Solutions to Problem Set 3
1.
a. False : an increase in
G
shifts the IS to the right,
Y
↑
and
i
↑
,
so
C
↑
because income
has increased, but the effect on I is ambiguous.
b. Uncertain :
Y
↑
but the interest rate could go up or down depending on the entity of
the shifts and the slopes of the IS and LM.
c. True : the reduction of the fiscal deficit is pursued through a
↓
G
or an
↑
T
, both
policy shift the IS to the left, the
i
↓
and
Y
↓
,
and the
I
↑
(no effect of
↓
Y
)
d. False : with banks the CB controls only indirectly the
Ms
2.
a
.d0
: output sensitivity (sales) of investment
d1
: interest sensitivity of investment
Y = [1/(1c1d0)]{c0  c1T + G}  [d1/(1c1d0)]i
Or in the iY space :
i =
{c0  c1T + G}/d1  [(1c1d0)/d1]Y
b. slope = 
[(1c1d0)/d1]
c.
the larger is the interest sensitivity of investment, the flatter is the IS, thus a small
reduction of i has a large impact on I and therefore on Y.
a.
e
: income sensitivity of
Md
f
: interest sensitivity of
Md
b.
the slope is (e/f)
c.
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 Fall '09
 Geurrieri
 Monetary Policy, Public Finance, LM, LM LM

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