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Economics 5310: Applications of IS-LM Model

Assume the following structural equations that describe behavior in the economys goodsmarket and money market during the current period (i.e. given exogenous effects).

Yp = C + I + G + NXC = Ca - d r + c (Y T)T = To + t Y

I = Io f r

NX = NXo - e Y

G = Go(M/P)d = (M/P)s

(M/P)d = k Y g r

(M/P)s = (Mo/Po)

Assume known parameter values of c, t, e, and k that are the marginal propensity toconsume, to tax, to import, and to demand money, respectively, that are induced from a

change in income. Also assume known parameter values of d, f, and g that are the

marginal responsiveness of consumption, investment, and money demand, respectively,

that are induced from a change in the interest rate.

I. Evaluate the influence of the each of the following (other things equal) on the interest

rate, bond prices, real income, real consumption, real investment, and real net exports:(Specify any behavior assumptions that you are applying in your analysis,)

Note: Bond prices always move inversely to current market interest rates.

1. A political campaign creates a wave of pessimism that sweeps across the land.

This will shift the IS curve to the left as pessimism reduces consumption and

investment at every level of income. When the IS curve shifts to the left, the interest

rate and income decrease. This results in higher bond prices and higher net exportsas induced imports decrease (acts as an automatic stabilizer).

2. Members of the baby boom generation, now well into adulthood, become

increasingly concerned about having a comfortable retirement.

The IS curve will shift to the left as more people save more and consume less at

every level of income. (Effects of r, bond prices, income, and NX the same as

above).

3. A buy American campaign is successful and foreign countries do not retaliate in

any way.

The IS curve will shift to the right as buying American will increase autonomous net

exports as imports fall. The Interest rate increases, income increases, bond prices

fall, NX decrease with more induced imports.

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4. The administration reduces the income tax rate.

The IS curve will flatten out. This will increase Y and r as consumption increases

due to higher income multiplier, but it will crowd out investment and net exports.

5. A change in the nominal interest rate and exchange rate is matched by a change inthe expected rate of inflation.

No change, as the real interest rate remains the same. The supply and demand for

real money balances is unchanged.

6. Government spending increases because of war.

The IS curve shifts to the right as government spending increases; increasing

income, interest rates, and consumption through the multiplier effect, but reducing

investment (crowding out effect) and net exports (higher induced imports).

7. The Fed purchases Treasury Bills in the open market.

The LM curve will shift to the right as purchasing T-Bills in the open market

increases the money supply; lowering the interest rate. The lower interest rates will

increase investment, consumption and income. The higher income will reduce net

exports due to higher induced imports.

8. The demand for money becomes more sensitive to changes in the interest rate.

An increased sensitivity to interest rates in the demand for money will flatten out

the LM curve, causing the interest rates to fall and income to rise. Bond prices will

rise, investment and consumption will increase, but net exports will decrease due to

higher induced imports.

9. People begin to expect a decline in the near future of the interest rate on bonds.

The demand for money falls as the demand for bonds increases, The LM curve

shifts to the right as people expect capital gains, causing a self fulfilling prediction to

occur. Interest rates will decrease, investment and consumption will increase

causing higher real income. Net exports decrease due to higher induced imports.

10. A new law is passed to make automatic teller machines illegal.

The LM curve shifts to the left as people demand more money at every level of

income. The interest rate rises, income falls, investment and consumption fall, net

exports rise, and bond prices fall due to a lower demand for bonds.

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11. People are able to move funds more easily between their bond accounts to their

checking account.

The LM curve shifts to the right, as the velocity of money will increase (people

economize on their money balances, holding less money at every level of income).

Bond prices rise as the interest rate falls, investment and consumption rise, netexports fall.

12. The public is less sensitive to changes in interest rates on their willingness to holdmoney.

The LM curve will become steeper, while maintaining the same intercept on the

income axis. The interest rate will rise causing investment and consumption to

decrease, net exports to increase, and bond prices to fall unless the money supply is

increased.

13. The aggregate price level falls.

The supply of real money balances increases, causing the LM curve to shift to the

right. Income will rise, the real interest rate falls, investment and consumption rise,

net exports fall.

14. The real opportunity cost of holding money increases. (Note the real interest rateis an endogenous variable.)

Since the real interest rate is endogenous it may temporarily increase above its

equilibrium level. At the same level of income in the good market the rate of

injection would be less than the rate of leakage, reducing causing the interest rate to

decrease to decrease the injection rate back to equilibrium. At the same level of

income in the money market, the higher interest rate would result in a demand for

money below the supply of money, causing the interest rate to fall to raise the

demand for money until equilibrium was reestablished.

II. The Effectiveness of Macroeconomic Stabilization Policy

1. How would the effectiveness of fiscal policy be influenced if the demand formoney is insensitive to a change in the interest rate?

This results in a completely vertical LM curve. Fiscal policy is completely offset by

the effect of higher interest rates on investment unless the money supply is

increased.

2. How would the effectiveness of monetary policy be influenced if the demand for

money is insensitive to a change in the interest rate.

Monetary policy is completely effective with all new money used for transactions.

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3. Assume that the Federal Reserve has decided to maintain the current level of real

GDP and Congress votes for a tax cut. What happens to interest rates and the

composition of output in the economy?

The tax cut shifts the IS curve to the right with a partial crowding out if the money

supply is unchanged. To keep the level of income constant the Fed lowers themoney supply, shifting the LM curve to the left, further increasing the interest rate

until investment and consumption spending decrease to completely crowd out the

initial stimulus on consumption of the tax cut.

4. What is likely to happen to interest rates if a fiscal policy deficit occurs and the

Fed does not act to change the money supply?

Under normal IS and LM slopes, a fiscal policy deficit shifts the IS curve to the right

increasing income and the interest rate. Without more money, the interest rate rises

to partially crowd out public spending by reduced investment spending.

III. (Supplement to Problem Set 1) Suppose the NX function

also depends negatively on the interest rate. Assume amarginal responsiveness of NX to interest rates equal to h, so

that the new function is as follows:

NX = NX0 e Y h r

1. Why is NX negatively related to r?

A lower real interest rate lower the real exchange rate of the dollar if real interest

rates do not change abroad. This is because people will demand fewer dollars to

buy our financial assets (capital account deficit). The lower real exchange ratesmakes our goods cheaper, adding to our net exports (current account surplus).

2. What happens to the slope of the IS curve?

The IS curve becomes flatter, i.e. more sensitive to a change in the interest rate.

Now a lower interest rate not only leads to more domestic investment, but it adds to

net exports, increasing domestic spending in the goods market.

3. Is monetary policy more or less effective in changing real output?

Other things equal, monetary policy is more effective, since a change in interest

rates resulting from Fed policy has a greater effect on the goods market. (Note that

the central bank can lower the exchange rate by either buying domestic bonds,

adding to the money supply, or buy selling dollars to buy foreign currencies, also

adding to the domestic money supply.)

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