Question #35663

Consider the following closed economy with zero inflation where the price index is 1. Consumers always spend 50 percent of their disposable income. Businesses invest $200 when the real interest rate is 0 and reduce investment by $25 for every 1 percentage point rise in the real interest rate, r. Government purchases are $200 and taxes are $200. The central bank sets the nominal interest at 4% per year plus inflation plus 1% for every point that inflation is over 0% per year. However, like the ECB, the central bank has a single mandate, inflation, and does not change the interest rate with changes in output.
a. Write the equations of the IS curve and the MP curve.
b. Find the equilibrium real interest rate (r) and the equilibrium level of national
output (Y).
c. Suppose that government purchases are raised from $200 to $350. Graph the IS
curve shift. What are the new equilibrium interest rate and level of output?
d. Suppose that inflation rises to 2% per year. What are the effects on the MP curve
and on the equilibrium output?

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