Class performance – 11.07.2018 & 16.07.

2018

1. Referring to the graph above, assume that the economy is in equilibrium at point A, then an
increase in government purchases shifts the IS curve to the right, while the real interest rate
remains constant. Explain, step-by-step, how the components of expenditure adjust to bring the
economy to its new equilibrium.

Answer: The increase in G causes negative unplanned inventory investment, so firms respond
by increasing output. As output rises, consumption rises, so inventories continue to shrink and
output continues to rise. The increase in consumption is always a fraction of the increase in
output, because the marginal propensity to consume is less than one. The increase in
consumption, the decline in inventories, and the increase in output all converge to zero as the
economy approaches its new equilibrium at point C.

2. Suppose the economy is just recovering from a recession and all signs now point to robust
growth. How might this transition from recovery to expansion be reflected in the monetary
policy curve?

Answer: The monetary policy curve will have been relatively low, as policy makers kept
interest rates as low as possible to hasten recovery from the recession. Once the recession is
over, the monetary policy curve will shift up, since low interest rates are no longer appropriate,
and to reduce the danger that spending will climb too rapidly and cause inflation to rise. The
curve may become steeper, as well, so that any increases in inflation are countered by
substantial increases in the real interest rate.

3. From the given monetary policy curve, the real interest rate was initially 6.6 percent, and would
rise to 8.2 percent in response to the increase in inflation from 2 percent to 4 percent. Since this
increase in the real interest rate would cause output to decline from 16.8 to 13.6, we know that
the IS curve is Y = 30 - 2r. If output is to be 16, the real interest rate must be 7 percent. The
monetary policy curve with slope 0.8 and coordinates 4, 7 is r = 3.8 + 0.8π.

Answer: From the given monetary policy curve, the real interest rate was initially 6.6 percent,
and would rise to 8.2 percent in response to the increase in inflation from 2 percent to 4 percent.
Since this increase in the real interest rate would cause output to decline from 16.8 to 13.6, we
know that the IS curve is Y = 30 - 2r. If output is to be 16, the real interest rate must be 7
percent. The monetary policy curve with slope 0.8 and coordinates 4, 7 is r = 3.8 + 0.8π.

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