Business Conditions Analysis

ECON 736

Analytical Assignment #2 â€“ Introduction to the Aggregate Expenditures and

IS-LM Models

Professor Yamin Ahmad

Instructions:

Welcome to the workbook for Analytical Assignment #2. There are two parts to this

Analytical Assignment. Part A consists of 20 questions based on your answers to the

questions below. Part B consists of both numerical and freeâ€response questions and is

also worth 20 points. The two combined means that there are a total of 40 points available

for Analytical Assignment #2. Whether you work on this assignment by yourself, or with

another classmate, you will need to individually submit responses to the questions

below in order to receive a score for the assignment.

For this assignment, you should go through and answer all the questions in this workbook

before starting the assignment within Canvas. Once you have completed the workbook,

use that to answer the questions that are posed in both Part A and B of this assignment.

I would highly recommend that you not start either parts of the assignment until you

have worked through and solved the questions in this workbook, otherwise the

questions will not make sense on Canvas.

Please write up any calculations and solutions in a separate document, for example either

in a Word document, or a compiled LaTeX pdf file. You may also write out the solutions

by hand on paper, although you will have to convert them to a single pdf file for

submission. If you handâ€write out the solutions on paper, please make sure that they are

legible. Once you have solved the questions, report your solutions by answering the

questions in both Part A and B of this assignment. Please remember to upload your any

documents etc at the end of part A within the Canvas Assignment when you submit

your solutions since I may wish to check your calculations and see where you might have

made any errors for your feedback. If you are working with someone else, make sure to

have both your names in the accompanying filename. You may use your lecture notes and

the textbook.

Within Canvas, you may attempt Part A up to twice and Canvas will keep the highest

score. Once you have completed Part A, you should begin Part B, the link to which may

be found on the main course module page for this week. All the questions being asked

within Canvas may be found in what follows next. Please work through them and let me

know if you have any questions.

Econ 736 Analytical Assignment #2

Part A (20 points): The Aggregate Expenditures Model and Introduction

to the ISâ€LM Model

1. Consider the Keynesian Consumption Function: C ï€½ c 0 ï€« c 1 ï€¨Y ï€ T ï€© . Describe what

the various components mean, i.e. what do ï»C ,c 0 ,c 1,Y ,T ï½ represent?

2. How would you interpret the terms ï»c 0 ,c 1ï½ ?

3. What kind of values can c 1 take?

For questions 4â€6, suppose that the economy is characterized by the following equations:

C ï€½ 160 ï€« 0.6 ï€¨Y ï€ T ï€©

I ï€½ 150

G ï€½ 150

T ï€½ 100

4. Solve for the value of real GDP in equilibrium, i.e. Y * .

5. Solve for disposable income, Y D ï‚º Y ï€ T .

ï€¨ ï€©

6. Solve for consumption expenditures C * in equilibrium.

For questions 7 â€“ 13, consider the following AE/Keynesian Model:

Suppose that we are in a small open economy in which aggregate expenditures, AE, is the

sum of consumption spending by households, investment spending by firms, government

expenditures and net exports. You may assume that net exports are independent of real

GDP and taxes are lumpâ€sum. The numbers in the table below are in billions.

Real

Government

Net

Aggregate

GDP

Consumption

Investment

Expenditures

Exports

Taxes

Expenditures

1,000

1,300

200

150

â€50

100

A

2,000

B

200

150

â€50

100

2,400

3,000

2,900

200

150

â€50

100

3,200

4,000

3,700

200

150

â€50

100

4,000

5,000

4,500

200

150

â€50

100

4,800

7â€8. For the table above, calculate the missing values, A and B.

1

Econ 736 Analytical Assignment #2

9. From the table above, what kind of situation is the country in with regards to the trade

balance (i.e. do we have a trade surplus or deficit or balanced trade)? What kind of

situation is the country in with regards to the domestic balance (i.e. is the government

running a budget deficit or budget surplus or balanced budget)?

10. Use the table above to calculate the slope of the AE curve. [Hint: Recall that the slope

of the AE curve is the additional increase in aggregate expenditures arising from an

increase in GDP.]

11. Recall that the Aggregate Expenditure function is written as:

AE ï€½ AE0 ï€« ï€¨ slope of AE ï€© ï‚´ Y

where AE0 is Autonomous Expenditures. Use the table in and your answer to question 10

above to calculate Autonomous Expenditure AE0. [Hint: Calculate induced expenditures

for any given level of GDP, and use your answer to figure out AE0]

12. In the table above, what is the value of real GDP in equilibrium?

13. Suppose that the government decides to spend 200 billion more. By calculating the

multiplier (or any other way), calculate the value of the new equilibrium value of real

GDP!

