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Answers to Problems in the Textbook: Conceptual Problems: 1. The model in Chapter 9 assumed that both the price level and the interest rate were fixed. But the ISLM model lets the interest rate fluctuate and determines the combination of output demanded and the interest rate for a fixed price level. It should be noted that while the upward-sloping AD-curve in Chapter 9 (the [C+I+G+NX]-line in the Keynesian cross diagram) assumed that interest rates and prices were fixed, the downward-sloping AD-curve that is derived at the end of Chapter 10 from the IS-LM model lets the price level fluctuate and describes all combinations of the price level and the level of output demanded at which the goods and money sector simultaneously are in equilibrium.

2.a. If the expenditure multiplier () becomes larger, the increase in equilibrium income caused by a unit change in intended spending also becomes larger. Assume investment spending increases due to a change in the interest rate. If the multiplier becomes larger, any increase in spending will cause a larger increase in equilibrium income. This means that the IS-curve will become flatter as the size of the expenditure multiplier becomes larger. If aggregate demand becomes more sensitive to interest rates, any change in the interest rate causes the [C+I+G+NX]-line to shift up by a larger amount and, given a certain size of the expenditure multiplier , this will increase equilibrium income by a larger amount. As a result, the IScurve will become flatter. 2.b. Monetary policy changes affect interest rates and this leads to a change in intended spending, which is reflected in a change in income. In 2.a. it was explained that a steep IS-curve means either that the multiplier is small or that desired spending is not very interest sensitive. Therefore, an increase in money supply will reduce interest rates. However, this does not result in a large increase in aggregate demand if spending is very interest insensitive. Similarly, if the multiplier is small, then any change in spending will not affect output significantly. Therefore, the steeper the IS-curve, the weaker the effect of monetary policy changes on equilibrium output. 3. Assume that money supply is fixed. Any increase in income will increase money demand and the resulting excess demand for money will drive the interest rate up. This, in turn, will reduce the quantity of money balances demanded to bring the money sector back to equilibrium. But if money demand is very interest insensitive, then a larger increase in the interest rate is needed to reach a new equilibrium in the money sector. As a result, the LM-curve becomes steeper. Along the LM-curve, an increase in the interest rate is always associated with an increase in income. This means that an increase in money demand (due to an increase in income) has to be offset by a decrease in the quantity of money demanded (due to an increase in the interest rate) to keep the money sector in equilibrium. But if money demand becomes more income sensitive, a smaller change 141

in income is required for any specific change in the interest rate to keep the money sector in equilibrium. Therefore, the LM-curve becomes steeper as money demand becomes more income sensitive. 4.a. A horizontal LM-curve implies that the public is willing to hold whatever money is supplied at any given interest rate. Therefore, changes in income will not affect the equilibrium interest rate in the money sector. But if the interest rate is fixed, we are back to the analysis of the simple Keynesian model used in Chapter 9. In other words, there is no offsetting effect (or crowding-out effect) to fiscal policy. 4.b. A horizontal LM-curve implies that changes in income do not affect interest rates in the money sector. Therefore, if expansionary fiscal policy is implemented, the IS-curve shifts to the right, but the level of investment spending is no longer negatively affected by rising interest rates, that is, there is no crowding-out effect. In terms of Figure 10-3, the interest rate not longer serves as the link between the goods and assets markets. 4.c. A horizontal LM-curve results if the public is willing to hold whatever money balances are supplied at a given interest rate. This situation is called the liquidity trap. Similarly, if the Fed is prepared to peg the interest rate at a certain level, then any change in income will be accompanied by an appropriate change in money supply. This will lead to continuous shifts in the

the interest rate will never change. 5. From the material presented in the text we know that when intended spending becomes more interest sensitive, then the IS-curve becomes flatter. Now assume that an increase in the interest rate stimulates saving and therefore reduces the level of consumption. This means that now not only investment spending but also consumption is negatively affected by an increase in the interest rate. In other words, the [C+I+G+NX]-line in the Keynesian cross diagram will now shift down further than previously and the level of equilibrium income will decrease more than before. In other words, the IS-curve has become flatter. This can also be shown algebraically, since we can now write the consumption function as follows: C = C* + cYD - gi In a simple model of the expenditure sector without income taxes, the equation for aggregate demand will now be AD = Ao + cY - (b + g)i. From Y = AD ==> Y = [1/(1 - c)][Ao - (b + g)i] ==> i = [1/(b + g)]Ao - [(1 - c)/(b + g)]Y Therefore, the slope of the IS-curve has been reduced from (1 - c)/b to (1 - c)/(b + g).

