Assume that real output is fixed at Y 300 consumption is fi

Assume that real output is fixed at Y = 300, consumption is fixed at C = 200, government spending is fixed at G = 30.

Assume that the Investment function takes the following form I(r) = 75r, where r is given in percent terms (i.e., r = 2 signifies an interest rate of 2%).

Assume that the quantity equation of money holds M · V = P · Y and the velocity of money is constant V .

a) If the money supply increases by %3, by what percentage rate do prices change? That is, what is the inflation rate?

(b) What is the real rate of investment r in this economy? What is the investment level I?

(c) What is the nominal interest rate i?

(d) If government spending G increases to 35, what happens to the real

rate of investment r, investment I, and the nominal interest rate i?

Solution

I = Y – C – G

I = 75-r, Y = 300, C = 200, G = 30

Putting all the values in above equation

75-r = 300-200-30

75-r = 70

R = 5%

So real rate is 5%

Nominal rate = (1+0.05)(1+0.03)-1

                      = 0.0815~8.15%

If G= 35

I = 300-200-35= 65

Then, 75-r = 65

R = 10%

Nominal rate = (1 + 0.10)(1 +0.03) – 1 = 13.3%