Question

Suppose that the demand for real money balances depends on disposable income. That is, the money demand function is M/P = (Y-T) - k(r+Eπ). Using the IS-LM model, discuss whether this change in the money demand function alters the following:

a. The analysis of changes in government purchases.

b. The analysis of changes in taxes.

Answer 1

ANSWER:

GIVEN THAT:

THE DEMAND FOR REAL MONEY BALANCES DEPENDS ON DISPOSABLE INCOME:

A. THE ANALYSIS OF CHANGES IN GOVERNMENT:

1. This is known as the Pigou effect as it shows the effect of disposable income on real money balances. 2. Now with an increase government spending, the extent of the crowding out will be lower as now disposable income is a argument in the money demand function.

3. As government spending increases, the impact on interest rates is less and so the crowding out effect on invesment is less and so the extent of the increase in output is more due to the money demand function change.

B. THE ANALYSIS OF CHANGES IN TAXES:

1. A change in taxes will now mean that an expansionery fiscal policy through a cut in taxes will now also have an impact on the demand for real money balances.

2. As disposable income is now a argument of the demand for real money balances function, a increase in disposable income will mean an increase in the demand for real money balances.

3. This will cause the LM curve to shift rightwards and cause a fall in the interest rates and the increase in output.

4. A change in fiscal policy will now effect the LM curve as well through the impact of disposable income.