This question studies the effects of monetary policy in a closed economy. The ec

Question

This question studies the effects of monetary policy in a closed economy. The economy is characterized by the following equations:

Cd = 300 + 0.6(Y T) 1300r

Id = 100 2700r

Md= P[0.102Y 200(r + e)]

(a) Derive the FE curve, the IS curve with real interest rate r as a function of output Y , and the LM curves with real interest rate r as a function of output Y and price level P.

(b) Using your equations, find the long-run equilibrium values of real output Y , the real interest rate r, the price level P, consumption C, and investment I. Illustrate the results using a IS-LM-FE diagram to depict the long-run equilibrium.

(c) Suppose that the central bank decides to shrink the nominal money supply from M = 100 to 90.

i) Derive the new LM curve.

ii) According to the Keynesian view, the price level adjustment is sluggish in the short-run, so that the economy reaches a short-run equilibrium which is different from the long-run (general) equilibrium. Assume that the price level P is fixed at the level you have obtained in part (b). Find the short-run equilibrium values of real output Y , the real interest rate r, the price level P, consumption C, and investment I. How does the economy respond in the short-run?

iii) In the long-run, prices can adjust freely. The price level will adjust until the economy reaches the long-run (general) equilibrium. Find the long-run (general) equilibrium values of real output Y , the real interest rate r, the price level P, consumption C, and investment I. How does the economy respond in the long-run (compare your answer with the one in part b)?

Explanation / Answer

The economy is Closed economy.

Explanation:- The economy is closed becaue there are neither any imports nor any exports prevalent in the economy.

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