Ch. 8 - ECN101 Intermediate Macroeconomics Winter 2009...

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ECN101 Intermediate Macroeconomics Winter 2009 Professor E.A.Frenkel Homework 8 Solutions For any typos or mistakes in the sketched solutions, please contact any of the TAs You can assume that we are dealing with a closed economy here. (1) You are an economic policy maker. Your economy is running at a less than full employment real income level. You want to raise the level of real income. Using the IS LM diagram, what policy (policies) might you suggest to reach your goal? Would the policy you recommend be related to whether or not you desired stable interest rates in your economy? Hints: Assume a fixed price level and a closed economy. You should be able to describe in words and show graphically what is happening in the economy as policy (policies) affect the economy and the income level rises. Solution: The economy is originally operating at point A, where the output is less than full employment real income level. To raise the level of real income, we can use either fiscal policy or monetary policy, or a combination of two. For example, if we use fiscal policy only, such as increasing government spending or cutting taxes, then the IS curve would shift outward to IS 2 , the new equilibrium is achieved at point B, where real income is increased to the natural level and interest rate rises as well. If we use monetary policy by increasing money supply or the velocity of money, then we are shifting the LM curve outward to LM 2 , the new equilibrium is at point C, where we reach the full employment income level with a lower interest rate than before. However, if the economy desires a stable interest rate, then we need to use a combination of fiscal and monetary policy, as shown below, the IS curve shifts to IS 3 , the LM shifts to LM 3 , equilibrium achieves at point D. Figure 1 The IS-LM Model 1 Y Y
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(2) According to the Keynesian Cross diagram, a $10 billion rise in government spending with no other policy shifts in the economy will push real income to a new equilibrium level that is a multiple of the original $10 billion expenditure. According to the IS LM diagram, this same $10 billion rise in government spending also will push real income to a higher equilibrium level, but by less than what is indicated by the Keynesian Cross.
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Ch. 8 - ECN101 Intermediate Macroeconomics Winter 2009...

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