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11. Use the IS-LM model to determine the effects of each of the following on thegeneral equilibrium values of the real wage, employment, output, the real interest rate,consumption, investment, and the price level.a. A reduction in the effective tax rate on capital that increases desired investment.Answer:Idr; MPKf, τ()If ↓τ, then the investment schedule shifts to the right.Adjustment story:at rothe level of desired savings is less than the level of desiredinvestment. That is equivalent to saying the followingY <Cd+Id+Gi.e., the Goods Market is not in equilibrium at ro. Explain adjustment in the goodsmarket in terms of movements alongdesired savings and desired investment. (Notethat we are assuming that prices of the goods are not changing)at ro: Y< cd+ Id+ G ⇒consumers save less and firms invest more when the interst rate it low
2⇒↑r eliminates the excess demand for goods over the supply by ↓cd& ↓Iduntil Y= cd+ Id+ G adjustment along the savings schedule:↑r ⇒↑Sd=Y−↓Cd−Gadjustment along the investment schedule:↑r ⇒↑r + d()pk= ↑uc⇒ ↓It=↓K∗−Kt+dKtNow we can write out the IS function explicitlyIS r, Y; yfe, W, G, T, MPKf, τIf ↓τthen the IS curve shifts up, i.e., to the right.Note that when we consider changes in r and Y, then we are contemplatingmovements alongthe IS curve!When an exogenous variable changes, we are considering what happens to theequilibrium interest rate for agivenlevel of output, Y.Asset Market Equilibrium:Recall our money demand functionMd= PLY, r + πe()In equilibriumMs= Md⇒Ms= PLY, r + πe()⇒MsP= LY, r + πe()
3Now we can graph this relationshipMoney supply changes: ↑Pshifts the money supply curve to the leftAdjustment Story: at r1the quantity of money demanded exceeds the quantity ofmoney supplied. As money holders sell some of their nonmonetary assets so they canhold more money in their portfolios, the price of nonmonetary assets is driven down.This raises the real interest rate on nonmonetary assets. As r rises the quantity ofmoney demanded falls (movement along a negatively sloped money demand curve),until equilibrium is reached. Show with the money demand equation.
5b. The expected rate of inflation rises.Answer: If ↑πethen real money demand falls, i.e., shifts back.Adjustment Story: at the old interest rate, the supply of money exceeds thequantity of money demanded. Agents purchase nonmonetary assets, driving theirprices up and their real returns (the real interest rate paid on the asset) down. As thereal interest rate falls, individuals find the nonmonetary asset less and less attractiverelative to money. Eventually the interest rate will fall so low that the excess supplyof money and the excess demand for nonmonetary assets are zero.