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Assignment - IS-LM

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Assignment - IS-LM

Uploaded by

yoursgauravsingh
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Assignment 5 – IS-LM

Question 1. You are given the following information regarding the economy:

C = a + b*YD - consumption demand function

I = I0 – d*r – investment demand function


Government spending = G; Net Taxes = T, YD = Y – T
a. Find out the equation for the I-S curve

Ans. IS Curve: Y = C + I(r) + G


 Y = a + b*(Y-T) + I0 – d*r +G
 (1-b)*Y = [a – b*T + I0 + G] – d*r
 r = [a – b*T + I0 + G]/ d – ([1-b]/d)*Y – (I-S)

b. What is the slope of the I-S curve? How does it change with the size of MPC (b) and
interest sensitivity of investment demand (d)?
Ans.
Slope of the I-S curve = (1-b)/d
Higher MPC (higher b) implies smaller slope (or flatter I-S curve)
Higher in interest sensitivity of investment demand (higher ‘d’) implies smaller slope
(flatter I-S curve).

c. Suppose that the government imposes a proportionate income tax (T = t*Y, where
0<t<1) instead of the lump-sum tax (fixed amount). How does this change the slope
of the I-S curve? What happens to the slope of the I-S curve when the rate of income
tax – ‘t’ goes up?
IS Curve with proportionate income tax –

Y=C+I+G
 Y = a + b*(Y – t*Y) + I0 – d*r +G
 Y = a + b*(1-t)*Y + I0 – d*r +G
 (1-b*(1-t))*Y = [a + I0 + G] – d*r
 r = [a + I0 + G]/ d – ([1-b*(1-t)]/d)*Y
New slope of the I-S curve – (1-b*(1-t))/d (notice that introduction of proportionate income
tax increases the numerator (1- b + b*t) and therefore increases the slope of the I-S curve
(makes I-S curve steeper.)
A higher ‘t’ increases the slope of the I-S curve (makes the I-S curve steeper).
Question 2. Demand for the real money balances is given by:
(M/P)d = kY – hi (1)
Supply of real money balances is fixed at: (M/P)s (2)
a. Find out the equation for the LM Curve.
Ans. Equation for the LM curve is given by: (M/P)d = (M/P)s
 kY – hi = (M/P)s
 g

b. What is the slope of the LM curve? How does the slope change with the size of k
(income sensitivity) and h (interest sensitivity) of the demand for money?
Ans. Slope of the L-M curve is (k/h).
Higher income sensitivity (k) means bigger slope of LM (steeper LM curve)
Higher interest sensitivity (h) means smaller slope of LM (flatter LM curve)

Question 3. In the Keynesian-cross model, a decrease in the interest rate ______ planned
investment spending and ______ the equilibrium level of output in the goods market.
a. increases; increases [x]
b. increases; decreases
c. decreases; decreases
d. decreases; increases

Question 4. If the interest rate is above the equilibrium value, the:


a. demand for real balances exceeds the supply.
b. supply of real balances exceeds the demand. [x]
c. market for real balances clears.
d. demand for real balances increases.

Question 5.
Based on the graph, If firms are producing at level Y3, then inventories will ______, inducing
firms to ______ production.
a. rise; increase
b. rise; decrease [x]
c. fall; increase
d. fall; decrease

Question 6.

Based on the graph, if the interest rate is r3, then people will ______ bonds and the interest
rate will ______.
a. sell; rise [x]
b. sell; fall
c. buy; rise
d. buy; fall

Question 7. With the real money supply held constant, the theory of liquidity preference
implies that a higher income level will be consistent with:
a. no change in the interest rate.
b. a lower interest rate.
c. a higher interest rate. [x]
d. first a lower and then a higher interest rate

Question 8. Assume the autonomous components in the demand for GDP are G=100 and X=150. C =
30+0.7Y (from a marginal rate of consumption out of disposable income of 0.8 and the tax rate of
12.5% on income). M = 25 + 0.2Y. Investment is a downward sloping function in the interest rate I =
25−20×r.

• Derive the IS function and show it in the graph.


Answer

• What happens to the IS curve is foreign demand increases autonomous exports by 50 units?

Answer:

Question 9. Real money demand is given by (M/P)d = aY − br = 12.5Y −400r.

a) Show the interest rate as a function of income and money demand for (real) money.

LM Curve:

b) For a giving nominal supply of money (MS) of 125 CU and a price level of 1.25, calculate the
LM function and graph it.

Answer:
c) Assume the IS function is given by r = 10 − 0.02Y, calculate the equilibrium level of the
interest rate and national income.

Answer:

d) How does the equilibrium change with an expansion of the nominal supply of money to
893.75 CU

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