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6.

In the IS-LM model, a simultaneous decline in interest rates and income can only be caused by a shift of the IS-curve to the left. This shift in the IS-curve could have been caused by a decrease in private spending due to negative business expectations or a decline in consumer confidence. In 1991, the economy was in a recession and firms did not want to invest in new machinery and, since consumer confidence was very low, people were not expected to increase their level of spending. In the IS-LM diagram the adjustment process can be described as follows: Io ==> Y (the IS-curve shifts left) ==> md ==> i ==> I ==> Y . Effect: Y and i . i IS1 i1 i2 ISo LM

0 Y2 Technical Problems: 1.a. Each point on the IS-curve represents an equilibrium in the expenditure sector. Therefore the IScurve can be derived by setting Y = C + I + G = (0.8)[1 - (0.25)]Y + 900 - 50i + 800 = 1,700 + (0.6)Y - 50i ==> (0.4)Y = 1,700 - 50i ==> Y = (2.5)(1,700 - 50i) ==> Y = 4,250 - 125i. 1.b. The IS-curve shows all combinations of the interest rate and the level of output such that the expenditure sector (the goods market) is in equilibrium, that is, intended spending is equal to actual output. A decrease in the interest rate stimulates investment spending, making intended spending greater than actual output. The resulting unintended inventory decrease leads firms to increase their production to the point where actual output is again equal to intended spending. This means that the IS-curve is downward sloping. 1.c. Each point on the LM-curve represents an equilibrium in the money sector. Therefore the LM-curve can be derived by setting real money supply equal to real money demand, that is, M/P = L ==> 500 = (0.25)Y - 62.5i ==> Y = 4(500 + 62.5i) ==> Y = 2,000 + 250i. 1.d. The LM-curve shows all combinations of the interest rate and level of output such that the money sector is in equilibrium, that is, the demand for real money balances is equal to the supply of real money balances. An increase in income will increase the demand for real money balances. Given a 143 Y1 Y

fixed real money supply, this will lead to an increase in interest rates, which will then reduce the quantity of real money balances demanded until the money market clears. In other words, the LMcurve is upward sloping. 1.e. The level of income (Y) and the interest rate (i) at the equilibrium are determined by the intersection of the IS-curve with the LM-curve. At this point, the expenditure sector and the money sector are both in equilibrium simultaneously. From IS = LM ==> 4,250 - 125i = 2,000 + 250i ==> 2,250 = 375I ==> i = 6 ==> Y = 4,250 - 125*6 = 4,250 - 750 ==> Y = 3,500 Check: Y = 2,000 + 250*6 = 2,000 + 1,500 = 3,500 i 125 IS

2.a. As we have seen in 1.a., the value of the expenditure multiplier is = 2.5. This multiplier is derived in the same way as in Chapter 9. But now intended spending also depends on the interest rate, so we no longer have Y = Ao, but rather Y = (Ao - bi) = (1/[1 - c + ct])(Ao - bi) ==> Y = (2.5)(1,700 - 50i) = 4,250 - 125i. 2.b.This can be answered most easily with a numerical example. Assume that government purchases increase by G = 300. The IS-curve shifts parallel to the right by ==> IS = (2.5)(300) = 750. Therefore IS': Y = 5,000 - 125i From IS' = LM ==> 5,000 - 125i = 2,000 + 250i ==> 375i = 3,000 ==> i = 8 ==> Y = 2,000 + 250*8 ==> Y = 4,000 ==> Y = 500

