E304SP07Hw11Ans - The Pennsylvania State University...

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The Pennsylvania State University Spring Semester, 2007 Department of Economics Clifford Economics 304 Homework #11 Due : Wednesday, April 25 , AT THE BEGINNING OF LECTURE – NO HOMEOWRK WILL BE ACCEPTED ONCE THE LECTURE HAS BEGUN! Instructions: Please show all work or points will be taken off. 1. Use the Keynesian model to analyze the effects of each of the following events on output, the real interest rate, employment and the price level in the short run and in the long run. Include appropriate graphs in your answer. a. The government provides a tax incentive that causes an increase in desired investment. The lost tax revenue is replaced by an increase in lump sum taxes. Since there is no change in total tax collections, there is no change in desired saving. However, the tax incentives cause an increase in desired investment so that the real interest rate will be higher at every level of real income. This means that the IS curve shifts to the right. Short Run : The rightward shift in the IS curve results in an increase in aggregate demand, represented by the intersection of the new IS curve with the LM curve. Since this is the short run, the price level does not adjust, and firms adjust output in response to the increase in aggregate demand, so that output increases and the price level does not change. The new intersection of the IS and LM curves is at a higher real interest rate, so the real interest rate increases. The level of employment is determined by the level of effective demand, which increases as output increases, so employment goes up. Y f Y S r 0 r S r 1 E 1 E S E 0 r FE IS 0 IS 1 LM 0 LM 1 Y
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Long Run : The price level adjusts upward to restore the economy to general equilibrium. Graphically, the LM curve will shift upward, which means that there will be a further increase in the real interest rate. Since the level of output returns to the full-employment level of output, the level of employment returns to the full-employment level of employment. So in the long run, there is no effect on output or employment, but the real interest rate and the price level increase. b.
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This note was uploaded on 10/29/2008 for the course ECON 304 taught by Professor Stone,mistyriano,alejandro during the Spring '07 term at Penn State.

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E304SP07Hw11Ans - The Pennsylvania State University...

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