f07 ec51 ps7 answers

f07 ec51 ps7 answers - Economics 51D Due 5 November 2007...

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Economics 51D Due 5 November 2007 Problem Set 7 Answers 1. IS-LM, just another four-letter word model A. A cut in taxes increases demand by increasing consumption at every interest rate, since after- tax income rises. This means that the IS curve shifts to the right, and in particular it shifts by the lump-sum tax multiplier times the change in taxes. The rightward shift in IS indicates that equilibrium income in the goods market rises for each level of the interest rate. But as income rises, money demand also rises in the goods market, which makes money demand exceed money supply (which hasn’t changed). The only way for equilibrium to be reestablished in the money market is for interest rates to rise. But as interest rates rise, we know that investment declines somewhat. This means that the net change in Y will be smaller than the shift in the IS curve, as the diagram shows. The implied shift in the AD curve will correspond to the change in Y implied in the IS-LM model. In the AS-AD model so far, we have only really considered the goods-market impact of the change in taxes. We have argued that the AD curve shifts by the lump-sum tax multiplier times the change in rates. But this doesn’t factor in the money-market response to the increase in output, which plays out as described above. So the upshot is that the net shift in the AD curve, when we take in the money market response, looks more like the shift implied by the IS-LM model. 1
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When the Fed makes a huge open-market sale, this removes money from the system. So for every level of income, the interest rate rises. This means that the LM curve shifts to the left. The interest rate rises and the short-run level of output falls. The story is the same as the one we told before—as r rises, this reduces investment and so demand falls. The IS-LM model actually fills in this gap a little, since it shows how the goods market and money market must interact. Again, however, the IS-LM model incorporates the feedback effects between the money and goods markets. If we consider the money market only, the interest rate rises by a certain amount in order to reestablish equilibrium between money supply and money demand. But because of the decline in output (which itself results from the fall in investment), money demand falls a bit as a result of this decline and thus makes r fall just a little. So on net, the rise in r is less than is implied by the money market model considered alone. Overall, the IS-LM model doesn’t tell us anything different about the general results of policy changes, but it does show that the feedback effects between money and goods markets tend to dampen the effects of fiscal and monetary policy changes—either on output, as in the size of the shift in the AD curve, or on the interest rate. Hence, the effect on P will also be dampened, to the extent that the shift in AD will be smaller. 3
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This note was uploaded on 03/31/2009 for the course ECON 5161 taught by Professor Fullenkampf during the Fall '07 term at Duke.

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f07 ec51 ps7 answers - Economics 51D Due 5 November 2007...

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