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SS 2012

Problem Set 4 - IS-LM model

1. Consider a closed economy which can be characterized by the following equations:

C = 700 + 0.8Y

D

I = 500 + 0.1Y −2000i

G = 400

T = 500

M

P

d

= 0.2Y −4000i

M

P

s

= 400

(a) Solve for the goods market equilibrium and state the equation for the IS-curve. Calculate

the multiplier and give an interpretation of your result.

(b) Solve for the money market equilibrium and state the equation for the LM-curve.

(c) Determine the equilibrium values for real GDP (Y ), the interest rate (i), private con-

sumption (C), investment (I) and private saving (S). Show that in equilibrium total

saving equals investments.

(d) Suppose that government uses expansionary ﬁscal policy and increases government ex-

penditures to G = 800. What happens to the equilibrium? (Repeat exercise (c) for the

new government expenditures.)

(e) Suppose that government expenditures are again at their initial value G = 400 and

suppose that instead the central bank uses expansionary monetary policy to increase

the real money supply to

M

P

s

= 900. What happens to the equilibrium? (Repeat

exercise (c) for the new real money supply.)

(f) Suppose that all variables are back at their original levels and suppose that the gov-

ernment targets an equilibrium level of real GDP of 8000. Further suppose that the

government wants to achieve this target solely by changing its consumption. Which

level of G is required to achieve this goal? What happens to the budget deﬁcit in the

new equilibrium?

(g) Suppose that all variables are back at their initial values and suppose that again a level

of real GDP of 8000 is targeted. However, because of the negative implications of ﬁscal

policy found in (f), the central bank tries to achieve this goal solely through monetary

policy.

Which interest rate should the central bank target if it wants to increase equilibrium

real GDP to 8000? (Hint: use the IS-curve to answer this question)

What kind of monetary policy is needed to achieve this goal? (Hint: determine the level

of real money supply needed to implement this target interest rate from the LM-curve)

2. Consider the situation after the German reuniﬁcation, i.e. a situation in which (starting from

an equilibrium on both the goods and the ﬁnancial market) the government uses expansionary

ﬁscal policy, whereas the central bank uses contractionary monetary policy.

(a) Explain how the IS-curve can be obtained graphically from the equilibrium condition on

the goods market.

(b) Explain how the LM-curve can be obtained graphically from the equilibrium condition

on the money market.

(c) Explain what is meant by expansionary ﬁscal policy. What eﬀect does expansionary

ﬁscal policy have on the IS or LM-curve?

(d) Explain what is meant by contractionary monetary policy. What eﬀect does contrac-

tionary monetary policy have on the IS or LM-curve?

(e) Consider expansionary ﬁscal policy and contractionary monetary policy together. What

happens to the initial equilibrium? (Graphical analysis and explanation)

What is the eﬀect on real GDP (Y ), the interest rate (i), private consumption (C) and

investment (i)? (Explain your answer, also explain if some of the eﬀects depend on the

strength of the policy or are ambiguous.)

3. Suppose that a closed economy is in its equilibrium. However, the government and the central

bank of this economy want to achieve the following goal. Which kind of policy mix would

you recommend them? (Base your answer on a graphical analysis of the IS-LM model)

(a) The policymakers want to increase output (Y ) without changing the interest rate.

(b) The government wants to reduce the budget deﬁcit without changing output.

Also explain which eﬀects your proposed policy mix has on private consumption (C) and

investment demand (I).

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