Supplementary Solution Manual for Midterm II

<Q.5 of Chapter 5>

a. IS relation: (negative) relation between Y and i obtained from the equilibrium condition in the
goods market

Y = C + I + G = 200 + 0.25(Y 200) + 150 + 0.25Y 1000i + 250

Y = 1100 2000i

b. If 5%, equilibrium output: Y = 1100 2000 0.05 = 1000

M
c. Note that the equilibrium condition in the money market is P
= Y L(i). The question supposes
that the real money demand function is more concretely given as Y L(i) = 2Y 8000i so that
M
the equilibrium condition in the money market becomes P
= 2Y 8000i. If 5%, the real money
supply in the case of equilibrium in the money market would be:
M
= 2 1000 8000 0.05 = 1600
P
d. Equilibrium consumption: C = 200 + 0.25(Y T ) = 200 + 0.25(1000 200) = 400
Equilibrium investment: I = 150 + 0.25Y 1000i = 150 + 0.25 1000 1000 0.05 = 350
Y = C + I + G = 400 + 350 + 250 = 1000; yes, it is the same as the equilibrium output
obtained in (b).

e. In case the central bank implements an expansionary monetary policy by cutting the rate to
i = 3%:

Equilibrium output: Y = 1100 2000 0.03 = 1040 (from the IS relation in (a))
Equilibrium consumption: C = 200 + 0.25(Y T ) = 200 + 0.25(1040 200) = 410
Equilibrium investment: I = 150 + 0.25Y 1000i = 150 + 0.25 1040 1000 0.03 = 380
Y = C + I + G = 410 + 380 + 250 = 1040; yes, it is the same as the equilibrium output
obtained from the IS relation above.
M M
Equilibrium P
: From (c), we have P
= 2Y 8000i = 2 1040 8000 0.03 = 1840
M
All of Y , C, I, and P
increased due to the expansionary monetary policy.

f. In case of expansionary fiscal policy that raises G = 400:

Equilibrium output:

Y = C + I + G = 200 + 0.25(Y 200) + 150 + 0.25Y 1000i + 400

Y = 1100 2000i
Y = 1400 2000 0.05 = 1300

1
 Equilibrium consumption: C = 200 + 0.25(Y T ) = 200 + 0.25(1300 200) = 475
Equilibrium investment: I = 150 + 0.25Y 1000i = 150 + 0.25 1300 1000 0.05 = 425
Y = C + I + G = 475 + 425 + 400 = 1300; as expected, it is the same as the equilibrium
output obtained above.
M M
Equilibrium P
: From (c), we have P
= 2Y 8000i = 2 1300 8000 0.05 = 2200
M
All of Y , C, I, and P
increased due to the expansionary fiscal policy.

<Q.3 of Chapter 7>

3. W = P (1 u) is given in the question as a specific functional form of the wage function W =

P e F (u, z). On the other hand, we know the price function P = (1 + m)W . The former can be
W W 1
rearranged into P
= 1 u which is the wage-setting relation and the latter into P
= 1+m

which is the pricesetting relation.
W 1 1
a. P
= 1+m
= 1.05
= 0.952 (since m = 5%)

b. From the two relations, we obtain the equilibrium condition in the labor market as
1
1u=
1+m
from which the natural rate of unemployment is derived as
1 1
u=1 =1 = 0.048 = 4.8%
1+m 1.05

c. When m = 10%,
1 1
u=1 =1 = 0.09 = 9%
1+m 1.1

where m = 0.05, m0 = 0.1, un = 4.8% and u0n = 9%