Q3. Why does the IS curve slope downward?

A fall in the interest rate motivates firm to increase investment spending, which drives up the
total planned expenditure (PE). To restore the equilibrium in the goods market, the output (Y)
must increase. Therefore, the IS curve is downward slopping.

Q4. Why does the LM curve slope upward?

P2. In the Keynesian cross model, assume that the consumption function is given by C =
120 + 0.8 (Y−T). Planned investment is 200; government purchases and taxes are both 400.
a) Graph planned expenditure as a function of income.

Extra Note:
Y=PE is the line showing all possible equilibrium points. It can be seen as supply curve
because total supply equals total demand.

b) What is the equilibrium level of income?

Equilibrium income is the income level you will find when Y equal PE
Y = PE
Y=C+I+G
Y = 120 + 0.8(Y – T) + 200 + 400
Given taxes is 400,
Y = 120 + 0.8(Y – 400) + 200 + 400
Y = 720 + 0.8Y – 320
0.2Y = 400
Y = 2,000

c) If government purchases increase to 420, what is the new equilibrium income?

What is the multiplier for government purchases?
If government purchases increase to 420,
Y = 120 + 0.8(Y – 400) + 200 + 420
Y = 740 + 0.8Y – 320
 0.2Y = 420
Y = 2,100

Government purchases multiplier = 1 / (1 – MPC) = 1 / (1 – 0.8) = 5

Conclusion
ΔG is 20, but ΔY is 100. ΔG < ΔY is because of the multiplier effect.

d) What level of government purchases is needed to achieve an income of 2,400? (Taxes

remain at 400.)
To achieve an income of 2,400,
2,400 = 120 + 0.8(2,400 – 400) + 200 + G
2,080 = 1,600 + G
480 = G
OR
Government purchases multiplier = 1 / (1 – MPC)
= 1 / (1 – 0.8)
=5
ΔY = 2,400 – 2,000 = 400

To achieve an income of 2,400,

ΔY = ΔG x m
400 = ΔG x 5
80 = ΔG
 Government purchases has to increase by 80.

e) What level of taxes is needed to achieve an income of 2,400? (Government purchases

remain at 400.)
Tax multiplier = [– MPC / (1 – MPC)]
= [– 0.8 / (1 – 0.8)]
=–4

To achieve an income of 2,400,

ΔY = ΔT x m
400 = ΔT x – 4
– 100 = ΔT
 Taxes has to decrease by 100. (tax cut)

Conclusion:
To increase Y, taxes must fall.
P6. The following equations describe an economy.

a) Identify each of the variables and briefly explain their meaning.

Y=C+I+G
Money demand is a function of income, Y and interest. Thus, (M/P)d means demand side.
P = 4, means the price level.
b) From the above list, use the relevant set of equations to derive the IS curve. Graph
the IS curve on an appropriately labelled graph.
IS: Y = C + I + G
Y = 50 + 0.75(Y – T) + (150 – 10r) + 250
Given tax = 200,
Y = 50 + 0.75(Y – 200) + (150 – 10r) + 250
Y = 450 + 0.75Y – 150 – 10r
0.25Y = 300 – 10r
Y = 1,200 – 40r

c) From the above list, use the relevant set of equations to derive the LM curve. Graph
the LM curve on the same graph you used in part (b).
(M / P)d = (M / P)s
Y – 50r = 3,000 / 4
Y – 50r = 750
LM: Y = 750 + 50r

Graph of IS-LM curve

d) What is the equilibrium level of income and the equilibrium interest rate?
IS = LM
1,200 – 40r = 750 + 50r
450 = 90r
5=r

When r = 5,
Y = 1,200 – 40(5)
Y = 1,000