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# ans1 - Problem Set#1 ANSWERS Due Tuesday QUESTIONS 1...

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Problem Set #1 (Fall 2007) 1/9 Problem Set #1 ANSWERS Due Tuesday, September 18, 2007 QUESTIONS 1. Suppose that the economy is in equilibrium at its potential output level with a big government budget deficit and a big current account deficit. On a single IS-LM diagram, clearly show the effects on equilibrium income and interest rates of the following 2 scenarios. Be sure to provide a brief economic explanation for the different results of these 2 scenarios. a. Scenario #1: A large increase in tax rates (in red). b. Scenario #2: A large increase in government spending (in blue). Now, assume that the central bank follows a stabilizing policy, i.e., it uses monetary policy to keep the economy at its potential output level. On your IS-LM diagram, clearly show how this would affect equilibrium income and interest rates for the change in tax rates (in green) and the change in government spending (in orange or brown). IS2 r r4 r2 r0 r1 r3 Y1 Yn=Y0 Y2 Y Y3 = Y4 LM4 LM0 LM3 IS0 IS1

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Problem Set #1 (Fall 2007) 2/9 Scenario #1. An increase in tax rates, t 1 , decreases disposable income which decreases consumer spending through the marginal propensity to consume. This causes the IS curve to shift to the left to IS1. Equilibrium income is decreased by a multiplied amount. The decrease in income reduces the demand for money. Because the money supply is fixed, interest rates fall to r1. Lower interest rates stimulate some interest-sensitive spending, i.e., C and I, and limits the decrease in equilibrium income to Y1. If the Federal Reserve then follows a stabilizing policy, it will increase the money supply. This will shift the LM curve to the right to LM3. Because the money supply is now greater than the demand for money, interest rates fall to r3. Lower interest rates stimulate some interest-sensitive spending, i.e., C and I, which fully offsets the decrease in spending caused by the increase in tax rates. Equilibrium income rises to Y3, which is equal to Yn. Scenario #2. An increase in government spending, G, increases autonomous spending and shifts the IS curve to the right to IS2. Equilibrium income is increased by a multiplied amount. The increase in income raises the demand for money. Because the money supply is fixed, interest rates rise to r2. Higher interest rates restrains some interest-sensitive spending, i.e., C and I, and limits the increase in equilibrium income to Y2. If the Federal Reserve then follows a stabilizing policy, it will decrease the money supply. This will shift the LM curve to the left to LM4. Because the money supply is now less than the demand for money, interest rates rise to r4. Higher interest rates restrain some interest-sensitive spending, i.e., C and I, which fully offsets the increase in government spending. Equilibrium income falls to Y4, which is equal to Yn.
Problem Set #1 (Fall 2007) 3/9 Finally, after both the fiscal and monetary policy changes have taken place, indicate whether each of the following variables is higher under Scenario #1 (increase in tax rates) or Scenario #2 (increase in

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ans1 - Problem Set#1 ANSWERS Due Tuesday QUESTIONS 1...

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