Answer to Question #218788 in Macroeconomics for SAIF

Question #218788

Q.1 IS-LM and Aggregate Demand

a) Derive the IS Curve (graphically) for a three sector economy. What does it represent? What will happen

to shape of the IS curve if the marginal propensity to save decreases?

b) Using Keynes’ liquidity preference theory, explain why aggregate demand for money function is

downward sloping? What will happen to the position of aggregate money demand and the LM-curve if

expected inflation increase?

c) What is Keynes effect? What condition(s) in the money market make the Keynes effect ineffective?

d) Using a fixed price IS-LM framework show (graphically) that the effectiveness of monetary policy

depends on the shape of the IS curve.

Q.2 Labor Market and Aggregate Supply

a) Under what assumption(s) aggregate supply curve may become horizontal / vertical?

b) Explain the effect of a decrease in the stock of wealth on real wages, aggregate employment and

aggregate output supply.


1
Expert's answer
2021-07-20T10:46:47-0400




a) The investment demand schedule is downward sloping, which means that as the level of interest in the economy grows, so does the level of production. Now, as interest rates fall, the investment grows, and as investment rises, the AD curve moves higher, indicating that production levels rise. This may be summarized as the growth in output accompanied by a reduction in interest rates, as seen by the IS curve.

b) The amount of money demanded in an economy is determined by the level of income and the rate of interest. As the amount of income grows, so does the money demand in the economy, which is referred to as the transaction demand for money, whereas an increase in interest rates causes a decrease in money demand in the economy because of the opportunity cost of keeping money rises. As a result, the money demand curve slopes downward. With projected inflation, buying power is expected to decline, and consumers will want more cash in hand. As a result, the LM curve will move upwards.

c) The Keynes effect refers to the shift in commodity price levels caused by changes in interest rates. As the price level decreases, so does the real money supply, which leads to lower interest rates and therefore more investment, which leads to increased production as investment grows.

There are several instances where the Keynes effect does not operate.

a. The liquid trap or the horizontal LM curve

b. Vertical IS curve corresponding to inelastic spending with regard to the interest rate.

d) Monetary policy is useless in modifying the level of production in the case of vertical IS, but extremely successful in the case of horizontal IS.


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