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When interest rates are assumed to be constant, the size of the multiplier is equal to = 2.5, that is, (Y)/(G) = 750/300 = 2.5. But when interest rates are allowed to vary, the size of the multiplier is reduced to 1 = (Y)/(G) = 500/300 = 1.67. 2.c. Since an increase in government purchases by G = 300 causes a change in the interest rate of 2 percentage points, government spending has to change by G = 150 to increase the interest rate by 1 percentage point. 2.d. The simple multiplier in 2.a. shows the magnitude of the horizontal shift in the IS-curve, given a change in autonomous spending by one unit. But an increase in income increases money demand and the interest rate. The increase in the interest rate crowds out some investment spending and this has a dampening effect on income. The multiplier effect in 2.b. is therefore smaller than the multiplier effect in 2.a. 3.a. An increase in the income tax rate (t) will reduce the size of the expenditure multiplier (). But as the multiplier becomes smaller, the IS-curve becomes steeper. As we can see from the equation for the IS-curve, this is not a parallel shift but rather a rotation around the vertical intercept. Y = (Ao - bi) = [1/(1 - c + ct)](Ao - bi) ==> i = (1/b)Ao - (/b)Y = (1/b)Ao - (1/b)[1 - c + ct]Y 3.b. If the IS-curve shifts to the left and becomes steeper, the equilibrium income level will decrease. A higher tax rate reduces private spending and this will lower national income. 3.c. When the income tax rate is increased, the equilibrium interest rate will also decrease. The adjustment to the new equilibrium can be expressed as follows (see graph on the next page): t up ==> C down ==> Y down ==> md down ==> i down ==> I up ==> Y up. Effect: Y and i

IS1 i i1 i2 ISo LM

0 Y2 Y1 Y

145

4.a. If money demand is less interest sensitive, then the LM-curve is steeper and monetary policy changes affect equilibrium income to a larger degree. If money supply is assumed to be fixed, the adjustment to a new equilibrium in the money sector has to come solely through changes in money demand. If money demand is less interest sensitive, any increase in money supply requires a larger increase in income and a larger decrease in the interest rate in order to bring the money sector into a new equilibrium. i IS i1 i2 i2 LM1 LM2 i1 i IS LM1 LM2

Y1

Y2

Y1 Y2

The adjustment process in each of the two diagrams is the same; however, in the case of a more interest-sensitive money demand (a flatter LM-curve), the change in Y and i will be smaller. (M/P) up ==> i down ==> I up ==> Y up ==> md up ==> i up Effect: Y and i

Section 10-5 derives the equation for the LM-curve and the equation for the monetary policy multiplier as i = (1/h)[kY - (M/P)] and (Y)/(M/P) = (b/h) respectively. If money demand becomes more interest sensitive, the value of h becomes larger and the slope of the LM-curve becomes flatter, while the size of the monetary policy multiplier becomes smaller. 4.b. An increase in money supply drives interest rates down. This decrease in interest rates will stimulate intended spending and thus income. If money demand becomes less interest sensitive, a larger increase in income is required to bring the money sector into equilibrium. But this implies that the overall decrease in the interest rate has to be larger, given that the interest sensitivity of spending has not changed. 5. The price adjustment, that is, the movement along the AD-curve, can be explained in the following way: With nominal money supply (M) fixed, real money balances (M/P) will decrease as the price level (P) increases. There is an excess demand for money and interest rates will rise. This will lead to a decrease in investment spending and thus the level of output demanded will decrease. In other words, the LM-curve will shift to the left as real money balances decrease. 146

6.

In the classical case, the AS-curve is vertical. Therefore, any increase in aggregate demand due to expansionary monetary policy will, in the long run, not lead to any increase in output but simply lead to an increase in the price level. An increase in money supply will first shift the LM-curve to the right. This implies a shift of the AD-curve to the right. Therefore we have excess demand for goods and services and prices will begin to rise. But as the price level rises, real money balances will begin to fall again, eventually returning to their original level. Therefore, the shift of the LM-curve to the right due to the expansionary monetary policy and the resulting shift of the AD-curve will be exactly offset by a shift of the LM-curve to the left and a movement along the AD-curve to the new long-run equilibrium due to the price adjustment. At this new long-run equilibrium, the level of output and interest rates will not have changed while the price level will have changed proportionally to the nominal money supply, leaving real money balances unchanged. In other words, money is neutral in the long run (the classical case).

