1.Use the IS-LM model to predict the effects of the following cases on the equilibrium income Y and the interest rate r. Show your answer on a graph and explain briefly the reason behind the shift in any of the curves, and movement along in any of the curves. Explain what happens in the goods&services market and the money market; all in the short run. Model you answer after the textbook discussion in chapter 12
a. Increase in government spending
b. Increase in money supply
c. Increase in taxes
d. Stock market boom
2. Using the Keynesian cross model describe in words how the multiplier process work and why an increase in government spending could drive the economy out of recession. Make also use of graphs of the Keynesian cross and AD-AS model to show the recession and then the effect of the increase of government spending.
3. If we describe the phases the US economy took since 2008 as: A) Recession and decline in private spending,2008, B) fiscal and monetary stimulus, 2009-2012. C)Gov spending cut 2013 d) private spending boom, accompanied with contractor monetary policy.
Us IS-LM and AD-AS short run analysis for each phase. Also, assume a flat SRAS, as we had very low inflation and the economy was operating under its full capacity. and mark the full employment level of output in each graph.
4. What are the main hypotheses that explain the Great Depression? Use IS-LM and AD-AS models in your answer and elaborate on the contrast between Pigou = the Real Balance effect and the debt-deflation effect. Which effect would call for active fiscal policy and which effect would be against it? Why?
5. Solve Problem 2 chapter 11 and Problem 4 from Chapter 12.
The pictures of the question are in the final review folder in canvas
Solutions to the Quantitative Problems:
Problem 2 chapter 11
2. a. Total planned expenditure is
PE = C(Y – T) + I + G.
Plugging in the consumption function and the values for investment I, government purchases G, and taxes T given in the question, total planned expenditure PE is
PE = 120 + 0.80(Y – 400) + 200 + 400
= 0.80Y + 400.
This equation is graphed in Figure 11-8.
b. To find the equilibrium level of income, combine the planned-expenditure equation derived in part (a) with the equilibrium condition Y = PE:
Y = 0.80Y + 400
Y = 2,000.
The equilibrium level of income is 2,000, as indicated in Figure 11-8.
c. If government purchases increase to 420, then planned expenditure changes to PE = 0.80Y + 420. Equilibrium income increases to Y = 2,100. Therefore, an increase in government purchases of 20 (i.e., 420 – 400 = 20) increases income by 100. This is what we expect to find, because the formula for the government-purchases multiplier is 1/(1 – MPC), the MPC is 0.80, and the government-purchases multiplier therefore has a numerical value of 5.
d. An income level of 2,400 represents an increase of 400 over the original level of income. The government-purchases multiplier is 1/(1 – MPC): the MPC in this example equals 0.80, so the government-purchases multiplier is 5. This means that government purchases must increase by 80 (to a level of 480) for income to increase by 400.
e. An income level of 2,400 represents an increase of 400 over the original level of income. The tax multiplier is –MPC/(1 – MPC): the MPC in this example equals 0.80, so the tax multiplier is 4. This means that taxes must decrease by 100 (to a level of 300) for income to increase by 400.
Problem 4 from Chapter 12
4. a. The IS curve is given by:
Y = C(Y – T) + I(r) + G.
We can plug in the consumption and investment functions and values for G and T as given in the question and then rearrange to solve for the IS curve for this economy:
Y = 500 + 0.75(Y – 1,000) + 1,000 – 50r + 1,000
Y – 0.75Y = 1,750 – 50r
(1 – 0.75)Y = 1,750 – 50r
Y = (1/0.25) (1,750 – 50r)
Y = 7,000 – 200r.
The LM curve is determined by equating the demand for and supply of real money balances. The supply of real balances is 6,000/2 = 3,000. Setting this equal to money demand, we find:
3,000 = Y – 200r.
Y = 3,000 + 200r.
Equating the IS and LM equations, we can solve for r:
7,000 – 200r = 3,000 + 200r
4,000 = 400r
r = 10.
Now that we know r, we can solve for Y by substituting it into either the IS or the LM equation. We find:
Y = 5,000.
Therefore, the equilibrium interest rate is 10 percent and the equilibrium level of output is 5,000. This is labeled as point a in Figure 12-17 in part e below.
b. If taxes fall by 20% then taxes are now equal to 800 and we can recalculate the IS curve equation:
Y = 500 + 0.75(Y – 800) + 1,000 – 50r + 1,000
Y – 0.75Y = 1,900 – 50r
(1 – 0.75)Y = 1,900 – 50r
Y = (1/0.25) (1,900 – 50r)
Y = 7,600 – 200r.
Equating the new IS and old LM equations, we can solve for r:
7,600 – 200r = 3,000 + 200r
4,600 = 400r
r = 11.5.
Now that we know r, we can solve for Y by substituting it into either the IS or the LM equation. We find:
Y = 5,300.
Therefore, the equilibrium interest rate is 11.5 percent and the equilibrium level of output is 5,300. The decrease in taxes will shift the IS curve to the right. The new equilibrium point is labeled as point b in Figure 12-17 in part e below. The tax multiplier measures the change in equilibrium output divided by the change in taxes, or 300/-200 = -1.5.
c. To find the value of the money supply that will keep the interest rate at the original level of 10 percent after the tax cut, rewrite the LM curve equation so that it is a function of M:
M/2 = Y – 200r
Y = M/2 + 200r.
Now we can equate this new equation for the LM curve with the new IS curve, plug in the value of 10 for the interest rate r and solve for the money supply M:
7,600 – 200r = M/2 + 200r
7,600 – 200(10) = M/2 + 200(10)
M = 7,200.
If the money supply has a value of 7,200 then the level of output is 5,600. The increase in the money supply will shift the LM curve to the right. This new equilibrium point is illustrated as point c in Figure 12-17 in part e below. The tax multiplier measures the change in equilibrium output divided by the change in taxes, or 600/-200 = -3.
d. To find the value of the money supply that will keep output at the original level of 5,000 after the tax cut, rewrite the LM curve equation so that it is a function of M, and solve for r:
M/2 = Y – 200r
200r = Y – M/2
r = Y/200 – M/400.
Rewrite the IS curve equation so that r is defined as a function of Y:
Y = 7,600 – 200r
200r = 7,600 – Y
r = 7,600/200 – Y/200.
Now we can equate these new equations for the IS and LM curves, plug in the value of 5,000 for the level of output Y and solve for the money supply M:
7,600/200 – Y/200 = Y/200 – M/400
7,600 – Y = Y – M/2
M = 4,800.
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If the money supply has a value of 4,800 then the level of the interest rate is 13. The decrease in the money supply will shift the LM curve to the left. This new equilibrium point is illustrated as point d in Figure 12-17 in part e below. The tax multiplier measures the change in equilibrium output divided by the change in taxes, or 0/-200 = 0.
Note that this problem could have been solved in a different way. From the IS curve equation, if you know Y is equal to 5,000 then you can solve for the interest rate r. You can then plug these values for output and the interest rate into the LM curve equation and solve for the money supply M.
e. The four equilibrium points are illustrated in Figure 12-17.
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