# Assume that YD is \$4,000 in Year 1 and also equal to \$4,000 in Year 2. What is consumption in Year 2

April 14, 2018

Problem 4Suppose that we have a consumption function given as:C = 220 + 0.9YPWhere YP is permanent disposable income. Suppose as well that consumers forecast their permanent income (YP) by using a simple average of disposable income from the present and previous years:YPt = 0.5(YDt + YDt-1)Where YD is actual disposable income.A. Assume that YD is \$4,000 in Year 1 and also equal to \$4,000 in Year 2. What is consumption in Year 2?B. Now suppose that YD increases to \$5,000 in Year 3 and remains at \$5,000 all future years. What is consumption in Year 3 and 4 and all remaining years? Briefly explain why consumption responds the way it does to an increase in income.C. What is the short-run marginal propensity to consume? What is the long-run marginal propensity to consume?D. Briefly explain why this formulation of consumption may provide a more accurate description of consumption than the simple consumption function that depends only on current income.Problem 5Consider an economy specified by the following:Y = PE = C + I + G + NX (Income identity)C = 300 + 0.8YD (Consumption)I = 200 – 1,500R (Investment)NX = 100 – 0.04Y – 500R (Net exports)MD = (0.5Y – 2,000R) (Money demand)Also assume that government spending G = \$200, the tax rate t = 0.2, and the moneysupply MS = \$550 (and assume the price level is constant at P = 1).A. What is the IS curve?B. What is the LM curve?C. What are the values of income (Y) and the interest rate (R) when the IS-LM model is in equilibrium?

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