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Business Conditions Analysis
ECON 736
Analytical Assignment #2 – 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 free‐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 hand‐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 IS‐LM Model
1. Consider the Keynesian Consumption Function: C  c 0  c 1 Y  T  . Describe what
the various components mean, i.e. what do C ,c 0 ,c 1,Y ,T  represent?
2. How would you interpret the terms c 0 ,c 1 ?
3. What kind of values can c 1 take?
For questions 4‐6, suppose that the economy is characterized by the following equations:
C  160  0.6 Y  T 
I  150
G  150
T  100
4. Solve for the value of real GDP in equilibrium, i.e. Y * .
5. Solve for disposable income, Y D  Y  T .
 
6. Solve for consumption expenditures C * in equilibrium.
For questions 7 – 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 lump‐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
‐50
100
A
2,000
B
200
150
‐50
100
2,400
3,000
2,900
200
150
‐50
100
3,200
4,000
3,700
200
150
‐50
100
4,000
5,000
4,500
200
150
‐50
100
4,800
7‐8. 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  AE0   slope of AE   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 – 17, consider the following equations from the IS‐LM model:
Goods Market:
C  c 0  c 1 Y  T 
I  I 0  br
G  G0
T  T0
Y  C  I G
Money Market:
L  r ,Y   m 0  kY  hr
M M
P P
M
 L  r ,Y 
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.
2
Econ 736 Analytical Assignment #2
16. Which of the equations above represent reduced‐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 – 20, consider the following reduced form version of the IS‐LM
Model:
Goods Market Equilibrium:
Y 
c 0  c 1T 0  I 0  G
b
r

1 c1
1 c1
Money Market equilibrium:
M
 m 0  kY  hr
P
18.
Which
components
of
the
equations
above,
i.e.
Y , r ,c 0 , I 0 ,G 0 ,T 0 , m0 ,c 1, b , k , h , M , P  represent the endogenous variables? If
the answer is none, pick none.
19.
Which
components
of
the
equations
above,
i.e.
Y , r ,c 0 , I 0 ,G 0 ,T 0 , m0 ,c 1, b , k , h , M , P  represent the exogenous variables? If
the answer is none, pick none.
20.
Which
components
of
the
equations
above,
i.e.
Y , r ,c 0 , I 0 ,G 0 ,T 0 , m0 ,c 1, b , k , h , M , P  represent the model parameters? If the
answer is none, pick none.
Part B (20 points): The IS‐LM Model
Please note that you may only attempt Part B once in Canvas
For all the questions in part B, consider the following IS‐LM model:
Goods Market:
C  200  0.25 Y  T 
I  150  0.25Y  1000r
G  250; T  200
Money Market:
3
Econ 736 Analytical Assignment #2
d
M 
   2Y  8000r
 P
M
 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.
6‐7. 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
 1840 .
P
8 ‐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  400 .
Now set
10‐11. 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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