Question

The following equations describe a small open economy.

[Figures are in millions of dollars; interest rate (i) is in percent]. Assume that the price level is fixed.

Goods Market                                    Money Market

C = 250 + 0.8YD                                      L = 0.25Y – 62.5i

YD = Y + TR – T                                      Ms/P = 250

T = 100 + 0.25Y

I = 300 – 50i

G = 350; TR = 150

Goods market equilibrium condition: Y = C + I + G + X-M

Money market equilibrium condition: L = Ms/P

a) What is the equation that describes the IS curve (Y_IS)?

b) What is the equation describing the LM curve (Y_LM)?

c) What are the equilibrium levels of income (Y_o) and interest rate (i_o)?

d) Suppose Government reduces the marginal tax rate (t) from 25%

(as given in the model) to 15%.

i) Calculate the change in the level of income (Y) and interest rate (i) that results from this fiscal expansion whilst nominal money supply remains the same.

ii) Calculate the magnitude of crowding out that will result from the above fiscal

expansion.

e) If you were your Reserve Bank advisor, what would you recommend the Reserve Bank to do to keep the interest rate constant?

f) Show the impact of the above d) and e) on the IS-LM framework. Would the IS curve now relatively flatter or steeper and why?

Answer 1

Crowding out occurs when with increase in interest rates leads to fall in investments. ​​​​​​