Question

You are given the following information about an economy(interest rate is measured in percentage points). A five percent interest is r = 5.

1. You are given the following information about an economy (note: the interest rate is measured in percentage points. A five percent interest is r5): (M/P) = 100 (M/P)"=0.2 Y - 10 C = 150+ 0.667 YD-10 I=200 - 10r + 0.1 Y G=200 NX = 50 | T = 0.25 Y YD = Y-T A. (i) Derive the IS equation (solve for r-interest rate). Graph the curve. (Do not worry if the slope seems small. This is because a one percentage point change in r will be associated with a large change in Y in dollars.) (ii) Derive and graph the LM curve (again, solve for r). (iii) Calculate the equilibrium income and interest rate. Illustrate graphically. (iv) Calculate Consumption and Investment at the equilibrium point. (v) Calculate the fiscal budget surplus. B. Suppose government spending rises to G = 400 (change of 200). (i) Calculate the new IS and LM curves. (ii) Calculate the new equilibrium GDP and interest rate. (iii) Illustrate graphically on the same graph as in Part A) (iv) What is the change in Y? What is the change in G? What is the government spending multiplier, AY/AG? Is this different than the multiplier in the simple Keynesian model (with proportional taxes but without interest rates)? Explain why. (v) Calculate Investment at the new equilibrium. Does investment rise or decline? Explain why. Is it possible for Investment to move in the opposite direction? (vi) What is the new fiscal budget surplus? Why did the budget change less than the $200 change in government spending? C. Suppose instead of an increase in G, money supply is increased to (M/P)' = 200 (change is 100) Use G =200 as in part A. (i) Calculate the new IS and LM curves. (ii) Calculate the new equilibrium Y and r and show graphically include the original IS & LM curves from Part A to illustrate which curve has shifted). (iii) Calculate Investment at the new equilibrium. Explain why it changes from Part A. (iv) What happens to the fiscal surplus? Explain why it changes. D) Increasing G and increasing M/P have similar effects on Y. In what way do they have different effects? How will this affect the composition of output (C, 1, G)?

Answer 1

IS curve shows goods market equilibrium and is obtained by equating Y to AD.

LM curve shows money market equilibrium and is shown by equating money supply to money demand.

Fiscal budget Surplus is government revenue minus government expenditure.

1 is Equation : AD, C+ It G+ NX = 150+ 0.66740-10% + 200 -10+0.14 +200 + 50 . 600 + 0.667 (4-6.954) - 9091 oly 600 + 0.54 +0.14 - 2011 AD = 600 +0.64 - 204 Equilibruiny . AD 3 Y: 600 +0.64 - 204 5) 0.4y = 600 - 204 14 = 1500 - 500 Equation for is curue Plothing the is cwme : ra 9 1500 30 10 is come 500 1000 1500 1) LM equation : At money market Equilibrium ; (mpje (mp) 100.= 0.24 - 109 0.24 = 100 + 100 Y = 500 + Som Рpng cm щеш, я, Y 10 1 500 1 1000 010 110 um um y 500 000 1500

" At Equilibrium both Goods and money market curve it. Is and Im wrue inter sect we can find equilibrium Y and r in Following manness: put value of from im into is wrue equation : . Soot 50% = 1500 - 5097 100.94 1000 91: 10 and y: Soo +SOCIO) - Soot soo - 1000 This can be seen graphically : in curu olsuwwe iv 500 1000 1500 2000 2500 At Equivbrium Ytooo, 9=10 Cs ISD + 0.667(4-0.254) -109 C: 150+ 0.54 - 109 = 150 +0.5C1000) - 10(10) i iso + 500 – 100 ; 550 C= 550 At Equilibrium I= 200-109 + oily • 200 - rollo) + 0.1(1000) = 200-100+ 100 : 200 Fiscal Budget surplus! T-G: T: 0.254 = 0.95(1000) = 15x1000 = 250 G = 200 4 T-G = 250 - 200 - 50.