in government expenditures affect the IS and LM curves?

The increase in government expenditures shifts the IS curve to the right, since for any given interest rate, there is now a higher level of income at which the goods market is in equilibrium. The LM curve also shifts to the right, since for any given interest rate, there is now a higher level of income at which the money market is in equilibrium. This leads to a higher equilibrium level of income and an indeterminate change in the equilibrium interest rate, since the two effects may offset each other.

3. Suppose the economy is initially in equilibrium at a real interest rate of 3%, a price level of $100, and an output level of $200 billion. Suppose the central bank increases the money supply by 10%.

a. What is the new equilibrium interest rate?

The LM curve is given by:

M/P = Y/3 - r/3

At the initial equilibrium, we have:

200 = M/P * 100/3 - 3/3 M/P = 603/100

After the increase in the money supply, we have:

M/P = 603/100 * 1.1 = 663.3/100

Equating this expression with Y/3 - r/3, we get:

200/3 - r/3 = 663.3/100 r = 2.99%

b. What is the new equilibrium price level and output level?

The AD curve is given by:

Y = 200 - 20r + 2(M/P)

At the initial equilibrium, we have:

200 = 200 - 200.03 + 2603/100 P = $100

After the increase in the money supply, we have:

P = 663.3/4 = $165.825

Equating this expression with Y = 200 - 20r + 2(M/P), we get:

Y = 200 - 200.0299 + 2663.3/165.825 Y = $212.44 billio