Introduction to Macroeconomics

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).