Question

IS Data:

AD = C+I+G C = $210 + 0.9YD G = $300 I = $400 – 48i

YD = Y–TA+TR TR = $100 TA = 0.33Y

[Note, round the AD slope to one decimal]

LM Data: L = Md/P = 5Y – 150i Ms/P = $8,750

If Government uses fiscal policy to increase spending from $300 to $420; find the new equilibrium values for i and Y

Answer 1

We have following information

Consumption = 210 + 0.9YD, where YD is disposable income

Government expenditure = 300

Investment = 400 – 48i where i is interest rate

Y = (210 + 0.9YD) + 300 + (400 – 48i)

Y = (210 + 0.9YD) + 300 + (400 – 48i)

Y = [210 + 0.9(Y – TA + TR)] + 300 + (400 – 48i)

Y = [210 + 0.9(Y – 0.33Y + 100)] + 300 + (400 – 48i)

Y = [210 + 0.9(0.67Y + 100)] + 300 + (400 – 48i)

Y = 210 + 0.603Y + 90 + 300 + 400 – 48i

Y – 0.603Y = 210 + 90 + 300 + 400 – 48i

0.397Y = 1000 – 48i

i = 20.8 – 0.0083Y, equation for IS Curve

We have

Demand for money: Md/P = 5Y – 150i

Supply of money: Ms/P = 8750

Equating demand and supply

5Y – 150i = 8750

150i = – 8750 + 5Y

i = – 58.3 + 0.033Y, equation for LM Curve

Equating IS and LM Curve equations

20.8 – 0.0083Y = – 58.3 + 0.033Y

79.1 = 0.0413Y

Y = $1,915.25

i = – 58.3 + 0.033Y

i = – 58.3 + (0.033 × 1915.25)

i = 4.9%

Now, it is given that Government expenditure has increased from $300 to $420

0.397Y = 1120 – 48i

i = 23.3 – 0.0083Y, equation for IS Curve

LM equation will remain the same

Equating the new IS equation with the LM equation

23.3 – 0.0083Y = – 58.3 + 0.033Y

Y = $1,976.6

i = – 58.3 + 0.033Y

i = – 58.3 + (0.033 × 1976.6)

i = 6.9%