# Suppose that we have a consumption function given as: C = 220 + 0.9YP

March 14, 2016

Problem 4
Suppose that we have a consumption function given as:

C = 220 + 0.9YP

Where 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 5
Consider 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 money
supply 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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