Question

# 1. According to the IS-LM model, what happens to the interest rate, income, consumption

and investment under the following circumstances? Use graphs to explain

a. The central bank increases the money supply. (4marks)

b. The government increases government purchases. (4marks)

c. The government increases taxes. (4marks)

2. Consider the economy of Hicksonia.

a. C=300+0.50(Y-T)

The investment function is I=100-20t

Government purchases and taxes are both 150.For this economy, use a graph to illustrate

the LM curve for r ranging from 0 to 8. (4marks)

b. The money demand function in Hicksonia is

(M/P)d = Y-150r

The money supply M is 1,000 and the price level P is 2. For this economy, use a graph to

illustrate the LM curve for r ranging from 0 to 8. (4marks)

c. Calculate the equilibrium interest rate and the equilibrium level of income Y.

(4marks)

d. Suppose the government purchases are raised from 150 to 200. How much does

the IS curve shift? Calculate the new equilibrium interest rate and level of

income? (3marks)

e. Suppose instead that the money supply is raised from 1,000 to 1,200. How much

does the LM curve shift? Calculate are the new equilibrium interest rate and level

of income? (3marks)

f. With the initial values of monetary and fiscal policy, suppose that the price level

rises from 2 to 4. Explain the impacts. Calculate are the new equilibrium interest

rate and level of income? (2marks)

g. Derive and graph an equation for the aggregate demand curve. Describe what

happens to this aggregate demand curve if fiscal or monetary policy changes, as in

parts (d) and (e)? (8marks)

Step-by-step explanation
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