Question

In: Economics

Goods Market:  C=50 + 0.8(Y-T) Money Market: M/P=490 I=120-400r L(r,y)=.5y-100r G=110 T=50 a. What are the IS...

Goods Market:  C=50 + 0.8(Y-T) Money Market: M/P=490 I=120-400r L(r,y)=.5y-100r G=110 T=50

a. What are the IS and LM equations? Calculate and show graphically the equilibrium output and interest rates?

b. Suppose there is an increased risk in the financial markets changing money demand by 50 units (add or subtract 50 from money demand). Calculate the SR and LR.

c. If the Federal Reserve wanted to stabilize the economy while at the SR equilibrium what policy would they need to conduct? Show this graphically and calculate how large of a policy they would need to conduct.

d. If the Government wanted to stabilize the economy while at the SR equilibrium what three policies could they conduct? Show this graphically and calculate how large of each of the policies would need to be. How different are these policies from what would have been suggested from the Fiscal Multipliers that were learned in introduction to macro?

Solutions

Expert Solution

c) The decision variables available to the government are money supply M (they can release more money into the economy), government expenditure G (government funded projects to boost aggregate demand) and Taxation.

Of the three, Taxation has no effect on Output or Interest rate. Fiscal policy impacts both output and interest rate. Monetary policy impacts output but not interest rate.

The key priority in the case of output contraction from a fall in the money supply is to stabilize the output.

We see here that the investment function is very sensitive to the interest rate i.e. the IS curve . A large sensitivity of investment to interest rate will mean that more of the expansionary effect of an increase in government spending will be offset by an interest-rate induced decline in investment. This makes pure fiscal policy strategically unviable in this case.

Monetary policy is more effective the higher the interest elasticity of investment and thus the flatter the IS schedule. But we see the interest elasticity of money demand is also very high, which would suggest the efficacy of fiscal policy.

Within a Keynsian framework there is a preference for a policy mix of relatively tight fiscal policy and easy monetary policy to keep the interest rate low and encourage investmenet. Moreover, whenever fiscal policy actions are used to expand the economy, the Keynsians would like to see an accomodating monetary policy - an accompanying increase in the money supply that will prevent the interest rate from rising and thus prevent the crowding out of investment.

Fiscal multipliers have three additional parameters.


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