7.a. An increase in the demand for money will shift the LM-curve to the left, raising the interest rate and lowering the level of output demanded. As a result, the AD-curve will also shift to the left. In the Keynesian case, the price level is assumed to be fixed, that is, the AS-curve is horizontal. In this case, the decrease in income in the AD-AS diagram is equivalent to the decrease in income in the IS-LM diagram, since there is no price adjustment, that is, the real balance effect does not come into play. 7.b. An increase in the demand for money will shift the LM-curve to the left, raising the interest rate and lowering the level of output demanded. As a result, the AD-curve will also shift to the left. In the classical case, the level of output will not change, since the AS-curve is vertical. In this case, the shift in the AD-curve will simply be reflected in a price decrease, but the level of output will remain unchanged. The real balance effect causes the LM-curve to shift back to its original level, since the price decrease causes an increase in real money balances.

Additional Problems: 1. True or false? Explain your answer. A decrease in the marginal propensity to save implies that the IS-curve will become steeper. False A decrease in the marginal propensity to save (s = 1 - c) is equivalent to an increase in the marginal propensity to consume (c), which, in turn, implies an increase in the expenditure multiplier (). But with a larger expenditure multiplier, any increase in investment spending due to a decrease in the interest rate will lead to a larger increase in income. Therefore the IS-curve will become flatter and not steeper. 2. True or false? Explain your answer. If the central bank keeps the supply of money constant, then the money supply curve is vertical, which implies a vertical LM-curve.

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False. Equilibrium in the money sector implies that real money supply is equal to real money demand, that is, ms = M/P = md(i,Y). This implies that any increase in income (Y) will increase the demand for money. To bring the money sector back into equilibrium, interest rates (i) have to rise simultaneously to bring the quantity of money demanded back to the original level (equal to the fixed supply of money). Therefore, to keep the money sector in equilibrium, an increase in income must always be associated with an increase in the interest rate and the LM-curve must be upward sloping. 3. "Restrictive monetary policy reduces consumption and investment." Comment on this statement. A reduction in money supply raises interest rates, which will, in turn, have a negative effect on the level of investment spending. The level of consumption may also decrease as it becomes more costly to finance expenditures by borrowing money. But even if it is assumed that consumption is not affected by changes in the interest rate, consumption will still decrease since restrictive monetary policy will reduce national income and therefore private spending. 4. "If government spending is increased, money demand will increase." Comment. A change in government spending directly affects the expenditure sector and therefore the IS-curve. But in an IS-LM framework, the money sector is also affected indirectly. An increase in the level of government spending will shift the IS-curve to the right, leading to an increase in income. But the increase in income will lead to an increase in money demand, so the interest rate will have to increase in order to lower the quantity of money demanded and to bring the money sector back into equilibrium. Overall no change in money demand can occur, since equilibrium in the money sector requires that ms = M/P = md, that is, money supply has to be equal to money demand, and money supply is assumed to be fixed. 5. "An increase in autonomous investment reduces the interest rate and therefore the money sector will no longer be in equilibrium." Comment on this statement. An increase in autonomous investment shifts the IS-curve to the right. The increase in income leads to an increase in the demand for money, which means that interest rates increase. The increase in interest rates then reduces the quantity of money demanded again to bring the money market back to equilibrium. 6. "A monetary expansion leaves the budget surplus unaffected." Comment on this statement. Expansionary monetary policy, that is, an increase in money supply, will lower interest rates (the LMcurve will shift to the right). Lower interest rates will lead to an increase in investment spending and the economy will therefore be stimulated. But a higher level of national income increases the governments tax revenues and therefore the budget surplus will increase.

