BUSINESS ADMINISTRATION DEPARTMENT

Name: Nguyễn Đức Minh

Student’s number: HS173138
Class: FIN1701

FIN 201 – Fall 22 – Vinh Pham

Essay test (90’)
Three exercises cover contents of chapter 8,9 and 12.

1. Consider an economy with a constant nominal money supply, a constant level of real output Y =
100, and a constant real interest rate r= 0.10.
Suppose that the income elasticity of money demand is 0.5 and the interest elasticity of money
demand is -0.1.

a. By what percentage does the equilibrium price level differ from its initial value if output
increases to Y = 106 (and r remains at 0.10)? (1.5 pts)
ΔP/P = ηγΔY/Y = 0.5 x 6% = -3%. => The price will be 3% lower.

b. By what percentage does the equilibrium price level differ from its initial value if the real
interest increases to r = 0.11 (and Y remains at 100)? (1.5 pts)
ΔP/P = ηrΔr/r = -(-0.1) x 0.1 = 1%. The price will be 1% higher.

2. During the period 1973-1975, the United States experienced a stagflation, i.e a simultaneous deep
recession and steep inflation. Is this most likely the result of a supply shock or a demand shock?
Illustrate, using AD-AS analysis. (2pts)
The 1973–1975 recession was the result of a supply shock, not a demand shock because:
A recession happens at a point in which output has declined, but the price level has risen. This
matches what happened with a supply shock: A negative supply shock raises production costs and
reduces the quantity producers are willing to supply at any given aggregate price level, leading to
a leftward shift of the short-run aggregate supply curve. The U.S. economy experienced severe
negative supply shocks following disruptions to world oil supplies in 1973 and 1975.

P1 increase to P2, Y1 decrease to Y2

 BUSINESS ADMINISTRATION DEPARTMENT

3. Consider the following economy.

Desired consumption: Cd = 250 + 0.5(Y - T) - 500r.
Desired investment: Id = 250 - 500r.
Real money demand: L = 0.5Y – 500i
Full-employment output: Ybar = 1000
Expected inflation: Pi(e) = 0

Suppose that T = G = 200 and that Money Supply M = 7650.

a. Find an equation describing the IS curve. (0.5pts)
T = G = 200, M = 7650. The IS curve gives Y = 1000 - 2000r + 2G –T = 1000 - 2000r + (2 x
200) - 200 = 1200 - 2000r. The LM curve gives 7650 / P = 0. 5 Y - 500r. To find the
aggregate demand curve, eliminate r in the two equations by multiplying the LM curve
through by 4 and rearrange the resulting equation and the IS curve.
LM: 7650 / P = 0. 5 Y - 500r. Multiplying by 4 gives 30,600 / P = 2 Y - 2000r. Rearranging
gives 2000r 2Y- 30,600 / P. IS: Y = 1200 - 2000r. Rearranging gives 2000r = 1200 - Y.
Setting the right-hand sides of these two equations to each other (since both equal 2000r)
gives: 2Y - (30,600 / P) = 1200 - Y, or 3Y = 1200 + (30,600 / P), or Y = 400 + (10,200 / P);
this is the AD curve.
With Y = 1000 at full employment, the AD curve gives 1000 = 400 + (10,200 / P), or P = 17.
From the IS curve Y = 1200 - 2000r, so 1000 = 1200 - 2000r, or 2000r = 200, so r = 0. 10.
Consumption is C = 250 + 0.5(Y - T) - 500r = 250 + 0.5(1000 - 200) - (500 x 0. 10) = 600.
Investment is I = 250 - 500r = 250 - (500 x 0. 10) = 200.

b. Find an equation describing the LM curve. (0.5pts)

Following the same steps as above, with M = 9000 instead of 7650, gives the aggregate
demand curve AD: Y =400 + (12,000 P). With Y = 1000, this gives P = 20. Nothing has
changed in the IS equation, so it still gives r = 0.10. And nothing has changed in either the
consumption or investment equations, so we still get C = 600 and I =200. Money is neutral
here, as no real variables are affected and the price level changes in proportion to the money
supply.

c. Find an equation for the aggregate demand curve. What are the equilibrium values of output,
consumption, investment, the real interest rate, and price level? (2pts)
- T = G = 200, M = 7650.
- The IS curve gives Y = 1000 - 2000r + 2G –T = 1000 - 2000r + (2 x 200) - 200 = 1200 -
2000r.
- The LM curve gives 7650 / P = 0. 5 Y - 500r.
- To find the aggregate demand curve, eliminate r in the two equations by multiplying the LM
curve by 4 and rearrange the resulting equation and the IS curve.
- LM: 7650 / P = 0. 5 Y - 500r, multiplying by 4 gives 30,600 / P = 2 Y - 2000r. Rearranging
gives 2000r = 2Y- 30,600 / P.
- IS: Y = 1200 - 2000r. Rearranging gives 2000r = 1200 - Y. Setting the right-hand sides of
these two equations to each other (since both equal 2000r) gives: 2Y - (30,600 / P) = 1200 -
Y, or 3Y = 1200 + (30,600 / P), or Y = 400 + (10,200 / P); this is the AD curve.
- With Y = 1000 at full employment, the AD curve gives 1000 = 400 + (10,200 / P), or P =
17. From the IS curve Y = 1200 - 2000r, so 1000 = 1200 - 2000r, or 2000r = 200, so r = 0. 10.
Consumption is C = 250 + 0.5(Y - T) - 500r = 250 + 0.5(1000 - 200) - (500 x 0. 10) = 600.
Investment is I = 250 - 500r = 250 - (500 x 0. 10) = 200.
 BUSINESS ADMINISTRATION DEPARTMENT

d. If the Money supply increases from 7650 to 9000, what is the effect of this monetary
development on IS curve? On LM curve? On output, real interest rate, and price level? (2pts)
- With M = 9000 instead of 7650
=> the aggregate demand curve AD: Y = 400 + (12,000 P).
- With Y = 1000, this gives P = 20.
- Nothing has changed in the IS equation, so it still gives r = 0. 10.
- Nothing has changed in either the consumption or investment equations
=> C = 600 and I = 200.
- Money is neutral here, as no real variables are affected and the price level changes in
proportion to the money supply.