Question

Calculate the government purchases multiplier for the full IS-LM model:  

Consumption Function: C = 200 + .5(Y-T)

Investment Function:

I = 1000 - 200r

M/P = Y - 400r

G = T = 400 ; M = 1200 ; P = 1

a.Write the simplified IS equation and the simplified LM equation.

b.Solve for the equilibrium level of output and the interest rate.

c.Government spending increases from 400 to 600. Solve for the equilibrium level of output and the interest rate.

d.Calculate the government purchases multiplier for the full IS-LM model: (). Is this multiplier larger or smaller than the multiplier from the Keynesian cross (which uses the MPC)? Explain the differences between these models. Explain why the models give different results.

Answer 1

  

The government purchases multiplier calculated for the full IS-LM model requires the amount of change in government purchases and the corresponding change in output. However the multiplier from Keynesian cross only requires the marginal propensity to consume(MPC) from the consumption function.

The model of multiplier estimation using first method is based on two equilibrium points, while the second model of estimation using MPC doesn't need equilibrium points.

The two models give different results because, the first model only accounts for the immediate effect of change in government purchases on the aggregate demand. While the second model also accounts for the subsequent series of rise in income and consumer spending from the initial increase in aggregate demand.