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7. "Restrictive monetary policy implies lower tax revenues and therefore to an increase in the budget deficit." Comment on this statement. A decrease in money supply will shift the LM-curve to the left. This will lead to an increase in the interest rate, which will lead to a reduction in spending and thus national income. But as income decreases, so does income tax revenue. Therefore, the budget deficit will increase because of the change in its cyclical component. 8. If the demand for money becomes more sensitive to changes in income, then the LM-curve becomes flatter. Comment on this statement. Along the LM-curve, an increase in the interest rate is always associated with an increase in income. This means that an increase in money demand (due to an increase in income) has to be offset by a decrease in the quantity of money demanded (due to an increase in the interest rate) to keep the money sector in equilibrium. But if money demand becomes more income sensitive, a smaller change in income is required for any specific change in the interest rate to keep the money sector in equilibrium. Therefore, the LM-curve becomes steeper (and not flatter) as money demand becomes more sensitive to changes in income. 9. A decrease in the income tax rate will increase the demand for money, shifting the LM-curve to the right. Comment on this statement. A decrease in the income tax rate (t) will increase the expenditure multiplier (). But with a larger expenditure multiplier, any increase in investment spending due to a decrease in the interest rate will lead to a larger increase in income. Since fiscal policy affects the expenditure sector, the IS-curve (not the LMcurve) will shift. The IS-curve will become flatter and shift to the right. This will lead to a new equilibrium at a higher level of income (Y) and a higher interest rate (i). But money supply is fixed and the LM-curve remains unaffected by fiscal policy. Therefore, at the new equilibrium (the intersection of the new IS-curve with the old LM-curve) the demand for money will not have changed, since the money sector has to be in an equilibrium at ms = md(i,Y). 10. If the demand for money becomes more insensitive to changes in the interest rate, equilibrium in the money sector will have to be restored mostly through changes in income. This implies a flat LM-curve. Comment on this statement. Any increase in income will increase money demand and this will drive the interest rate up. Therefore, the quantity of money balances demanded will decline again until the money sector is back in equilibrium. But if money demand is very interest insensitive, then a larger increase in the interest rate is needed to reach a new equilibrium in the money sector. This means that the LM-curve is steep and not flat. 11. Assume the following IS-LM model: Expenditure Sector Money Sector Sp = C + I + G + NX M = 700 C = 100 + (4/5)YD P =2 YD = Y - TA md = (1/3)Y + 200 - 10i TA = (1/4)Y 149

I = 300 - 20i G = 120 NX = -20 (a) Derive the equilibrium values of consumption (C) and money demand (md). (b) How much of investment (I) will be crowded out if the government increases its purchases by G = 160 and nominal money supply (M) remains unchanged? (c) By how much will the equilibrium level of income (Y) and the interest rate (i) change, if nominal money supply is also increased to M' = 1,100? a. Sp = 100 + (4/5)[Y - (1/4)Y] + 300 - 20i + 120 - 20 = 500 + (4/5)(3/4)Y 20i = 500 + (3/5)Y - 20i From Y = Sp ==> Y = 500 + (3/5)Y - 20i ==> (2/5)Y = 500 - 20i ==> Y = (2.5)(500 - 20i) ==> Y = 1,250 - 50i IS-curve

From M/P = md ==> 700/2 = (1/3)Y + 200 - 10i ==> (1/3)Y = 150 + 10i ==> Y = 3(150 + 10i) ==> Y = 450 + 30i LM-curve

IS = LM ==> 1,250 - 50i = 450 + 30i ==> 800 = 80i ==> i = 10 ==> Y = 1,250 - 50*10 ==> Y = 750 C = 100 + (4/5)(3/4)750 = 100 + (3/5)750 ==> C = 550 ms = M/P = 700/2 = 350 = md Check: md = (1/3)750 + 200 - 10*10 = 350

i 25 ISo LMo

IS' = LM ==> 1,650 - 50i = 450 + 30i ==> 1,200 = 80i ==> i = 15 ==> Y = 1,650 - 50*15 ==> Y = 900 Since i = + 5 ==> I = - 20*5 ==> I = - 100 Check: Sp = G + I = 160 100 = 60 ==> Y = 1(Sp) = 2.5*60 =150

i 33 25 15 10 0

IS1 LMo

450

750 900

1,250 1,650

c. From M'/P = md ==> 1,100/2 = (1/3)Y + 200 - 20i ==> (1/3)Y = 350 - 20i ==> Y = 3(350 - 20i) ==> Y = 1,050 + 30i IS1 = LM1 ==> 1,650 - 50i = 1,050 + 30i ==> 600 = 80i ==> i = 7.5 ==> Y = 1,650 - 50(7.5) = 1,275. ==> i = - 7.5 and Y = 375 as compared to (b).

