Economics 4023

Midterm 2021, Part 2

Question #2

a) Derive the slope of the AD equation implied by the following IS-LM model.
Y = C[Y] + I [ i, Y] + G
M/P = L [ i, Y]

Answer:

Y = C[Y] + I [ i, Y] + G

M/P = L [ i, Y]

⇨ M = P*L [ i, Y]

The total differential is:

dY = CY dY + Ii di + dG

dM = L.dP + P. Li di + P.LY dY

On any given AD, dG = dM = 0

Now,

dY = CY dY + Ii di + 0

⇨ dY - CY dY = Ii di
⇨ {1-CY} dY - Ii di = 0

0 = L.dP + P. Li di + P.LY dY

⇨ P.LY dY + P. Li di = - L.dP

Using matrices, we have:

[ 1−C Y −I i LY Li ] [ dY di ] =[ 0−L ][ dP ]
Note: M = P. L(i ,Y) implies L(i ,Y) = M/P; replace ‘L’ with ‘M/P’

Using Cramer’s Rule, we will find dY/dP

dY
dP
∨¿ AD ¿ =
−
M
( )
P i
I

( 1−C Y ) Li + LY I i
Slope of AD,

( 1−C Y ) Li + LY I i
dP
∨¿ AD ¿=
dY − ( MP ) I i

Question #3

Consider the slope and shifts of the following IS curve.

Y = C[(1-t)Y] + I[ i, Y ] + G
a) Derive its slope.
b) Assuming that the IS is upward sloping, show how a change in G shifts the IS line,
assuming dY=0 (a vertical slice). Draw a diagram to illustrate your result.
c) Assuming that the IS is upward sloping, show how a change in G shifts the IS line,
assuming di=0 (a horizontal slice). Draw a diagram to illustrate your result.

Answer:

(a) Y = C[(1-t)Y] + I[ i, Y ] + G

Totally differentiate the IS curve –

dY = CY (1-t) dY – YCY dt + Ii di + IY dY + dG

Along a given IS, dt = dG = 0.

So, we have:

dY = CY (1-t) dY + Ii di + IY dY

⇨ dY – CY (1-t) dY – IY dY = Ii di
⇨ dY {1- CY (1-t) - IY } = Ii di
⇨ Ii di = dY {1- CY (1-t) - IY }

The slope of IS ,

di
∨¿ IS ¿=
{1−C Y ( 1−t ) – I Y }
dY Ii
(b) Here, G denotes Government expenditure. A change in G shifts the IS curve instant as
output of economy rise. [dY = 0]

Here,

Y = C[(1-t)Y] + I[ i, Y ] + G

Totally differentiate the IS curve –

dY = CY (1-t) dY – YCY dt + Ii di + IY dY + dG

⇨ dY = CY (1-t) dY + Ii di + IY dY + dG [dt = 0]
⇨ 0 = 0 + Ii di + 0 + dG [ vertical shift dY = 0]
1
⇨ di / dG = - I > 0
i

Due to gradually change in G, Y changes and i changes. Hence IS curve shifts.

(c) A change in G inputs IS curve algebraically differentiating.

Y = C[(1-t)Y] + I[ i, Y ] + G

⇨ dY = CY (1-t) dY – YCY dt + Ii di + IY dY + dG
⇨ dY = CY (1-t) dY – 0 + Ii di + IY dY + dG [dt = 0]
⇨ dY = CY (1-t) dY + 0 + IY dY + dG [ horizontal shift di = 0]
⇨ dY – CY (1-t) dY + IY dY = dG
⇨ { 1 – CY (1-t) – IY } dY = dG
1
⇨ dY / dG = 1 – C ( 1−t ) – I < 0
{ Y Y}

Graphically,
Due to change in G, i remains same but Y changes. Hence IS curve shifts.

Question #1

Consider the following IS-LM model that incorporates an accelerator effect.

Y = C[Y] + I[ i, Y ] + G
M = L[ i , Y ]
a) Derive dY/dG and show that its sign is ambiguous.
b) Appeal to the correspondence principle assuming that the money market continuously and
instantaneously clears. Sign the dY/dG multiplier.
HINT: eliminate ‘dr’ from the IS using the LM equation. Now you have one equation, use the
same approach to the correspondence principle as that used analyzing stability in the AE
model.

Answer:

Here,

Y = C[Y] + I[ i, Y ] + G
M = L[ i , Y ]
The total differential is:

dY = CY dY + Ii di + IY dY + dG

⇨ dY - CY dY – Ii di – IY dY = dG
⇨ {1 – CY – IY } dY – Ii di = dG
dM = Li di + LY dY

⇨ LY dY + Li di = dM

Using matrices, we have:

[ 1−C Y −I Y −I i LY Li ] [ dY di ] =[ 1 0 ][ dG ] + [ 0 1 ][ dM ]
This coefficient has an ambiguous sign.

Using Cramer's Rule we find that:

| A* | = Li {1 – CY – IY} + Ii LY

dY |1−I i 0 Li| Li Li
dG =
|A |
¿ = |A¿| = Li { 1−C Y −I Y }+ I i LY

(b) Here,

Y = C[Y] + I[ i, Y ] + G
The total differential is:

dY = CY dY + Ii di + IY dY + dG

⇨ dY - CY dY – Ii di – IY dY = dG
⇨ {1 – CY – IY } dY = dG [di = 0]

dY 1
dG = {1−C Y −I Y } < 0