Question

5. In the Keynesian-cross analysis, assume that the analysis of taxes is changed so that taxes, T, are made a function of income, as in T=T + tY, where T and t are parameters of the tax code and t is positive but less than 1. As compared to a case where t is zero, the multiplier for government purchases in this case will: A) not change. B) be smaller. C) be bigger. D) be equal to 1. 6. Exhibit: Policy Interaction Interest rate, r Y Y Y Y4 Income, Output, Y Based on the graph, starting from equilibrium at interest rate r3, income Y2, IS1, and LM1, if there is an increase in government spending that shifts the IS curve to IS2, then in order to keep output constant, the Federal Reserve should _ _the money supply, shifting to A) increase; LM2 B) decrease; LM2 C) increase; LM3 D) decrease; LM3

Answer 1

Answer

5)

The correct answer is (B) be smaller.

According to Keynesian cross Model Equilibrium occurs when Y = AE and AE = C + I + G

where Y = Aggregate real output, , AE = Aggregate expenditure, C = Consumption = Co + c(Y - T) = Co + c(Y - (To + tY)), I = investment and is autonomous, G = Government spending and is also autonomous. To = Autonomous tax, t = Tax rate

Thus At equilibrium Y = AE => Y = C + I + G => Y = Co + c(Y - (To + tY)) + I + G

=> Y - cY +tcY = Co - cTo + I + G

=> Y(1 - c + tc) = Co - cTo + I + G

=> Y = [1/(1 - c + tc)][Co - cTo + I + G]

Here Multiplier(m) = [1/(1 - c + tc)]

If t = 0 them multiplier = 1/(1 - c) and If 1 > t > 0 then multiplier = 1/(1 - c +tc). As, 1/(1 - c +tc) < 1/(1 - c) thus multiplier when t( = 0) > multiplier when t is positive and lesser than 1.

Thus, multiplier will decrease.

Hence the correct answer is (B) be smaller.

6)

The correct answer is (D) decrease; LM₃

Equilibrium occurs when IS and LM curve intersects. Initially Real Output = Y₂ i.e. point where IS₁ and LM₁ intersects. Now IS curve shifts to the right from IS₁ to IS₂. Now we have output to be same as Y₂. We have to find LM curve where New IS intersects LM curve when Y = Y₂.

We can see from above graph that LM curve at which IS₂ intersects LM curve at Real output = Y₂ is LM₃.

That is we want LM curve to shift leftward from LM₁ to LM₃. LM curve shifts to the left when Money supply decreases. Thus federal bank should decrease Money supply if they wants output to be at Y₂.

Hence the correct answer is (D) decrease; LM₃