**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...

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