An economy with fixed prices and unemployed labour has the following relationships: Consumption: C = 140 +0.6(Y-T) Government expenditure: G = 100 Lump sum direct tax: T = 100 Investment: I = 200-10 r Money demand: MD = 0.1 Y - 5 r Money supply: MS = 50. Where Y is national income, and r is the interest rate (in percent). (a) Derive the IS and LM curves for this economy. (b) Calculate equilibrium national income and the interest rate. (c) Now suppose that full employment national income is Y = 900. The government decides to increase both G and T to 200. Will it achieve full employment? (d) Using your results in (b) and (c) above, comment on the value of the balanced budget multiplier. (e) [Suppose instead that, starting from the original position in (a) and (b) above, the central bank aims to achieve full employment (Y = 900) by using monetary policy. What interest rate should it aim to set and by how much should it increase the money supply? [Hint: start with the IS curve].
