Consider a closed economy where firms fear that sales will soon decline and therefore reduce investment...

Consider a closed economy where firms fear that sales will soon decline and therefore reduce investment (demand shock), although they are not currently facing lower than usual sales and there have been no changes in the interest rate.

A) Use the linear specification of the IS-LM model and its graphical representation to explain what is the effect of the demand shock on the equilibrium level of output assuming that the central bank does not change the monetary policy following the shock.

B) How would your answer change assuming, instead, that the central bank takes monetary policy decisions to avoid changes in the level of output following the shock?

Expert Solution

Part 1) Let us assume that the economy is currently operating at point E with output level of Y1 and interest rate of r1. Now, it is given that firms have reduced investment. This acts like an exogenous event which will shift the IS curve downward from IS1 to IS2. As a result, the income level will decline to Y2 and interest rate will decline to r2.

Part 2) Now, it is given that the Central Bank uses monetary policy measure to avoid changes in the level of output following the decline in the investment. So, the Central Bank can increase the money supply to achieve this objective. An increase in the money supply shifts the LM curve downward from LM1 to LM2. For a given level of income an increase in the money supply will result in people increasing their speculative balances. As a result, the price of bonds will increase while their yield (interest rate) will fall.

So, while the output level will again reach the initial level of Y1, the interest rate will further decline to r3.

Rahul Sunny answered 1 year ago

In a closed economy Keynesian Cross framework show how a decline in investment will lead to...

In a closed economy Keynesian Cross framework show how a decline in investment will lead to a fall in income. Explain the role of the consumption function and the multiplier in this process.

Question 2 Consider a small closed economy. The government wants to reduce the budget deficit by...

Question 2 Consider a small closed economy. The government wants to reduce the budget deficit by reducing its spending. a. Use the goods market and IS curve to illustrate graphically the impact of the reduction in government spending on output. b. Now use the goods market and money market diagrams and the IS-LM model to illustrate graphically the impact of the reduction in government spending on output c. Why the effect of the reduction in government spending on output is...

Consider a closed economy income-expenditure model of the economy where the country begins in a long-run...

Consider a closed economy income-expenditure model of the economy where the country begins in a long-run equilibrium. • Investment (I) and government spending (G) are ﬁxed: I = 41.5, G = 26. • The income tax rate is t = 6.25%, so tax revenue equals T = tY . • The consumption function is C = 12 + 0.8Yd, where Yd = (1 − t)Y . For the calculations below, write your answers as either a fraction or to two...

Consider a closed economy where aggregate expenditure is AE = C + I + G. Government...

Consider a closed economy where aggregate expenditure is AE = C + I + G. Government purchases (G) is a constant, which do not vary with output level (Y). Consumption (C) is an increasing function of disposable income YD: C = a + bYD. In this economy, we have lump sum tax only; YD = Y –T. Investment is an increasing function of Y: I = k + iY. 1. The equilibrium condition is Y = AE. Solve for the...

Consider a closed economy, where the marginal propensity to consume is 0:9. What would be the...

Consider a closed economy, where the marginal propensity to consume is 0:9. What would be the e§ect on private, public and national saving of a $10 million decrease in both taxes and government spending? Would the equilibrium real interest rate increase, decrease, or stay the same?

Consider a closed economy (no international trade) under a simple Keynesian model. Assume investment is a...

Consider a closed economy (no international trade) under a simple Keynesian model. Assume investment is a constant. Tax is a lump-sum that does not depend on income. If a government increases its expenditure by $1 but at the same time increases the lump-sum tax by $1. Will real output be increased or decreased, and by how much?

Consider a closed economy with a fixed price: Consumption function: ? = 1+(3/4)(? − ?) Investment...

Consider a closed economy with a fixed price: Consumption function: ? = 1+(3/4)(? − ?) Investment function: ? = 10 Money demand function: (M/P) = ? − 2? Tax and government spending: ? = ? = 12 Money supply: ? = 500 Where C is consumption, Y is production, I is investment, ? is real interest rate expressed in percent, ? is tax, ? is government spending, ? is money supply. The price level of this economy is fixed at...

Consider the closed economy Classical model depicted below, where consumption depends positively on disposable income and...

Consider the closed economy Classical model depicted below, where consumption depends positively on disposable income and negatively on the real interest rate. 1) Suppose the government decides to reduce the overall level of taxes. What happens to public savings (Spublic), private savings (Sprivate), and total savings (S)?. 2) ) According to the Classical model, what are the long-run implications of the above change on the real interest rate (r), output (Y), and the expenditure components of output consumption (C), investment...

Consider the real intertemporal model with investment (closed economy). a. Using multiple related diagrams, show how...

Consider the real intertemporal model with investment (closed economy). a. Using multiple related diagrams, show how the labor market, production function, output supply, output demand, and interest rate all relate. b. Explain what influences the labor market, production function, output supply, output demand, and interest rate and how they relate

Consider the following closed Keynesian economy: Desired consumption and investment are given by: Cd = 200+0.8(Y...

Consider the following closed Keynesian economy: Desired consumption and investment are given by: Cd = 200+0.8(Y −T)−500r Id = 200 − 500r. Taxes and government expenditures are given by The real money demand is T = 20+0.25Y G = G=196. Md P = 0.5Y − 250(r + πe). The money supply M = 9890 and the expected inflation πe = 0.10. (a) Derive the equations for the IS and LM curves and show them on a (Y, r) graph. (b)...

Question