Question: Utopia is a closed economy and is characterized by the following equations:
Consumption: C = 5000 + 0.85(Y - T) - 500r
Investment: I = 2000 - 600r
Government spending: G = 1200
Taxes: T = 2200
Real money demand: (Md/P) = L(Y,i) = 0.65Y - 130i
Expected inflation: pe = 0
Production function: Y = 3K1/3L2/3
Note: Interest rates, i and r, are expressed in percentage points, i.e., if r = 2.5, then r = 2.5%.
Suppose the IS-LM model can used be to describe Utopia, and answer the following questions. Keep your answers to a minimum of THREE decimal points (for fractions).
a) Derive the IS and LM equations for this economy.
b) The supply of capital and labour in this economy are both equal to 6000; and the level of the nominal money supply is 11,118. Calculate the long-run or full-employment values of the output, consumption, investment, real interest rate, public saving, private saving, national saving, and price level.
c) Now suppose the government of Utopia is deciding on a new monetary policy regime. They are considering targeting the real interest rate to set the real interest rate equal to 3%. Assuming that the economy was initially at full-employment, for each real interest rate target what are the new values of output, consumption, investment, real interest rate, public saving, private saving, national saving, and price level in the short-run?
d) Suppose instead, the government of Utopia is considering targeting the real interest rate using fiscal policy via changes to government spending (not taxes). As before it is considering setting the real interest rate at 3%. Assuming that the economy was initially at full-employment, for each real interest rate target what are the new values of output, consumption, investment, real interest rate, public saving, private saving, national saving, and price level in the short-run? Which method of targeting the real interest rate is best for the government? Use a single IS/LM diagram (that depicts both types of targeting approaches) and words explain why this is so.