ECON 3130 - Macroeconomics: Problem Set 3 Assignment Solution

This assignment provides a comprehensive solution to a macroeconomics problem set. The solution includes the derivation of the IS and LM curves, calculation of equilibrium output and interest rates, and analysis of the effects of fiscal and monetary policy changes under a free-floating exchange rate regime. The problem set explores the impact of government spending increases, money supply decreases, and the implications of fixed versus flexible exchange rates. It also examines the short-run and long-run adjustments in the economy, including shifts in the IS and LM curves, changes in output, interest rates, and exchange rates, and the role of the central bank in managing the economy. The analysis incorporates the effects of changes in real wages, labor supply, and price levels, providing a complete understanding of macroeconomic principles.

a) IS equation with Y=C+I+G+X-IM
so , Y= 26+0.6*(Y-10)+23-50r +10+6-∈ -( 2+3∈)
0.4Y= 26-6+23+10+6-2-2 ∈ -50r
Y = 2.5 *( 57 -2∈-50r)
Y= 142.5-5 ∈-125r

b) LM equation will equate the Real Money Supply (Ms/P) and Money Demand
5Y-50r= 492 ,
Y= 98.4 +10r
c) Aggregate Demand function will be right side of the IS curve so
AD = C+I+G+X-M , AD = 57 -2∈-50r +0.6Y
d) IS Curve in terms of r

e) IS -LM in terms of ∈
f) Equation IS -LM equation to find the output
142.5-5∈-125r = 98.4 +10r , here r of 0.16
142.5 -5∈-125* 0.16= 98.4+10*0.16 ,
∈=4.5
Y = 100
g) Now when the Government Expenditure increase an amount of 2 , due to multiplier the Y will
increase by 2.5 times , so Ynew will be 100+2.5* 2 = 105
with this Y , the exchange rate will be
122.5 -5∈=105
∈=3.5

h) Shock movement
When the govt expenditure increase the IS curve shift outwards to IS' and the interest rate tend to
increase along with the output given the money supply. but because world interest rates are
fixed, with more money in the hands of people, they will tend to consume more rather than
invest and thus the output increase further which is the multiplier effect
i) When the Money Supply is decreased to 400, the new LM equation would be,
5Y-50r= 400 , Y= 80+10r
NEW IS-LM equilibrium will be established as
122.5 -5∈= 80+1.6
∈=8.18 and Y = 81.6

j) Shock Movement
When the Money Supply decrease in the market, the output goes down due to less demand for
goods, and because the interest rates are still the same as it is kept at 0.16, the output further
decreases because people find it better to invest. So consumption further decrease. When the
wages and prices are flexible, due to a decrease in money supply people will have less to spend,
and the price will come down. Due to an increase in the real wage, the supply of the workers will
increase. With more supply of workers, the real wage will go down and later on the production
would increase due to this.
k) Fixed exchange rate regime implies that the central bank fixes the exchange rate, and even
when the money supply changes In the economy, the exchange rate will not change. When the
interest rates are high in the domestic economy, the funds will flow in the economy, and thus it
will lead to an appreciation of the currency, which will hurt the exports of the economy. Thus to
take care of this appreciation in the exchange rate, RBI will buyback dollars in the market and
will supply the rupees. This can lead to high inflation in the economy though in the short run.
This is adopted because reserve bank will focus more on the price stability and less on the
exchange rate.

l) Effects of the fiscal shock are that the Output increase in economy and the exchange rate
appreciate which means more money is coming in the economy. Now the Central bank will have
to worry because they have to buy the dollar in the market to make a currency less appreciate
m) Due to monetary shock, the Money Supply is reduced exchange rate goes up in the economy,
which means that exports are promoted and thus the central bank will earn more money from
exports. Fiscal policy will have to effective because the demand for local goods has decreased,
and output has reduced. To take care of domestic production, the govt needs to increase public
expenditure.
n) When the exchange rate is flexible, Monetary Policy is more flexible because the changes in
the interest rate or money supply will automatically change the exchange rate such that
equilibrium is maintained. Fiscal Policy is better when the exchange rate is fixed because the

exports and imports do not change as they depend on the exchange rate only. Thus the
government can control the economy with taxes and expenditure.
A. When the government spending increase and the output is increased in the short run. As we
know that classical economists say that the long-run supply curve is vertical. Due to the
maximum labour availability of 50, the max production is 100. Due to change in the real wages,
the labour supply will increase as seen in part (j). Thus the final output will be 105, and the Price
level will change with
492/P = 5*105-50*0.16 , P= 1.05
B.

IN the long run, the Output is stabilized at YL. In the short term, the interest rates tend to
increase, but with increased rate, there would be more inflow of funds and change the exchange
rate. to manage the funds the central bank would keep the r constant and thus with more supply
of labour more Y is achieved
C. When the Money supply has reduced in the economy, the final output will be reduced to the
level of 81.6, and the price level will change as
492/P= 5*81.6-8 , P = 0.81
D.
In the long run, the economy moves to point M, which is the final point. The transition is showed
with arrows from the short run to the long run.