Business Conditions Analysis

Kashian

Quiz #1- Spring 2006

1. Suppose that the economy is characterized by the following equations: C = 160 + 0.6 Yd

I = 150

G =150

T = 100

a. Solve for GDP (Y)

Y = C+I+G

Y=160+0.6(Y-100)+150+150

Y = 400 + 0.6Y

Y = 1000

b. Disposable Income (Yd)

900 = Y - T

c. Consumption Spending

C = 160 + 540 = 700

d. If output is equal to 900, calculate total demand. Are we at equilibrium No, AD = 1000

e. If output is equal to 1000, calculate private savings. Is this equal to Investment? Private Savings = Y – C - T f. Calculate the marginal propensity to consume? g. What is autonomous consumption?

2. Suppose that a person’s wealth is $50,000 and that her yearly income is $60,000. Her money demand function is given by M = $Y(.35 –i) a. What is her demand for money and her demand for bonds when the interest rate is 5% and 10%?

Interest rate at 5%

M = 60,000 (.35 - .05)

M = 18000

Demand for bonds = Wealth - Md

Db = 50000 – 18000

Db = 32000

Interest rate at 10%

M = 60,000 (.35 - .1)

M = 15000

Demand for bonds = Wealth - Md

Db = 50000 – 15000

Db = 35000

b. Suppose that the interest rate is 10%. In percentage terms, what happens to her demand for money if her yearly income is reduced by 50%?

M = $Y(.35 – i)

M = 30000 (.35 -.1)

M = 7500

Demand for money is reduced by 50 % at the same 10% interest rate.

c. Suppose that the interest rate is 5%. In percentage terms, what happens to her demand for money if her yearly income is reduced by 50%?

M = $Y(.35 – i)

M = 30000 (.35 -.05)

M = 9000

Demand for money is reduced by 50 % at the same 5% interest rate.

d. Explain why these changes are different?

They are not different

e. Assume that $Y = $100 and the supply of money is $20, what is the equilibrium interest rate? (note correction)

Remember S=D, even with money.

Ms = Md

M = $YL(i)

20 = 100 (i)

i = .2 or 20%

f. Using the original model and the conceptual numbers provided in 2-e, how can the Federal Reserve lower interest rates?

Increase the supply of money. This will cause people to invest more which lowers interest rates. If $Y = 120, (i) = 16.7%.

3. Consider the following IS-LM model

C = 200 + .25 Yd

I = 100 + .25Y – 1000i

G = 250

T = 200

(M/P) = 2Y – 8000i

M/P = 1600

a. Derive the equation for the IS curve

Y = C + I + G = 200 + .25(y-200) + 100 + .25Y – 1000i + 250 Y = 1000 – 2000i

b. Derive the equation for the LM curve

M/P = 1600 = 2Y – 8000i

i = Y/4000 - 1/5

c. Solve for equilibrium real output

Substitute b into a;

(Posted old version of answer sheet—corrected 2-24-2006)

Y = 1000 – 2000(Y/4000 – 1/5)

Y = 1000 – Y/2 + 400

Y = 1400 – Y/2

3/2(Y) = 1400

3Y = 2800

Y = 2800/3

Y = 933.33

d. Solve for...