Download UNIVERSITY OF BRISTOL Department of Economics

Unit code: 11102
SKEA #4/01
UNIVERSITY OF BRISTOL
Department of Economics
Unit Title:
Introduction to Macroeconomics A
Lecturer:
Nigel W. Duck
Exercise 4
The IS-LM model and Equilibrium Aggregate Demand
Sketch Answers
1.
(i) Setting Y = C + I + G to find the IS curve equation gives that relation as
Y =[325-2500i]/0.4 = 812.5 - 6250i
Setting the nominal demand for money equal to supply to find the LM curve equation
gives that relation as: i = [0.8Y-250]/3000 = 0.000266Y-0.0833 or Y = 312.5+3750i
(ii) Substituting the expression for i from the LM curve into the IS curve and re-arranging
gives:
Y = 500
Slotting this value for Y into the LM equation gives i = 0.05
(iii) From the structural equations we can derive that C = 325; I = 125.
(iv) Total savings = Y-C-T + (T-G) = 125 which equals I
(v) If G increases to 75 the IS relationship becomes:
Y = 875-6250i. The LM relationship
is unchanged. Using the same method as before the equilibrium level of Y is now approx.
523.4 and the equilibrium level of i is approx. 0.056.
C = 336.7; I = 112.34; Total savings = 136.7 - 25 which equals I after allowing for
rounding.
(vi) If the quantity of money is raised to 300 the LM relation becomes
i = [0.8Y-300]/3000 = 0.000266Y-0.1 or Y = 375 + 3750i
Substituting this into the initial IS relationship gives,
Y = approx. 539 and i = approx. 0.0437
C = 344.5; I = 144.7; Total savings = 144.5 which (after allowing for rounding) = I;
Notice that in this case the interest rate has fallen and investment has risen.
(vii) From the original IS curve Y  [G  2500i ] / 0.4
From the original LM curve i  [0.8Y  M s ] / 3000
. Y
From the original Investment function I  2500i  01
We want a fiscal policy mix which generates  Y = 1000 and  I = 0. But the investment
relationship suggests that this will only occur if  i = 0.04; the LM curve relationship
implies that with  Y = 1000 and  i = 0.04 then  M s must be 680. From the IS relationship
it follows that  G must be 500. So the required fiscal/monetary mix involves increasing G
by 500 and increasing M s by 680.
ska4.doc
Unit code: 11102
SKEA #4/01
2.
(i) True, unless there are some extreme assumptions about parameters. The student should
explain the answer diagrammatically and provide an intuitive account of what is
happening.
(ii) False. The more sensitive investment expenditure is the shallower the IS curve: any given
horizontal shift in the LM due to a price change will imply a larger (horizontal) effect on
the intersection of IS and LM and hence a larger affect on equilibrium aggregate demand.
(iii) False. A price rise causes you to move up or down an AD curve not shift it.
ska4.doc