Question

Consider a closed economy. The goods market is represented by the following equations:

C = 160 + 0.6YD
I = 100 + 0.2Y – 500i

T = 100
G = 100
YD = Y - T

1. Derive the IS equation from the equilibrium position Y = Z ≡ C + I + G and draw the IS curve on the graph.

In the money market, the real money demand is (M d/P) = Y – 1,500i; and the real money supply is (Ms/P) = 600.

2. Derive the LM relation and draw the LM curve on the graph where you draw the IS curve.

3. Solve for the equilibrium output Y and equilibrium interest rate i when both goods market and money market are at the equilibrium. Identify this equilibrium point on the graph in part (1).

4. Suppose now the government spending (G) increases from 100 to 200.
On the IS-LM graph in part (1) illustrate the effect of this increase in government spending on the IS or LM curve and mark the new equilibrium output Y and interest rate i.

5. Following this increase in government spending, how much will be the new equilibrium output Y and interest rate i?

6. How much is the multiplier of government spending?

7. Following the government spending increase, does the equilibrium investment I decrease or increase?

8. Suppose at the same time that the government spending increases, FED would use the monetary policy tool to accommodate such an expansionary fiscal policy to keep the equilibrium interest rate unchanged. Under this circumstance, how much would be the new equilibrium output (Y)? How much is the ‘multiplier’ of the government spending in this case?

9. In practice, how does FED achieve such an accommodation policy as mentioned in part (9). Illustrate the effect of this policy on an IS-LM graph. As a result, how much does the real money supply (Ms/P) need to increase to remain the equilibrium interest rate unchanged when the government spending increases?

Answer 1