ECON 3012
PROBLEM 8
Answers
1. The AD curve is: Y = A + M(1/P). With the values given, this is, with numbers: Y = .8·625 +
5·60(1/P) = 500 + 300(1/P). Given the initial value of P = 1.0, Yr = 500 + 300 = 800 = Yn.
Therefore Y0 = 800.
i0 = .02·800 – .2·60·(1/1) = 16 – 12 = 4.
2.
a) A is now 687.5. AD1 is: Y = .8·687.5 + 300(1/P) = 550 + 300(1/P). Yr = 550 + 300 = 850 >
Yn. Therefore Y1 = Yn = 800. 800 = 550 + 300(1/P1)  1/P1 = (800-550)/300  P1 = 300/250 =
1.2. i1 = .02·800 – .2·60·(1/1.2) = 16 – 10 = 6. I crowded out MUST equal the increase in G,
since Y has not increased. So I = -G = -62.5.
ACTION: Government spending increases in the Real Sector – Goods Market – which,
including the multiplier process, should increase Output, Y. BUT Output is at full
employment, Yn , so Output CANNOT increase. But spending has increased, so something
has to happen. All that’s left is that Prices rise – “too many dollars chasing too few goods”;
initially $850 trying to buy $800 of goods (and services).
REACTION: This is ONLY in the Financial Sector – Financial Markets. Increased Prices
for a constant Output leads to increased Transactions Demand. Speculators have less
Money in their portfolios; they attempt to increase Money by selling Bonds. Supply of
Bonds increases, Price of Bonds falls, i increases.
FEEDBACK: In the Real Sector, the increased interest rate reduces private Investment, I,
reducing Y.
In this case, the reduction in Y during FEEDBACK must be equal to the transitory increase
in Y during ACTION because we began with Y0 = Yn and we finish with Y1 = Yn .
This also means a total or complete crowding out. Y = C + I + G; Y hasn’t changed and C is
a function of Y, so C hasn’t changed; G has increased by 62.5, so I must have fallen by 62.5.
b) A is now 662.5. AD2 is: Y = .8·662.5 + 300(1/P) = 530 + 300(1/P). Yr = 530 + 300(1/1.2) =
530 + 250 = 780 < Yn. Therefore Y2 = Yr = 780. P2 = P1 = 1.2. i2 = .02·780 – .2·60·(1/1.2) =
15.6 – 10 = 5.6.
Nothing new here, we’re back to IS and LM before the midterm, see the notes for ACTION,
REACTION, and FEEDBACK.
c) A is still 662.5. AD3 is: Y = .8·662.5 + 572(1/P) = 530 + 360(1/P). Yr = 530 + 360(1/1.2) =
530 + 300 = 830 > Yn. Therefore Y3 = Yn = 800. 800 = 530 + 360(1/P3)  1/P3 = (800530)/360  P3 = 360/270 = 1.33. i3 = .02·800 – .2·72·(1/1.33) = 16 – 10.8 = 5.2.
ACTION: The Money stock, M, increases in the Financial Sector – Financial Markets.
Speculators have more Money in their portfolios than they want; they attempt to increase
Bonds by buying Bonds. Demand for Bonds increases, Price of Bonds rises, i falls.
REACTION: In the Real Sector, the lower interest rate should increase private Investment,
I, which should increase Output, Y. BUT Output is at full employment, Yn , so Output
CANNOT increase. But spending has increased, so something has to happen. All that’s left
is that Prices rise – “too many dollars chasing too few goods”; initially $830 trying to buy
$800 of goods (and seervices).
FEEDBACK: In the Financial Sector, increased Prices for a constant Output leads to
increased Transactions Demand. Speculators have less Money in their portfolios; they
attempt to increase Money by selling Bonds. Supply of Bonds increases, Price of Bonds
falls, i increases.
In this case, HAD WE BEGUN WITH FULL EMPLOYMENT, the increase in i during
FEEDBACK would be equal to the decrease in i during ACTION because we would have
began with Y0 = Yn and we would have finished with Y1 = Yn . Since Y = C + I + G; Y would
not have changed and C is a function of Y, so C would not changed; G hasn’t changed so I
could not have changed.
(But we began with Y just slightly below Yn , so here, between Y = 780 and 800, P didn’t
rise. So here there was a small decrease in i which caused a small increase in I, which in
turn caused a small increase in Y. If you see something like this on the final, you will begin
with you will begin with Y = Yn , so the analysis above, before I start inside the parentheses,
will be correct.)
d) A is still 662.5. AD4 is: Y = .8·662.5 + 560(1/P) = 530 + 300(1/P). Yr = 530 + 300(1/1.33)
= 530 + 225 = 755 < Yn. Therefore Y4 = Yr = 755. P4 = P3 = 1.33. i4 = .02·775 – .2·60·(1/1.33)
= 15.1 – 9 = 6.1.
As with b), this is back to the model of IS and LM before the midterm.