# PS2 - My P Le EC224 A Problem Set 2 1 a Y = Z >...

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My P Le EC224 – A Problem Set 2 1. a. Y = Z >>> Contractionary fscal policy in the Form oF tax increases will make the slope steeper. The result is lower GDP in the economy because the higher taxes reduces consumer income and thereFore causes consumption to Fall as well. IS’ has a steeper slope than IS. The new equilibrium is where LM cuts IS’: Y0 Falls to Y1, and i0 Falls to i1. As tax rate increases, disposable income decreases, leading to a decrease in consumption, leading to a decrease in the demand For goods and a decrease in output. As income decreases, money demand decreases, thus interest rate goes down as money supply is given. b. I = S + (T-G) As tax rate increases, investment increases. So, to keep investment at its original level, government spending needs to increase (Fiscal expansion). The increase in government expenditures caused an increase in income For a given level oF interest rate. This corresponds to a shiFt oF the IS curve to the right. ±or a given level oF interest rate now we have more income. c. To keep the interest rate at the original level, the ±ed needs to raise the interest rate by decreasing the money supply (selling bonds) and shiFt the LM curve upward enough to oFFset the shiFt oF IS.

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At any level of income, a decrease in money leads to an increase in the interest rate. The increase interest rate leads to a decrease in investment and in turn, to a decrease in demand and output. As LM shifts up to LM’ as a result of the monetary contraction, interest rate increase from i1 to i0 (to the original interest rate) and output decreases from Y1 to Y2. Fiscal policy makers wouldn’t want the 2 nd method, in which G increases thus the deficit would become worse. The 3 rd method would reduce output a lot, thus unfavorable. Hence, I think that the 1 st method would be the best one. 2.a. For economy A:
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PS2 - My P Le EC224 A Problem Set 2 1 a Y = Z >...

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