1. INTRO TO MACROECONOMICS
Exercise 7 Twitter: @RajEcon
www.rajchandeteaching@blogspot.com
Raj.Chande@bristol.ac.uk

2. Q1
 Equilibrium level of aggregate demand (AD) occurs
when an economy’s real goods and capital goods
markets are in equilibrium.
 Eqbm in goods market: Goods demanded = goods
supplied, IS Curve gives interest rate (i), income (Y)
combinations
 Eqbm in capital market: Money supplied = money
demanded, LM curve gives i, Y combinations
 That’s your initial equilibrium. Disturbance: Price
level (P) increases.

3. 1) CTD, TRANSITION TO NEW EQBM
 P increase, real quantity of money falls
 Money demand greater than supply, public sell
bonds, interest rate increases and new eqbm is
reached in capital goods market
 But now i has gone up, investment (I) will fall and
eqbm AD must now occur at a lower Y and higher i.
 Now… here’s the focus of this question, how does
the sensitivity of I to i influence the overall change
in Y?
 Most of you too briefon this bit

4. BEST WAY IS TO COMPARE TWO EXTREMES
 A: Imagine if I was hugely sensitive to i, then a
small increase in i would cause a massive fall in I
and thus a large drop in Y would be required to
reach equilibrium AD again.
 B: If I didn’t really budge, then once the public sell
their bonds, that’s more or less the whole story.
Yes, i goes up, but the subsequent change in Y
would be very small.
 The question did ask you to focus on this ‘in
particular’. So do that.
 Now think, what would the AD curves look like for A
and B?

5. 2) AGAIN, ‘IN PARTICULAR’
 If AD was shallower for A, then what does that tell
you about the IS curve for A?

6. 3) JUST ALGEBRA, PG65 TELLS YOU HOW
 IS: Y = [c0+c1T + I(i, Πe) + G] / (1-c1)
 LM: Y = M / P.L(i)
 …and in AD eqbm, we know that Z = Y
 Remember, IS and LM on i, Y space, AD on P, Y
 Simply plug in the values you have been given and
rearrange to derive the IS curve.
Y = 2925 – 35000i …or more usefully…
i = 0.08357 – (Y/35000)

7. LM CURVE
 We have H, we have c, we have θ
 …and we know M = H/[c+θ(1-c)], so M is 125
 Again, just sub this in to your Md equation:
Md/P = M/P = 125/P = 0.4Y-5000i
Rearrange to get:
i = [Y – (312.5/P)]/12500

8. NOW AD
 IS & LM cross at one combination of i and Y
 AD curve on space of P and Y, so let’s get rid of i
 We know from LM expression that:
i = [Y – (312.5/P)]/12500 so sub into IS to get:
Y = 2925-35000[Y-(312.5/P)]/12500
Y = 769.7358 + 230.26/P

9. 3)II)
 If Y = 1000 and our AD curve tells us that:
Y = 769.7358 + 230.26/P
then just plug in Y = 1000 to get P = 1
Then using either IS or LM to get i:
1000 = 2925 – 35000ii = 0.055
Now we know i, we can calculate price of bond

10. III) AND IV)
 If you couldn’t do these, try again.
 Any problems, come see me, though Nigel will post
answers on BlackBoard soon.

11. 4) THE DOLLAR INDEX SINCE 1969