You will type answers to questions in Word as much as possible. If an answer requires graphs or
equations you will handwrite those two parts of an answer. Be careful to graph things clearly and in
detail. Handwritten equations should be clearly and carefully written.PLZ USING OWN WORDS
3. A linear version of the IS Curve can be algebraically written as:
Y = A br
where A represents all the things that shift the IS Curve (factors other than real output, Y, and
the real interest rate, r, for Cd
, Id
, NXd
, and G), and b is the interest sensitivity of spending, arising
from interest sensitivities of each component in desired spending.
The MP curve can be written as:
r = Q + cY + d
The real rate reacts to real output and the inflation rate (), with c and d being positive
parameters, and Q summarizes the effects on r of all target variables in the central bank interest
rate rule.
A. Derive algebraically an equation for the aggregate demand curve. Does inflation have a
negative effect on output in this equation (as it does in our lecture slides discussion of
aggregate demand)?
B. In a liquidity trap, the central bank has lowered the nominal interest rate to zero. Combining
this with the Fisher Equation you get: r = – (technically it is expected inflation, but to
simplify we will drop the expectation). Derive the aggregate demand curve equation under
this assumption.
C. Using the aggregate demand curve implied in Part B, draw the AD-A-LRAS graph assuming
the economy starts off in GE (at full employment). In your graph, the slope of the aggregate
demand curve is quantitatively larger (hence should be drawn steeper) than the slope of the
inflation adjustment curve. Suppose that for some reason the aggregate demand curve
shifts to the left. Show that shift in your graph. Is the economy in recession? When inflation
begins to adjust will this push output in the direction of full employment or will output be
pushed further away from full employment? Please illustrate clearly in your graph.
D. What sort of macroeconomic policy could work for the situation in Part C to bring the
economy back to GE? Monetary policy, fiscal policy, or both could be used? Simulative or
contractionary policy? (Hint: Look at the graph and think about the derivation). Explain how
you justify your policy recommendation.