25

IS1

LMo LM1

10 7.5 0 450

900 1,050 1,275 1,650

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12. Assume the money sector can be described by these equations: M/P = 400 and m d = (1/4)Y - 10i. In the expenditure sector only investment spending (I) is affected by the interest rate (i), and the equation of the IS-curve is: Y = 2,000 - 40i. (a) If the size of the expenditure multiplier is = 2, show the effect of an increase in government purchases by G = 200 on income and the interest rate. (b) Can you determine how much of investment is crowded out as a result of this increase in government spending? (c) If the money demand equation were changed to md = (1/4)Y, how would your answers in (a) and (b) change? a. From M/P = md ==> 400 = (1/4)Y - 10i ==> Y = 1,600 + 40i LM-curve

From IS = LM ==> 2,000 - 40i = 1,600 + 40i ==> 80i = 400 ==> i = 5 ==> Y = 2,000 - 40*5 ==> Y = 1,800 IS = 2*200 = 400 ==> IS' = 2,400 - 40i IS' = LM ==> 2,400 - 40i = 1,600 + 40i ==> 80i = 800 ==> i = 10 ==> Y = 1,600 + 40*10 ==> Y = 2,000 Therefore i = + 5 and Y = + 200

b. Since the size of the expenditure multiplier is = 2 but income only goes up by Y = 200, the fiscal

policy multiplier in the IS-LM model is 1= 1. But this means that the level of investment has been reduced by 100, that is, I = -100. This can be seen by restating the IS-curve as follows: Y = 2,000 - 40i = Y = 2(1,000 - 20i) Since government purchases are changed by G = 200 ==> Y = 2(1,200 - 20i), which means that the IS-curve shifts by IS = 2*200 = 400. But the increase in income is actually only Y = 200. This implies that investment changes by I = -100. Investment is of the form I = Io 20i; however, since the interest rate went up by i = 5, investment changes by I = - 20*5 = - 100. From Y = (Sp) ==> 200 = 2(Sp) ==> Sp = 100 But since Sp = G + I ==> 100 = 200 + I ==> I = - 100

c. If md = (1/4)Y, then we have the classical case, that is, a vertical LM-curve. In this case, fiscal expansion will not change income at all. This occurs since the increase in G will be offset by a decrease in I of equal magnitude due to an increase in the interest rate. (M/P) = md ==> 400 = (1/4)Y ==> Y = 1,600 LM-curve IS = LM ==> 2,000 - 40i = 1,600 ==> 40i = 400 ==> i = 10 ==> Y = 1,600

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IS' = LM ==> 2,400 - 40i = 1,600 ==> 40i = 800 ==> i = 20 ==> Y = 1,600 ==> I = - 200

13. Assume money demand (md) and money supply (ms) are defined as: md = (1/4)Y + 400 - 15i

and ms = 600, and intended spending is of the form: Sp = C + I + G + NX = 400 + (3/4)Y - 10i. Calculate the equilibrium levels of Y and i, and indicate by how much the Fed would have to change money supply to keep interest rates constant if the government increased its spending by G = 50. Show your solutions graphically and mathematically. ms = md ==> 600 = (1/4)Y + 400 - 15i ==> (1/4)Y = 200 + 15i ==> Y = 4(200 + 15i) ==> Y = 800 + 60i LM-curve Y = C + I + G + NX ==> Y = 400 + (3/4)Y - 10i ==> (1/4)Y = 400 - 10i ==> Y = 4(400 - 10i) ==> Y = 1,600 - 40i IS-curve From IS = LM ==> 1,600 - 40i = 800 + 60i ==> 100i = 800 ==> i = 8 ==> Y = 1,280 If government spending is increased by G = 50, the IS-curve will shift to the right) by (IS) = 4*50 = 200. If the Fed wants to keep the interest rate constant, money supply has to be increased in a way that shifts the LM-curve to the right by exactly the same amount as the IS-curve, that is, (LM) = 200. From Y = 2(200 + 15i) ==> (Y) = 2(ms) ==> 200 = 2(ms) ==> (ms) = 100, so money supply has to be increased by 100. Check: IS' = LM": 1,800 - 40i = 1,000 + 60i ==> 800 = 100i ==> i = 8 Y = 1,480

