Download 1. Assume the following model of the economy, with the price level

1. Assume the following model of the economy, with the price level fixed at 1.0:
C = 0.8(Y – T)
T = 1,000
Y=C+I+G
I = 800 – 20r
G = 1,000
Ms = 1,200
Ms/P = Md/P = 0.4Y – 40r
a) Write a numerical formula for the IS curve, showing Y as a function of r alone.
(Hint: Substitute out C, I, G, and T.)
3%
b) Write a numerical formula for the LM curve, showing Y as a function of r alone.
(Hint: Substitute out M/P.)
3%
c) What are the short-run equilibrium values of Y, r, Y – T, C, I, private saving,
public saving, and national saving? Check by ensuring that C + I + G = Y and
national saving equals I.
16%
d) Assume that G increases by 200. By how much will Y increase in short-run
equilibrium? What is the government-purchases multiplier (the change in Y
divided by the change in G)?
4%
e) Assume that G is back at its original level of 1,000, but Ms (the money supply)
increases by 200. By how much will Y increase in short-run equilibrium? What is
the multiplier for money supply (the change in Y divided by the change in Ms)?
4%
2.
a) Suppose Congress passes legislation that significantly reduces taxes. Use the
Keynesian-cross model to illustrate graphically the impact of a reduction in taxes
on the equilibrium level of income. Be sure to label: i. the axes; ii. the curves; iii.
the initial equilibrium values; iv. the direction the curve shifts; and v. the terminal
equilibrium values.
5%
b) Explain in words what happens to equilibrium income as a result of the tax cut and
the time horizon appropriate for this analysis.
5%
3.
a) An economy is initially at the natural level of output. There is an increase in
government spending. Use the IS-LM model to illustrate both the short-run and
long-run impact of this policy change. Be sure to label: i. the axes; ii. the curves; iii.
the initial equilibrium, iv. the short-run equilibrium, and v. the terminal
equilibrium.
5%
b) Explain in words the short-run and long-run impact of the change in government
spending on output and interest rates.
5%
4. Two identical countries, Country A and Country B, can each be described by a
Keynesian-cross model. The MPC is .9 in each country. Country A decides to
increase spending by $2 billion, while Country B decides to cut taxes by $2 billion.
In which country will the new equilibrium level of income be greater?
6%
5. Two identical countries, Alpha and Beta, can be described by the IS-LM model in
the short run. The governments of both countries cut taxes by the same amount. The
Central Bank of Alpha follows a policy of holding a constant money supply. The
Central Bank of Beta follows a policy of holding a constant interest rate. Compare the
impact of the tax cut on income and interest rates in the two countries.
6. Policymakers are contemplating undertaking either an increase in government
spending or an increase in the money supply. Either policy is forecast to have the
same impact on income in the short run. Use the IS-LM model to compare the impact
on consumption and investment of the two policy alternatives.
7. The principal method used by the Federal Reserve to change the money supply is
through open-market operations. Use the aggregate demand–aggregate supply model
to illustrate graphically the impact in the short run and the long run of a Federal
Reserve decision to increase open-market purchases.
a) Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the
direction the curves shift; v. the short-run equilibrium values; and vi. the long-run
equilibrium values.
b) State in words what happens to prices and output in the short run and the long run.
8. How can the Fed keep the economy from falling into a recession if the budget
deficit is reduced? Use the IS-LM model to illustrate graphically the impact of both
the fiscal policy reducing the deficit and the monetary policy, which prevents output
from falling. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium
values; iv. the direction the curves shift; and v. the terminal equilibrium values.