This preview shows page 1. Sign up to view the full content.
Unformatted text preview: ot
be the short run macroeconomic equilibrium since the increase in output will increase the
transaction demand for money, which is also an excess supply of bonds. The excess supply of
bonds pushes bond prices lower and so interest rates rise via the present value formula. Higher
real interest rates choke off some investment, which in turn, chokes off some output. That is,
investment is crowded out even though the government budget deficit does not change. Put
another way national savings (Y – C – G) falls even though government saving (T – G) does not
change because private saving (Y – C – T) falls due to the fall in output. To see this note that the
Keynesian consumption function is C = a + b(Y – T). The change in consumption is ΔC = b(ΔY –
ΔT). From the above we know that initially the IS shifts right by an amount equal to ΔG = ΔT =
ΔY. We’ve seen that this is not the equilibrium since the interest rate will rise and crowd out
investment and output. So equilibrium the increase in output is less than the increase in taxes, ΔY < ΔT. This implies that consumption falls in equilibrium ΔC = b(ΔY – ΔT) < 0. Since private
saving is Sp = Y – C – T the change in private saving is ΔSp = ΔY – ΔC – ΔT. Putting in the
change in consumption we have ΔSp = ΔY – b(ΔY – ΔT) – ΔT. Collecting terms we get ΔSp = (1
– b)ΔY – (1 – b)ΔT = (1 – b)(ΔY – ΔT) < 0 since b < 1 and ΔY < ΔT. Overall private saving falls
and government saving is constant, so national savings falls and so must investment.
5. Chapter 11 Problem #2
Answer:
a. The invention of the new highspeed chip increases investment demand, which shifts the
IS curve out. That is, at every interest rate, firms want to invest more. The shift in the IS
curve raises income and employment. The increase in income increases interest rates
because the higher income raises demand for money for transaction purposes. Since the
supply of money is not changing the interest rate must rise to keep the money market
(and the bond market) in equilibrium. The rise in interest rates partially offsets the
increase in investment demand, so that output does not rise by the full amount of the
rightward shift of the IS curve. Overall income, interest rates, consumption and
investment all increase. LM1 r IS2
IS1
Y1 Y3 Y2 Y b. The increased demand for cash shifts the LM curve up. This happens because households and
firms wish to hold more cash and the way they do this is to sell off some bonds. The excess
supply of bonds pushes bond prices lower, which increases interest rates by the present
value formula. The upward shift of the LM curve and the rise in interest rates lowers
investment and income. Consumption falls since income is lower. LM2
LM1 r r2
r1
IS1
Y
Y2 Y1 c. At any given level of income, consumers now wish to save more and consume less. Since
consumption falls and the IS curve shifts to the left. Since output is lower the demand for
money for transaction purposes falls so households and businesses convert their money into
bonds by buying more bonds. This is excess demand for bonds pushes bond prices up so
interest rates fall by the present value formula, Pbonds = FV/(1 + r). Lower interest rates
increase investment. Overall income, consumption and interest rates fall while investment
increases. Consumption falls for two reasons: first because consumers are saving more;
second, because income falls. Notice that the increase in investment due to lower interest
rates offsets some of the fall in consumption and acts as a shock absorber so that output
does not fall by as much as the leftward shift of the IS curve. r LM1 IS1
IS2
Y2 Y Y1 6. Chapter 11 Problem #3
Answer: a. The IS curve is given by:
Y = C (Y – T ) + I(r) + G .
We can plug in the consumption and investment functions and values for G and T
as given in the question and then rearrange to solve for the IS curve for this economy:
Y =200+0.75(Y–100)+200–25r+100 Y – 0.75Y = 425 – 25r
(1 – 0.75)Y = 425 – 25rY = (1/0.25) (425 – 25r)
Y = 1,700 – 100r.
b. The LM curve is determined by equating the demand for and supply of real money balances.
The supply of real balances is 1,000/2 = 500. Setting this equal to money demand, we find:
500 = Y – 100r. Y = 500 + 100r. Answers to Textbook Questions and Problems c. If we take the price level as given, then the IS and the LM e...
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 UBC.
 Winter '09
 ALVERO
 Economics

Click to edit the document details