i 45 40

8 0

800 1000 1280 1480 1600 1800 Y

153

14. Assume the equation for the IS-curve is Y = 1,200 40i, and the equation for the LM-curve is Y = 400 + 40i. (a) Determine the equilibrium value of Y and i. (b) If this is a simple model without income taxes, by how much will these values change if the government increases its expenditures by G = 400, financed by an equal increase in lump sum taxes (TAo = 400)? a. From IS = LM ==> 1,200 - 40i = 400 + 40i ==> 800 = 80i ==> i = 10 ==> Y = 400 + 40*10 ==> Y = 800 b. According to the balanced budget theorem, the IS-curve will shift horizontally by the increase in government purchases, that is, IS = G = TAo = 400. Thus the new IS-curve is of the form: Y = 1,600 - 40i. From IS' = LM ==> 1,600 - 40i = 400 + 40i ==> 1,200 = 80i ==> i = 15 ==> Y = 400 + 40*15 ==> Y = 1,000 15. Assume you have the following information about a macro model: Expenditure sector: Money sector: S = - 200 + (1/5)YD ms = 400 TA = (1/8)Y - 40 md = (1/4)Y + 100 - 5i TR = 60 I = 300 10i G = 70 NX = 150 - (1/5)Y Calculate the equilibrium values of investment (I), money demand (md), and net exports (NX). C = YD - S = YD [-200 + (1/5)Y] = 200 + (4/5)YD Sp = C + I + G + NX = 200 + (4/5)[Y- (1/8)Y + 40 + 60] + 300 - 10i + 70 + 150 - (1/5)Y = 720 + (4/5)(7/8)Y + (4/5)100 - 10i - (1/5)Y = 800 + (1/2)Y - 10i Y = Sp ==> Y = 800 + (1/2)Y - 10i ==> (1/2)Y = 800 - 10i Y = 2(800 - 10i) ==> Y = 1,600 - 20i IS-curve

ms = md ==> 400 = (1/4)Y + 100 - 5i ==> (1/4)Y = 300 + 5i ==> Y = 1,200 + 20i LM-curve i = 10 Y = 1,400

IS = LM ==> 1,600 - 20i = 1,200 + 20i ==> 40i = 400 ==> 154

md = ms = 300

16. Assume the following IS-LM model: expenditure sector: money sector: Sp = C + I + G + NX M = 500 C = 110 + (2/3)YD P =1 YD = Y - TA + TR md = (1/2)Y + 400 - 20i TA = (1/4)Y + 20 TR = 80 I = 250 - 5i G = 130 NX = -30 (a) Calculate the equilibrium values of investment (I), real money demand (md), and tax revenues (TA). (b) How much of investment (I) will be crowded out if the government increases spending by G = 100? a. Sp = C + I + G + NX = 110 + (2/3)(Y - TA + TR) + 250 - 5i + 130 - 30 = 460 + (2/3)[Y - (1/4)Y - 20 + 80] - 5i = 460 + (2/3)(3/4)Y + (2/3)60 - 5i = 500 + (1/2)Y - 5i From Y = Sp ==> Y = 500 + (1/2)Y - 5i ==>Y = 2(500 - 5i) ==> Y = 1,000 - 10i IS-curve From (M/P) = md ==> 500/1 = (1/2)Y + 400 - 20i ==> (1/2)Y = 100 + 20i ==> Y = 200 + 40i LM-curve From IS = LM ==> 1,000 - 10i = 200 + 40i ==> 800 = 50i ==> i = 16 ==> Y = 840 ==> I = 250 - 5*16 = 170 TA = (1/4)840 - 20 = 190 Since (M/P) = md ==> md = 500 Check: md = (1/2)840 + 400 - 20*16 = 500 b. If government expenditures are increased by G = 100, then the IS-curve will shift by this change times the multiplier, that is, IS = 2*100 = 200. Therefore, from IS' = LM ==> 1,200 - 10i = 200 + 40i ==>1,000 = 50i ==> i = 20 ==> Y = 1,000 Since i = 4 ==> I = - 4*5 = - 20 Check: I' = 250 - 5*20 = 150

155

156

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