ECO SCENARIO – AN LM Curve SHOCK

AN LM Curve SHOCK!Consider the following model of the economyProduction function: Y = A·K·N – N2/2Marginal product of labor: MPN = A·K – N.where the initial values of A = 6 and K = 10. The initial labor supply curve is given as: NS = 30 + 4wInitial conditions in the goods marketCd = 120 + .50(Y-T) – 500rId = 800 – 500rG = 100T = 100Md/P = 218 + 0.5Y- 1000(r + ?e) Nominal Money supply M = 3000 Expected inflation is equal to 3% (?e = 0.03)a) Now suppose that there is a shock to real money demand so that the new real money demand function is:Md/P = 248 + 0.5Y- 1000(r + ?e)Name and support two reasons why the nominal money stock might change like this – please do your best to relate your answer to real world events.b) What is the new, short run (fixed price level) expression for the LM curve? Please show all work.c) What is the short run, Keynesian (fixed price) level of equilibrium output and real interest rate? Please show all work.Please label these new short run conditions to your four diagrams as point B. Be sure to label diagrams completely with the inclusion of all the relevant shift variables like we did numerous times in the video lectures.d) Find the new price level associated with the long run general equilibrium.Please label these long run conditions to your four diagrams as point C. Be sure to label diagrams completely with the inclusion of all the relevant shift variables e) Let us focus on the movement from point A to B (the short -run) in your money market diagram. Explain why (and in what direction) the real interest rate had to change to ‘clear’ the money market.f) Now we know that one of the Fed’s mandates is price stability. What would the Fed have to do, in terms of open market operations, so that the price level remains at its initial value? Assume the money multiplier is 0.8. Please show your work. g) What else could the Fed do, besides conducting open market operations, in order to for the price level to remain at its initial value?

 

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