he following equations describe a Keynesian model of the economy: C desire = 500

Question

he following equations describe a Keynesian model of the economy:

C desire = 500 + 0.5(Y – T) – 100r

I desire = 350 – 100r

L = 0.5Y – 200i

pie e(expected inflation) = 0.05,

G = T = 200,

Y = 1850

M = 3560

Suppose government purchases decline to 175, with no change in taxes. What happens to the real interest rate, output, consumption, and investment in the short run (in which the price level is fixed)? What happens in the long run to the real interest rate, consumption, investment, and the price level?

Explanation / Answer

SOLUTION:

When P = 4, the LM curve is 3560/4 = 0.5Y - 200r - (200 * 0.05), or 0.5Y = 900 + 200r.

Combining it with IS curve provides Y = 1650 + G

When G = 175, Y = 1825, thus in the short run r = 0.0625; I = 343.75; C = 1306.25

In the long run, Y = 1850, thus r = 0; I = 350; C = 1325; P = 3.89

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