Answers to Quiz #4

According to the IS-LM model, what happens in the short run to the interest rate, income, consumption, and investment under the following circumstances? (Assume everything else is held constant. ) a. The central bank decreases the money supply. i. The interest rate ________increases_______________________ ii. Income ____________decreases__________________________ iii. Consumption ___________decreases______________________ iv. Investment ___________decreases________________________ b. The government decreases its level of expenditures. i. The interest rate _________decreases______________________ ii.Income ___________decreases___________________________ iii. Consumption __________decreases_______________________ iv. Investment ___________increases________________________ c. The government imposes a new lower level of taxes. i.The interest rate _________increases______________________ ii. Income ________________increases______________________ iii. Consumption ___________increases______ ________________ iv. Investment ______________decreases_____________________ d. The government increases government spending while at the same time it increases taxes by exactly the same amount. .The interest rate __________increases_____________________ ii. Income _____________increases but by less than the change in government spending and the change in taxes_________________________ iii. Consumption __________decreases_______________________ iv. Investment ______________decreases_____________________ 2. Use the following information to answer this set of questions. An economy can be described by the following equations: C = 200 + 0. 75(Y – T) I = 200 – 25r G = 100 and is constant and exogenously determined T = 100 and is constant and exogenously determinedThe demand for real money balances = M/P = Y – 100r M = money supply = 1000 P = price level = 2 a. Write an equation for the IS curve for this economy. IS: Y = 200 + 0. 75(Y – T) + G + I Y = 200 + 0. 75Y -0. 75(100) + 100 + 200 – 25r Y = 500 + 0. 75Y -75 – 25r .25Y = 425 – 25r Y = 1700 – 100r b. Write an equation for the LM curve for this economy. Supply of real money balances = demand for real money balances 1000/2 = Y – 100r Y = 500 + 100r c. What is the equilibrium interest rate and the equilibrium level of output for this economy given the above information? 00 + 100r = 1700 – 100r 200r = 1200 r = 6 Y = 500 + 100 (6) Y = 1100 d. What is the equilibrium level of consumption and the equilibrium level of investment for this economy? C = 200 + 0. 75(Y – T) C = 200 + 0. 75(1100 – 100) C = 200 + 0. 75(1000) C = 200 + 750 C = 950 I = 200 – 25r I = 200 – 25(6) I = 200 – 150 I = 50 e. Suppose that the money supply is increased to 1200. What is the new equilibrium level of interest rate and the new equilibrium level of output for this economy given this change? What is the new equilibrium level of consumption ? The new LM curve is Y = 600 + 100r and the IS curve is Y = 1700 – 100r.Thus, 600 + 100r = 1700 – 100r 200r = 1100 r = 5. 5 Y = 600 + 100(5. 5) Y = 1150 C = 200 + 0. 75(Y – T) C = 200 + 0. 75(1150 – 100) C = 200 + 987. 50 f. Suppose that the initial information is true (no change in the money supply). If government purchases increase to 150, what is the change in output predicted by the Keynesian Cross diagram? What is the actual change in output based upon the IS-LM model? The change in output predicted by the Keynesian Cross diagram is equal to (1/(1 – MPC))(change in government spending) or (1/0. 25)(50) = 200.The actual change in output based upon the IS-LM model will be less than this. To see this you need to first write the new IS curve: Y = C + I + G’ Y = 200 +0. 75(Y – T) + I + G’ Y = 200 + 0. 75Y – 0. 75(100) + 200 – 25r + 150 0. 25Y = 475 – 25r Y = 1900 – 100r Then, combine this IS curve w ith the LM curve to have 1900 – 100r = 500 + 100r 1400 = 200r r = 7 Thus, Y = 1900 – 100r Y = 1900 – 100(7) Y = 1200 The change in output is from the initial level of 1100 to the new level of 1200, or a change of 100 which is less than that predicted by the Keynesian Cross diagram.