Be sure to label i the axes ii the curves iii the

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Be sure to label: i. the axes; ii. The curves; iii. The initial
equilibrium values; iv. The direction the curve shifts; and v. the marginal equilibrium values. a. Please draw the IS – LM diagram. A reduction in government expenditure will shifts the IS curve to the left. Comparing the new equilibrium to the original one, we see that, at the new equilibrium, the income, Y, is lower. b) Explain in words what happens to equilibrium income as a result of the cut in government spending and the time horizon appropriate for this analysis. b. The level Y of is lower because of the (government expenditure) multiplier effect (at the initial interest rate). But a lower Y would mean a lower demand for money which means a higher demand for bonds, which means higher bond prices or lower interest rate (yield of the bonds). A lower interest rate will stimulate investment, which in turn will increase Y, thus partially offset the multiplier effect. But the net change in Y is still negative as seen in the diagram in part a. This analysis is appropriate for the short run (and prices are fixed – so there is no change in real money balances (M/P) or shift in the LM curve). 60. Two identical countries, Country A and Country B, can each be described by the goods market equilibrium equation is the IS-LM model. The MPC is 0.9 in each
country. Country A decides to increase government spending by $2 billion, while Country B decides to cut taxes by $2 billion. In which country will the new equilibrium level of income be greater? We use only the goods market equation to answer the question. Income in country A will increase more. The multiplier for G is 1/ ( 1 – MPC ) = 10. The multiplier for T is only MPC / ( 1 – MPC ) = 9. Hence A has an increase in Y of 2*10 = 20 while the increase in B is only 0.9*20 = 18. 61. Consider (only) the goods market equilibrium equation in the IS-LM model. Consumption is given by the equation C=200+2/3(Y-T). Planned investment is 300, as are government spending, G, and taxes, T. a.) Write down the goods market equilibrium equation in its original form. a. Y = C + I + G = 200 + 2/3(Y – T) + I + G. b) what is equilibrium Y? b. Using the equation in part a, we have: Y = 200 + 2/3( Y – 300) + 300 + 300 = 800 + Y*2/3 – 200 = 600 + Y*2 / 3. Solving for Y, we have Y = 1800. c) What are equilibrium consumption, private saving, public saving, and national saving?
c. Consumption = 200 + 2/3( 1800 – 300 ) = 1200. Private saving = Y – C – T = 1800 – 1200 – 300 = 300. Public saving = T – G = 0. National or total saving = 300. d) How much does equilibrium income decrease when G reduced to 200? What is the multiplier for government spending? d. The multiplier is 1 / (1 – MPC) = 3. Hence if G is reduced to 200 from 300, it means G is decreased by 100. Hence the decrease in Y is 3*100 = 300.

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