For questions 14 â€“ 17, consider the following equations from the ISâ€LM model:

Goods Market:

C ï€½ c 0 ï€« c 1 ï€¨Y ï€ T ï€©

I ï€½ I 0 ï€ br

G ï€½ G0

T ï€½ T0

Y ï€½ C ï€« I ï€«G

Money Market:

L ï€¨ r ,Y ï€© ï€½ m 0 ï€« kY ï€ hr

M ï€½M

P ï€½P

M

ï€½ L ï€¨ r ,Y ï€©

P

14. Which of the equations above represent definitional equations? (Select all that

apply). If the answer is none, pick none.

15. Which of the equations above represent behavioral equations? (Select all that

apply). If the answer is none, pick none.

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Econ 736 Analytical Assignment #2

16. Which of the equations above represent reducedâ€form equations? (Select all

that apply). If the answer is none, pick none.

17. Which of the equations above represent conditional equations? (Select all that

apply). If the answer is none, pick none.

For questions 18 â€“ 20, consider the following reduced form version of the ISâ€LM

Model:

Goods Market Equilibrium:

Y ï€½

c 0 ï€ c 1T 0 ï€« I 0 ï€« G

b

r

ï€

1ï€ c1

1ï€ c1

Money Market equilibrium:

M

ï€½ m 0 ï€« kY ï€ hr

P

18.

Which

components

of

the

equations

above,

i.e.

ï»Y , r ,c 0 , I 0 ,G 0 ,T 0 , m0 ,c 1, b , k , h , M , P ï½ represent the endogenous variables? If

the answer is none, pick none.

19.

Which

components

of

the

equations

above,

i.e.

ï»Y , r ,c 0 , I 0 ,G 0 ,T 0 , m0 ,c 1, b , k , h , M , P ï½ represent the exogenous variables? If

the answer is none, pick none.

20.

Which

components

of

the

equations

above,

i.e.

ï»Y , r ,c 0 , I 0 ,G 0 ,T 0 , m0 ,c 1, b , k , h , M , P ï½ represent the model parameters? If the

answer is none, pick none.

Part B (20 points): The ISâ€LM Model

Please note that you may only attempt Part B once in Canvas

For all the questions in part B, consider the following ISâ€LM model:

Goods Market:

C ï€½ 200 ï€« 0.25 ï€¨Y ï€ T ï€©

I ï€½ 150 ï€« 0.25Y ï€ 1000r

G ï€½ 250; T ï€½ 200

Money Market:

3

Econ 736 Analytical Assignment #2

d

ïƒ¦M ïƒ¶

ïƒ§ ïƒ· ï€½ 2Y ï€ 8000r

ïƒ¨ Pïƒ¸

M

ï€½ 1600

P

The questions for Part B are as follows:

(1. Enter your name, and the name of anyone else you worked with on this

assignment.)

2. Derive the IS relation.

3. Derive the LM relation.

4. Solve for the equilibrium level of output.

5. Solve for the equilibrium real interest rate.

6â€7. Solve for the equilibrium values of C and I and verify that you obtained the value

for Y by adding up the equilibrium values of C, I and G.

Now suppose that the money supply increases to

M

ï€½ 1840 .

P

8 â€9. Solve for Y, r, C and I and describe in words the effects of a monetary expansion.

M

equal to its initial value of 1600. Suppose instead that the government

P

increases spending to G ï€½ 400 .

Now set

10â€11. Solve for Y, C, I and r and then summarize the effects of fiscal policy on these

variables using words.

Once you have solved all these equations, please begin to submit the

solutions within Parts A and B of Analytical Assignment #2 in Canvas.

4

Business Conditions Analysis

ECON 736

Introduction to the Aggregate Expenditures and IS-LM Models

Professor Yamin Ahmad

Question 1: Components of Consumption

Solution

C represents consumption

C0 represents autonomous consumption

C1 represents marginal propensity to consume

Y represents level of output

T represents government taxation

Question 2: Interpreting C and C1

Solution

Autonomous consumption (c0) is the type of expenditure that a consumer must have even if

he or she does not have disposable income. Thus, a consumer cannot eliminate autonomous

consumption. The marginal propensity to consume (c1) determines the level to which

consumers saves or spends with respect to an aggregate increase in income.

Question 3: Values of C1

The marginal propensity to consume values can range from 0 to 1. Correct answer:

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