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Small open economy under floating exchange rates under

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Unformatted text preview: nment expenditure causes the economy’s planned expenditure to rise. This stimulates the production of goods and services, causing total income Y to rise. Now consider the money market: because Y has increased, money demand increases, which raises the interest rate. This higher real interest rate has ramifications back in the goods market. The fall in investment caused by higher interest rate partially offsets the expansionary effect of an increase in government purchases. Changes in taxes: in the IS- LM model, changes in taxes affect the economy much the same as changes in government purchases do, except the taxes affect expenditure through consumption. A tax cut encourage consumers to spend more, and therefore, increases planned expenditure. The tax multiplier shows that it raises the level of income at any given interest rate by ΔT x MPC/(1 – MPC). The IS curve shifts to the right by this amount. The higher interest rate depresses investment, so the increase in income is smaller in the IS- LM model than it is in the Keynesian cross. How monetary policy shifts the LM curve and changes the short- run equilibrium: Page 34 of 52 Jessica Gahtan Prof: Mokhles Hossain Macroeconomics ECON2000 Fall 2013 An increase in M leads to an increase in real money balances M/P because the price level is fixed in the short run. The theory of liquidity preference shows that for any given level of income, an increase in real money balances leads to a lower interest rate. Therefore, the LM curve shifts downward, lowering the interest rate and raising the level of income. When the central bank increases M, people have more money than they want to hold at that interest rate, so they deposit it in banks or buy bonds. The interest rate r then falls until people are willing to hold all the extra money that the central bank has created, bringing the money market to a new equilibrium. The lower interest rate has ramifications for the goods market, stimulating investment, which increases planned expenditure, production, and income Y. The monetary transmission mechanism is the process by which changes in the money supply influence the amount that households and firms wish to spend on goods and services. The IS- LM model shows an...
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