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Tutorial 4 Chapter 12

This document discusses the impacts of fiscal and monetary policy changes on interest rates, income, consumption, and investment. It provides examples of: 1) An increase in taxes, which is contractionary fiscal policy. Income falls due to a decrease in disposable income and consumption. Interest rates also fall as investment increases, though not enough to offset the fall in consumption so income still decreases. 2) A decrease in the money supply, which is contractionary monetary policy. The money supply fall causes prices to decrease, raising interest rates. This lowers investment, consumption, and income. 3) An economy described by equations is used to show the impacts of a tax cut, with the money supply or interest rate

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Renee Wong
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114 views

Tutorial 4 Chapter 12

This document discusses the impacts of fiscal and monetary policy changes on interest rates, income, consumption, and investment. It provides examples of: 1) An increase in taxes, which is contractionary fiscal policy. Income falls due to a decrease in disposable income and consumption. Interest rates also fall as investment increases, though not enough to offset the fall in consumption so income still decreases. 2) A decrease in the money supply, which is contractionary monetary policy. The money supply fall causes prices to decrease, raising interest rates. This lowers investment, consumption, and income. 3) An economy described by equations is used to show the impacts of a tax cut, with the money supply or interest rate

Uploaded by

Renee Wong
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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Q2.

What is the impact of an increase in taxes on the interest rate, income, consumption,
and investment?
−mpc −mpc
Y falls by the amount of ΔT x , where is
1−mpc 1−mpc
a tax multiplier.
IS shifts from IS1 to IS2. Equilibrium income falls from Y1
to Y2 because disposable income falls, causing
consumption to fall.
At the new equilibrium point, interest rate, r, falls. As a
result, investment increases. Increase in I is less than the
falls in C, hence income still falls at equilibrium Y, which
is lower than the initial level.
**This is a case of contractionary fiscal policy (increase in taxes).

Q3. What is the impact of a decrease in the money supply on the interest rate, income,
consumption, and investment?
A fall in money supply reduces real money balances at any
given price level (in layman’s term: less money is available
to buy goods and services while price level does not
change).
According to the Theory of Liquidity Preference, MV = PY,
V is constant. Y does not change in the short run, hence M
fall is followed by a fall in P. For P to fall, interest rate will
increase.
A fall in M is reflected by a shift of LM to the left, from
LM1 to LM2. At the new equilibrium point, Y falls from Y1
to Y2, r increases from r1 to r2. As a result, I falls.
**This is a case of contractionary monetary policy.

P4. An economy is initially described by the following equations:


C = 500 + 0.75(Y – T)
I = 1,000 – 50r
M/P = Y – 200r – money demand function
G = 1,000
T = 1,000
M = 6,000
P=2
a) Derive and graph the IS curve and the LM curve. Calculate the equilibrium interest
rate and level of income. Label that point A on your graph.
IS: Y = C + I + G
Y = 500 + 0.75(Y – T) + 1,000 – 50r + 1,000
Y = 2,500 + 0.75Y – 0.75(1,000) – 50r
0.25Y = 1,750 – 50r
Y = 7,000 – 200r

LM: (M/P)d = (M/P)s


Y – 200r = 6,000 / 2
Y = 3,000 + 200r

IS = LM
7,000 – 200r = 3,000 + 200r
4,000 = 400r
10 = r

At r = 10, using IS, Y = 7,000 – 200(10)


= 5,000

b) Suppose that a newly elected president cuts taxes by 20 percent. Assuming the money
supply is held constant, what are the new equilibrium interest rate and level of income?
What is the tax multiplier?
When taxes cut by 20 per cent,
IS1: Y = 500 + 0.75(Y – T) + 1,000 – 50r + 1,000
Y = 500 + 0.75(Y – 800) + 1,000 – 50r + 1,000
0.25Y = 1,900 – 50r
Y = 7,600 – 200r

IS1 = LM
7,600 – 200r = 3,000 + 200r
4,600 = 400r
11.5 = r

At r = 11.5, using LM, Y = 3,000 + 200(11.5)


= 5,300

To find tax multiplier, we can use ΔY = ΔT x -mt,


ΔY = 5,300 – 5,000 = 300
ΔT = 200
-mt = 300 / 200 = 1.5 or mt = -1.5
c) Now assume that the central bank adjusts the money supply to hold the interest rate
constant. What is the new level of income? What must the new money supply be? What
is the tax multiplier?
To hold r constant at ro, LM has to shift to the right (moves in the same direction as IS). New
LM has to be estimated.

Central Bank can shift LM by manipulating money supply (we, the spending units are at the
demand side of money market).

LM1: M/2 = Y – 200r


Y = M/2 + 200r

IS1: Y = 7,600 – 200r

IS1 = LM1
7,600 – 200r = M/2 + 200r
At ro = 10,
7,600 – 200(10) = M/2 + 200(10)
3,600 = M/2
7,200 = M

After increase of M, the new equilibrium Y is Y = 7,200/2 + 200(10) = 5,600

Tax multiplier, -mt = ΔY / ΔT


= (5,600 – 5,000) / 200
=3
**change of tax multiplier show that it has increased from -1.5 to -3 because expansionary
monetary policy reinforces fiscal policy.

d) Now assume that the central bank adjusts the money supply to hold the level of income
constant. What is the new equilibrium interest rate? What must the money supply be?
What is the tax multiplier?
To hold Y constant at 5,000, LM has to shift to the left (opposite direction of IS shift).

To do that, central bank has to allow r to increase.

IS1: Y = 7,600 – 200r


5,000 = 7,600 – 200r
200r = 2,600
r = 13

At Y = 5,000, r = 13
LM1: M/2 = Y – 200r
M/2 = 5,000 – 200(13)
M/2 = 2,400
M = 4,800

Tax multiplier, -mt = ΔY / ΔT


Since income does not change, mt = 0

e) Show the equilibria you calculated in parts (b), (c), and (d) on the graph you drew in
part (a). Label them points B, C, and D.

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