Calculate the IS and LM curves. Rather than looking at these curves in isolation, this homework will examine their intersection points and how the equilibrium changes when fiscal and monetary policy changes. It is important to graph the curves accurately in order to find the correct equilibrium points.
Use the following values to answer question 1. Assume a closed economy.
C = 200 + .8(Y-T)
T = 500
G = 500
IPlanned = 150 - 10r
1a. Calculate equilibrium GDP for interest rates of 3 and 9 percent. Use the formula for equilibrium GDP.
b. Plot the IS curve using graph paper or software.
c. Assume the money demand curve is
(M/P)d = .1*Y - 20*r
Assume that the real money supply equals 100.
Calculate the equilibrium interest rate in the money market for income levels of 1,600 and 2,400.
d. Plot the LM curve using graph paper or software.
e. What is the equilibrium levels of GDP and the interest rate? (the points where IS and LM intersect). Write the amounts in the first column of the table below.
f. Calculate the level of consumption and investment. Write the amounts in the first column in the table below.
g. Now assume that government spending increases from 500 to 600. Calculate the new IS curve.
h. Find the intersection of the new IS curve with the LM curve in part d. Calculate the new levels of Y, r, C and I. Complete the table below.
Equilibrium 1 Equilibrium 2
(G = 500) (G = 600) Change
Y
r
C
I
i. Now assume that government spending is equal to 500 but that the money supply increases to 150. Calculate the new LM curve.
j. Find the intersection of the new LM curve with the IS curve in part b. Calculate the new levels of Y, r, C and I. Complete the table below. Equilibrium 1 is the same as equilibrium 1 in the table of the previous page.
Equilibrium 1 Equilibrium 2
(M = 100) (M = 150) Change
Y
r
C
I
k. Bonus. Suppose you wanted to make the effect of government spending on GDP larger and the effect of increases in the money supply on GDP smaller. Rewrite one of the equations at the beginning of the problem to do this.
2. Consider the trilemma diagram in chapter 13 which shows three policy options.
a. A country which is adopting the monetary policy of another country is following which policy option?
b. Suppose the country of Economica has fixed exchange rates and has interest rates which differ from the rest of the world. Which policy option is Economica following?
3. Consider three different countries. Country A is a closed economy, country B is a small open economy with flexible exchange rates and country C is a large open economy with flexible exchange rates. In each country the government is enacting a tax cut equal to one percent of GDP.
a. In which country would GDP change proportionally the most? In which country would it increase the least?
b. In which country would the interest rate change the most? In which country would it increase the least?