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Review Questions 1. The position of the FE line is determined by the labor market and the production function. Labor supply and demand determine equilibrium employment. Using equilibrium employment in the production function gives the full-employment level of output. The FE line is vertical at that point. The FE line shifts to the right if there is an increase in labor supply or the capital stock or if there is a beneficial supply shock. 2. The IS curve shows combinations of the real interest rate (r) and output (Y) that leave the goods market in equilibrium. Equilibrium in the goods market occurs when the aggregate supply of goods (Y) equals the aggregate demand for goods (C d I d G). Since desired national saving (S d) is Y – C d – G, an equivalent condition is S d I d. Equilibrium is achieved by the adjustment of the real interest rate to make the desired level of saving equal to the desired level of investment. For different levels of output, there are different desired saving curves, with different equilibrium interest rates. When plotted on a figure showing output and the real interest rate, this forms the IS curve, as shown in Figure 9.15. The curve slopes downward because as output rises, the saving curve shifts along the investment curve and the real interest rate declines. Figure 9.15 The IS curve could shift down and to the left if: (1) expected future output falls, because this increases desired saving; (2) government purchases fall, because this increases desired saving; (3) the expected future marginal product of capital falls, because this decreases desired investment; or (4) corporate taxes increase, because this decreases desired investment. 3. The LM curve shows the combinations of output and the real interest rate that maintain equilibrium in the asset market. Equilibrium in the asset market occurs when real money demand equals the real money supply. Figure 9.16 shows the derivation of the LM curve and why it slopes upward. An increase in output from Y1 to Y2 raises money demand, shifting the money demand curve from MD(Y1) to MD(Y2). With money supply fixed at MS, there must be a higher real interest rate to get equilibrium in the asset market. This gives two points of the LM curve, plotted on the right half of the figure. The result is that higher output increases the real interest rate along the LM curve, so the LM curve slopes upward. Figure 9.16 5. The LM curve would shift down and to the right if the nominal money supply or expected inflation increased or if the price level or nominal interest rate on money decreased. In addition, the curve would shift down and to the right if there were a decrease in wealth, a decrease in the risk of alternative assets relative to the risk of holding money, an increase in the liquidity of alternative assets, or an increase in the efficiency of payment technologies. General equilibrium is a situation in which all markets in an economy are simultaneously in equilibrium. This is shown in Figure 9.17 as the point at which the FE line and the IS and LM curves intersect. If the economy is not initially in general equilibrium, output and the real interest rate are determined by the intersection of the IS and LM curves. Then adjustment of the price level moves the LM curve until it intersects the FE line and IS curve. Figure 9.17 7. The aggregate demand curve relates the price level to the aggregate demand for goods and services. It is downward sloping, because with a fixed nominal money supply, an increase in the price level shifts the LM curve up, so the level of output at the IS-LM intersection is lower. Factors that shift the aggregate demand curve up and to the right include (1) an increase in expected future output, which reduces desired saving, raises desired consumption, and shifts the IS curve up and to the right; (2) an increase in government purchases, which reduces desired saving and shifts the IS curve up and to the right; (3) an increase in expected future MPK, which increases desired investment and shifts the IS curve up and to the right; (4) a decrease in corporate taxes, which increases desired investment and shifts the IS curve up and to the right; (5) an increase in the nominal money supply, which raises the real money supply and shifts the LM curve down and to the right; (6) a decrease in the interest rate on money, which decreases the demand for money and shifts the LM curve down and to the right; and (7) an increase in the expected inflation rate, which reduces the demand for money and shifts the LM curve down and to the right. Numerical Question: 4. (a) First, look at labor market equilibrium. Labor supply is NS 55 10(1 – t)w. Labor demand (ND) comes from the equation w 5A – (0.005A ND). Substituting the latter equation into the former, and equating labor supply and labor demand gives N 100. Using this in either the labor supply or labor demand equation then gives w 9. Using N in the production function gives Y 950. (b) Next, look at goods market equilibrium and the IS curve. S d Y – C d – G Y – [300 0.8(Y – T) – 200r] – G Y – [300 (0.4Y – 16) – 200r] – G – 284 0.6Y 200r – G. Setting S d I d gives – 284 0.6Y 200r – G 258.5 – 250r. Solving this for r in terms of Y gives r (542.5 G)/450 – 0.004/3Y. When G 50, this is r 1.317 – 0.004/3 Y. With full-employment output of 950, using this in the IS curve and solving for r gives r 0.05. Plugging these results into the consumption and investment equations gives C 654 and I 246. (c) Next, look at asset market equilibrium and the LM curve. Setting money demand equal to money supply gives 9150/P 0.5Y – 250(r 0.02), which can be solved for r [0.5Y – (5 9150/P)]/250. With Y 950 and r 0.05, solving for P gives P 20. (d) With G 72.5, the IS curve becomes r 1.367 – 0.004/3 Y. With Y 950, the IS curve gives r .10, the LM curve gives P 20.56, the consumption equation gives C 644, and the investment equation gives I 233.5. The real wage, employment, and output are unaffected by the change.