Question

IV. a. Derive the IS curve graphically by using the appropriate graphs that are appropriately linked up, and by explaining clearly what you are doing and why.

      b. Use the graph for the IS-LM model (in i-Y space only) with the original eqm Y being full employment (that is, Y_FE) to show what will happen if President Trump enacts (another) tax cut. What is the name for this type of policy? What type of gap will exist, if any? What will happen to all the components of the goods and money markets?

Answer 1

a) Derivation of LM: Money demand is constant in the economy at Ms level. When money demand rises from Md to Md1, it cause interest rate to rise as banks have the opportunity to charge high interest rate while genuine buyers also willing to pay higher rate of interest. As money demand rises to Md2, rate of interest will rise further. When money demand rises, aggregate output rises as people will consume goods with that money which will raise the circulation of money in the economy and raises the GDP.  It derives the LM curve which says that when money demand rises, rate of interest rises with the level of output.

Derivation of IS curve: When money supply shifts left from LM to LM1, there would be less money in the market causing less circulation of money in the market which will raise the prices and less output would be traded causing output to shift leftward and prices to shift upward. When LM curve shifts further, prices rises further and output went down causing IS curve to downward sloping.

b) Effect of tax cut: Due to tax cut, people will get hike in their disposable income which will induce them to consume more goods and cause aggregate demand curve to shift right. A shift in aggregate demand to its right will shift IS curve to its right raising the level of GDP and interest rate. It will raise the output level from Y to Y1. It is the form of expansionary fiscal policy which raises the level of output. If output is at its natural level at Y, then output at Y1 level causes recessionary gap in the economy equal to Y1 - Y. Employment level will rise as more people are needed to produce more goods. Savings rate will raises due to the rise in rate of interest while investment level would fall with the rise in rate of interest.