Chapter 11 that for any ore and consume lessthen the

Info iconThis preview shows page 1. Sign up to view the full content.

View Full Document Right Arrow Icon
This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: st rate has a smaller aller effect on realeoutput Y because the because thewill be smaller. be smaller. ffect on real output Y multiplier multiplier will ty becomes more thrifty—meaningProblem #1 given level of income people 4. Chapter 11 that for any ore and consume less—then the planned-expenditure function shifts downAnswer: s in Figure 10–9 (note that C2 < C1). Equilibrium income falls from Y1 to Y2. B Y2 a. The central bank increases the money supply. Y = PE Figure the Answer: When the central bank increases 10–9money supply the real interest rate falls so the LM curve shifts downward. A central bank increases the money supply via an open market operation PE1 = C1 c (Y – from the to buy government+bonds T ) + I + G public. This results in an excess demand for bonds so bond A prices rise and interest rates fall according to the present value formula P bonds = FV/(1 + r). The PE = C + c (Y – T ) + I + G increase in the 2 2 supply and the resulting reduction in interest rates affect the goods market money over a time horizon of between 9 and 18 months. The fall in interest rates will increase investment and aggregate expenditure, AE, so that initially AE > Y; in words, initially spending exceeds output. This is only possible if inventories fall. Firms with lower inventories increase orders from their input suppliers, which increases demand for the output of other firms in the Y1economy. Thus firms hire more labor, buy more inputs and produce more output. This last is Y known as the multiplier effect. Since output and income increase, consumption will increase. Income, output rium saving remains unchanged. The national accounts identityM L tells us 1 ving equals investment, or S = I . In the Keynesian-cross model, we d that desired investment is fixed. This assumption implies that investr the same in the new equilibrium as it was in the old. We can conclude ving is exactly the same in both equilibria. radox of thrift is that even though thriftiness increases, saving is unaffectreased thriftiness leads only to a fall in income. For an individual, we usur1 sider thriftiness a virtue. From the perspective of the entire economy as nted by the Keynesian-cross model, however, thriftiness is a vice. r2 classical model of Chapter 3, the paradox of thrift does not arise. In that output is fixed by the factors of production and the production technology, interest rate adjusts to equilibrate saving and investment, where investepends on the interest rate. An increase in thriftiness decreases consumpd increases saving for any level of output; since output is fixed, the saving le shifts to the right, as in Figure 10–10. At the newY2 equilibrium, the interY1 is lower, and investment and saving are higher. LM2 Y b. The government increases government purchases. Answer: The IS curve shift to the right by the simple Keynesian multiplier [1/(1-b)]ΔG from Y1 to Y2. The initial increase in output results in an increased demand for money for transaction purposes so the money demand curve shifts to the right. An excess demand for money is an excess supply of bonds so bond prices fall and interest rates rise (by the present value formula). The increase in interest rates chokes off some investment spending so equilibrium output (Y3) is less than the original horizontal shift of the IS curve. r LM1 IS2 IS1 Y1 Y3 Y Y2 ΔY=[1/1-b]ΔG c. The government increases taxes. Answer: The question assumes that lump-sum taxes increase by ΔT. The IS curve shifts to the left by [-b/(1-b)] ΔT. Interest rates fall as does income. Consumption falls for two reasons: the increase in taxes reduces consumption directly since disposable income is lower; second, since GDP falls after-tax income also falls. The fall in income reduces money demand and interest rates fall which increases investment and this partially offsets the fall in consumption so the fall in output is not as great as the original leftward shift of the IS curve. d. The government increases government purchases and taxes by equal amounts. Answer: We can use the results of the previous two parts in this part. Summing these two effects we have the following: ΔY = [1/(1-b)]{-b ΔT + ΔG} which gives the horizontal shift of the IS curve. We can simplify this expression further since ΔT = ΔG; this yields ΔY = [1/(1-b)]{-bΔG + ΔG} = ΔG. In sum, the horizontal shift of the IS curve is ΔG = ΔT = ΔY. This, however, cann...
View Full Document

This note was uploaded on 10/01/2013 for the course ECON 302 taught by Professor Alvero during the Winter '09 term at The University of British Columbia.

Ask a homework question - tutors are online