MID-TERM TEST

Name: Phan Thảo Huyền

Student ID: 1911150504
Class: K58 – CLCKT Khối I – Anh 03
Course ID: KTEE402(2.2/2021)CLC.1
Course name: Macroeconomics II
Date of Submission: 15/06/2021

ASSIGNMENT
Using the IS – LM model and Mundell – Fleming model appropriately to answer the question
“what are the impacts of following factors on the economy”
I. Closed economy
1. The government increases income tax and central bank decreases required reserve ratio in
Short run
2. The central bank decreases discount rate and government increases spending in Long run
II. Open economy (all in short run)
1. The government increases spending and the central bank increases money supply in
flexible exchange rate system
2. The government increases tax and world interest rate increases in fixed exchange rate
system
3. The government implement trade policy to promote export and central bank buys more
government bond in flexible exchange rate system
 
ANSWERS:
I. CLOSED ECONOMY:
I.1. The government increases income tax, central bank decreases required reserve ratio
in short run.
Graph:

Explanation:
- Step 1:
+ Income tax increase called a fiscal policy, which make the shift in IS curve.(IS1)
+ Required reserve ratio was decreased - a method to increase money supply, according to
monetary policy; which shifts LM curve (LM1)
- Step 2:
IS1 → IS2
LM1 → LM2
+ Income tax increase is a contractionary fiscal policy, IS curve shifts left-ward
+ Required reserve ratio decrease is an expansionary monetary policy. LM curve shifts right-
ward
- Step 3:
E(new): A → B
Y is unclear, r decrease.
+ New equilibrium B is a point that lies lower than old equilibrium A.
 The government wants to change the structure of Y to better the efficiency of its
economy and endure public debt.
I.2. The central bank decreases discount rate and government increases spending in
LONG-RUN:
Graph:

Explanation:
- Step 1:
Using basic 3-step method from Short-run equilibrium:
+ Government spending increase means expansionary fiscal policy, accordingly shifts IS
curve right-ward.
+ Discount rate decrease leads to the increase of money supply, or so-called an expansionary
monetary policy. The effect of this policy is that LM curve shifts right.
IS1 → IS2
LM1 → LM2
E(new): A → B
- Step 2:
+ New output (point B) is on the right of old output (point B)
+ Level of output will increase to a greater level than potential output level Y*. This means
price level (P) will increase.
E (new): A → B.
Price increases.
- Step 3:
+ The shift of LM-curve will be to the left until potential output level reached as price
increases.
LM2 → LM3
New equilibrium: B → C
Y is unchanged at Y*, r increases
II. OPEN ECONOMY IN SHORT RUN:
II.1. The government increases spending - the central bank increases money supply in a
flexible exchange rate system:
Graph:

Explanation:
- Step 1:
Using basic 3-step method from Short-run equilibrium:
+ Government spending increase means expansionary fiscal policy, accordingly shifts IS
curve right-ward.
+ Increase of money supply is an expansionary monetary policy. The effect of this policy is
that LM curve shifts right.
IS1 → IS2
LM1 → LM2
 E(new): Unclear
- Step 2:
+ There are three cases of new equilibrium, as graphed above accordingly: standing higher
than BP line, lower BP line, or lying right to the BP line.
+ There is no way to define where exactly equilibrium point lies; that, it is unlikely to analyze
which effects the policies have on the exchange rate (e) and net export (NX)
E (new): unclear
The change of e and NX: unclear
- Step 3:
+ The IS-curve will always shift to the level of world’s interest rate r* (as represented in the
second graph, nevertheless.
+ Therefore, while output level Y increases, the interest rate remains const.
E(new): unclear.
Y increases
r is unchanged.
II.2. The government increases tax and world interest rate increases in fixed exchange
rate system:
Graph:

Explanation:
- Step 1:
Using basic 3-step method from Short-run equilibrium:
+ Tax increase stands for a fiscal policy, which make the shift in IS curve left-ward.
+ World interest rate increase from r1* to r2*, causes upward shift of BP line
IS1 → IS2
BP1 → BP2
E(new): A → B
- Step 2:
+ Point of equilibrium B lies lower than the BP line -> increase money supply in order to
maintain the fixed exchange rate.
- Step 3:
+ The shift of LM-curve is to the left until world’s interest rate reached; due to the increase in
money supply.
+ The domestic interest rate moves up from r1* to r2*, while output level decreases along the
change
LM1 → LM2
E(new): B → C
Y decreases
r increases.
II.3. The government implement trade policy to promote export and central bank buys
more government bond in flexible exchange rate system:
Graph:

Explanation:
- Step 1:
Using basic 3-step method from Short-run equilibrium:
+ Promoting export leads to the increase in the level of Total Output, which shifts IS-curve
right-ward.
+ According to Central bank buys government bond, money supply increases - an
expansionary monetary policy. This then shifts LM-curve right-ward
IS1 → IS2
LM1 → LM2
E(new): A → B
- Step 2:
+ It is given that export will be promoted, therefore, the new point of Equilibrium B must
lower than BP line.
+ Exchange rate decreases along the promotion.
E(new): A → B
Net export increases
Exchange rate decreases.
- Step 3:
+ B lies under BP line, which means that the IS curve must shift until the level of world’s
interest rate (r*) is reached.
+ While domestic interest rate remains the same at r* level, level of output Y increases (from
point B to C).
IS2 → IS3
E(new): B → C
Y increases, r is unchanged.