Tambela Vaughn_ECO-610-X2269 Fiscal & Monetary Policies 15TW2_Module 4_Short Paper

# Tambela Vaughn_ECO-610-X2269 Fiscal & Monetary Policies 15TW2_Module 4_Short Paper

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In the Module lecture, the provided example used an increase in government spending by 50 in response to high unemployment. What happens if the government chose to reduce government spending by that same amount? If spending decreased from 200 to 150; rather than increasing from 200 to 250, everything else being equal, then the result would be that the IS curve would shift towards the left. Thus, substituting 150 into the equation will produce the algebraic results of the government reducing spending by 50 to 150: Y = C + I + G’ + NX Where C = 100 + 0.9(1-t) Y; I = 200 – 500R; NX = 100 - 0.12Y – 500R; the tax rate, t = 0.2 Thus the equation is: Y = 100 + 0.9(1-0.2) Y + 200 – 500R + 150 + 100 − 0.12Y – 500R Y = 100 + 0.9(0.8) Y + 200 – 500R + 150 + 100 – 0.12Y – 500R Y = 100 + 0.72Y + 200 – 500R + 150 + 100 – 0.12Y − 500R* *[Please Note: (100 + 200 + 150 + 100 = 550); (0.72Y – 0.12Y = 0.6Y); (−500R −500R = −1,000R)] Y = 550 + 0.6Y – 1,000R 1Y – 0.6Y = 550 – 1,000R* * [Please Note: (1Y – 0.6Y = 0.4Y)]

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0.4Y = 550 – 1,000R* * (Please Note: 0.4/0.4 = 1; 550/0.4 = 1375; 1,000/0.4 = 2,500) Y’ = 1,375 – 2,500R To find the new level of GDP (Y) and the new interest rate, we set IS’ = LM, and solve for the interest rate as before: 1,375 – 2,500R = 1,000 + 2,500R (2,500 + 2,500 = 5,000; 1,375 – 1,000 = 375) 5000R = 375 R’ = 375/5,000 = 0.075 = 7.5% To solve for Y’ we plug R’ (7.5%) into Y’ = 1375 – 2500R: Y’ = 1,375 – 2,500(0.075) Y’ = 1,375 – 187.5 Y’ = \$1,187.5 When the R’ value of 0.075 is inputted into the LM equation: Y’ = 1,000 + 2,500(0.075) Y’ = 1,000 + 187.5 Y’ = \$1,187.5 As stated earlier, the IS curve will shift towards the left because ∆G equals −50 which causes a ∆Y equal to −\$62.50 (Y’ – Y = \$1,187.5 − \$1,250 = −\$62.50). The interest rate also
decreases by 2.5%, going from 10% to 7.5%. This will ultimately lead to an increase in private spending through investment due to the lower interest rate.

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• Winter '15

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