Determine consumption and investment

Assignment Help Microeconomics

Reference no: EM133200908

Assignment:

1. What determines the amount of output an economy produces?

2. What determines consumption and investment?

3. What makes the demand for the economy's output of goods and services equal the supply?

4. Explain what happens to consumption, investment, and the interest rate when the government increases taxes.

Problems and Applications

1. The government raises taxes by $100 billion. If the marginal propensity to consume is 0.6, what happens to the following? Do they rise or fall?

Public saving
Private saving
National saving
Investment

Question 1 - Fiscal Policy in the Short and Long Run for Closed Economy

Assume that the Congress decides to decrease government spending (↓G) in order to reduce the government budget deficit.

Part I: Use the IS-LM model to explain the impact on this policy in the short run. More specifically:

(a) Draw IS-LM graphs to analyze the effects of this decrease in G in the short run (Keynesian model). Show the implied changes in the IS-LM diagram.

(b) What are the effects of this policy in the short run on interest rates, investment, and income? And on prices? Show the chain of events.

Part II: Use analysis the Classical model to explain the impact on this policy in the long run. More specifically:

(c) What are the effects of this policy in the long run on savings, investment, consumption, real output, real interest rates, investment, and savings? Show the sequence of events.

(d) Show it graphically using the market for loanable funds (Hint: r in the Y-axis and I, S in the X-axis).

Question 2 - Monetary Policy in the short run and long run for closed Economy

Suppose that the chairman of the Federal Reserve Board decides to intervene in the economy at the Federal Open Market Committee Meeting, increasing short term interest rates:

(a) How can the Fed increase interest rates? Explain open market operations.

Part I - Keynesian Model Short Run

(b) Assuming that the economy starts from an equilibrium in the short run and long run, use the IS-LM diagrams to graphically illustrate the impact of the Federal reserve decision described in part (a) in the short run. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curves shift, v. the short-run equilibrium values.

(c) Now state in words the impact in the economy in the short run. In particular, explain what will happen in the goods markets and in the money markets. Show the sequence of events.

What are the final effects of this policy on prices and output in the short run?

(d) Explain what the monetary mechanism is in this context.

Part II - Classical Model Long Run

(e) Explain the relationship between money supply and prices based on the Quantity Theory and the assumptions of the Classical model (write down the quantity theory equation, the assumptions, and the consequent relationship between prices, P, and money supply, M). What happens to the level of prices, to nominal GDP, and to real GDP if the Federal Reserve Bank increases the supply of money?

(f) Using the quantity theory equation and the Fisher equation, state and explain the effect of an increase in money supply on prices, inflation, nominal interest rates, and the demand for money in the long run. Show the sequence of events (assume that inflation is zero before this increase in money supply).

(g) Explain why changes in money does not affect real GDP and real interest rates in the long run. Explain what determines real GDP and real interest rate (in the LR). Be complete.

(h) Explain what money neutrality is.

(i) Bonus credit: what is the Classical dichotomy is in this context?

Reference no: EM133200908

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