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.