Question

Suppose Congress decides to increase government spending and taxes by equal amounts. Use the IS-LM AD-SRAS-LRAS model to illustrate graphically the short run impact of the increase in government spending and taxes on output and interest rates, prices, consumption, unemployment rate and investment in short run. Explain clearly which curve would shift and why. What will be the long run impact of this increase in government spending and taxes on output and interest rates, prices, consumption, unemployment rate and investment. Show the appropriate movement of curves both for the short run and the long run. Be sure to label: i. the axes; ii. the curves; iii. The initial equilibrium values; iv. The direction the curves shift; and v. the short run equilibrium values and vi. The long run equilibrium values.

How can the Fed keep the economy from falling into a recession/boom due to the increase in government spending and taxes? Use a second IS-LM-SRAS-LRAS model to illustrate graphically the impact of both fiscal policy of increase in government spending and taxes and the monetary policy which prevents output from falling/rising. Be sure to label: i. the axes; ii. the curves; iii. The initial equilibrium values; iv. The direction the curves shift; and v. the terminal equilibrium values.

Use the Mundell-Fleming model (draw the appropriate graphs and show on the graphs as well) to predict what would happen to aggregate income, the exchange rate, and the trade balance under both floating and fixed exchange rates in response to the shock of a sudden decrease in exports in a small open economy.

Answer 1

The IS curve will be shift. The reason is stock market crash in exogenous in consumption.Such consumption is considered autonomous of income only when expenditure on these consumables does not vary with changes in income; generally, it may be required to fund necessities and debt obligations. If income levels are actually zero, this consumption counts as dissaving, because it is financed by borrowing or using up savings. Autonomous consumption contrasts with induced consumption. It will drop in investment,“correction” after overbuilding in the previous. widespread bank failures made it harder to obtain financing for investment. Contractionary fiscal policy,Politicians raised tax rates and cut spending to combat increasing deficits.

The Mundell-Fleming Model (MFM) describes the workings of a small economy open to international trade in goods and financial assets, and provides a framework for monetary and fiscal policy analysis.The basic framework is a static, non-microfounded model extending the Keynesian IS-LM model. Indeed, the MFM shares with the IS-LM model the philosophical and methodological approach, and the basic features: the model is linear and the main assumption is that consumer prices are fixed. As a matter of fact, the MFM nests the IS-LM model as a special case, for a particular parameterisation.
The starting point of the IS-LM model, which describes a closed economy, is the income identity, which requires the equality between the overall output of the economy and the sum of absorption channels: private consumption (C), private investment (I) and public spending (G):
Y=C+I+G

The money supply, in its baseline formulation, is instead exogenous and under the direct control of the Central Bank, and is therefore the monetary policy instrument (Ms =M°). Therefore, equilibrium in the external sector requires i = i*.
The general equilibrium is achieved when all markets clear at the same time. In the context of the MFM, this requires a triple of output, interest and exchange rates at which all equilibrium conditions are satisfied. From an analytical perspective, the solution to the model depends on the specific exchange-rate regime. With flexible exchange rates, the system can be solved recursively: equilibrium in the external sector determines the domestic interest rate (i =i*, and therefore the position of the BB curve), equilibrium in the money market determines the level of output Y°, given the equilibrium domestic interest rate (from the intersection of LM and BB), and finally the equilibrium in the goods market, given the levels of output and interest rate found earlier, implies the equilibrium level of the exchange rate (and therefore the position of the IS schedule that ensures a unique intersection among the BB, IS and LM curves).