1) The IS-LM Model
a) In the IS/LM model explain what happens to equilibrium output and interest rate if government
simultaneously pursues expansionary fiscal policy and the central bank opts for a contractionary
monetary policy. Show with the help of a graph along with a very brief verbal explanation.
b) Label the statements below as true or false and give a brief explanation for false statements
only.
i) For a given level of P (price), if M (nominal money) increases by 10%, M/P also increases by
10%
ii) A monetary expansion leads to a lower output and a higher interest rate.
iii) Equilibrium in the financial market implies that an increase in income leads to a decrease in
interest rate making the LM curve downward sloping.
c) Assume a model economy with the following parameters:
C= 100 + 0.25 YD ; I= 100 + 0.5Y - 3000i
G= 125 ; T= 100 ;
(M/P)d = 6Y - 24000i ; (M/P)s = 4500
Derive the IS and LM relation.
2) The short and medium run
a) Suppose that the mark-up of goods prices over marginal costs is 10% and that the wage-setting equation is W = P(1 – u), where u is the unemployment rate. Calculate the real wage, as
determined by the price-setting equation and the natural rate of unemployment.
b) Consider a situation (A) where the government increases its spending G, while keeping the
taxes T unchanged leading to an expansionary fiscal policy. Show in diagram below, what
happens to output and prices in the (B) short run and (C) medium run? Don’t forget to label the
axis.(images)
Extracted text: Yn Output, Y Price level, P