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FSU ECO 4203 - Chapter 10, 11, and 12

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Chapter 10, 11, and 12 (8th edition) (Older edition: ch. 9, 10, and 11)1. IS-LM curves and Policy Analysisa. Fiscal vs. Monetary policy. Shifting IS and/or LM.• Fiscal policy shifts the IS curve. The IS curve will shift to the right when there is an increase in government expenditures or taxes are cut. Fiscal policy variable are not the only factors that shift IS- any autonomous change in the aggregate expenditure will have this effect. An example is an autonomous change in investment demand due to changes in the expected profitability of investment projects. This causes a shift in investment demand function giving the level of investment for each level of interest rate.• An increase in money supply shifts the LM curve to the right. (Monetary policy)• A decline in money supply shifts the LM curve to the left. (Monetary policy)b. What happens to the equilibrium values of r, Y, I, ifi. Taxes cut• Shifts the IS curve to the right• The equilibrium level of income rises, as does the equilibrium interest rate.• Income increases because of the increase in aggregate expenditures both directly from decreasing T and indirectly from increasing C• As income increases, the transactions demand for money rises. Since the money supply is constant, higher money demand causes the equilibrium interest rate to rise• Note that the horizontal distance by which the IS curve shifts is equal to change in T times (MPC/1-MPC). This distance equals the amount by which income wouldhave increased in the Keynesian cross model, but income rises less than this amount. This is because when taxes decrease, the rate of interest must rise to maintain equilibrium in the money market. The increase in the interest rate will cause a decline in investment spending. The decline in investment spending will crowd out the increase in aggregate demand from the decreased T.ii. Government spending increases• Shifts the IS curve to the right• The equilibrium level of income rises, as does the equilibrium interest rate• Income increases because of the increase in aggregate expenditures both directly from the increase in G and indirectly from the increase in C• iii. The money supply increases• An increase in money supply creates an excess supply of money, which causes the interest rate to fall.• As the interest rate falls, investment is increased, and this increase causes income to rise, with a further income-induced increase in consumption.• A new equilibrium is achieved when a fall in the interest rate and the rise in income jointly increase money demand by an amount equal to the increase in money supply.c. What is the impact of “mix” policies on interest rate, income, consumption, and investment?Example: how the economy responds to a tax increase depending on the response of the money supply.d. How do the fiscal policy multipliers in the IS-LM model compare to those from the simple Keynesian Cross model? Are they larger or smaller? Why?For increase in government spending:• Note that the horizontal distance by which the IS curve shifts is equal to the change in G times (1/1-MPC). This distance equals the amount by which income would have increased in the Keynesian cross model. However, incomes rises by less than this amount. The reason is that when government spending increases, the rate of interest must rise to maintain equilibrium in the money market. The increase in the interest rate will cause a decline in investment spending. The decline in investment spending will crowd out the increase in aggregate demand from the increase in G.For decrease in taxes:• Note that the horizontal distance by which the IS curve shifts is equal to change in T times (MPC/1-MPC). This distance equals the amount by which income would have increased in the Keynesian cross model, but income rises less than this amount. This is because when taxes decrease, the rate of interest must rise to maintain equilibrium in the money market. The increase in the interest rate will cause a decline in investment spending. The decline in investment spending will crowd out the increase in aggregate demand from the decreased T.e. Explain the crowding-out effect.Explained in the above explanations regarding multipliers. f. What factor determines the slope of IS curve. How about the slope of LM curve?Elasticity determines the slopes of both curves. Higher interest sensitivity results in a more steep IS curve. The downward slope of the IS curve is explained by the multiplier effect of an increase in fixed investment resulting from a lower rate raises real GDP. Note: the IS curve stands for investment and saving, and represents what’s going on in the market for goods and services. LM stands for liquidity and money, and represents what’s happening to the supply and demand for money. Interest rate is the variable that links the two together. The upward slope of LM is determined by two things: transactionsdemand for money and speculative demand for money- these determine the quantity of cash balances demanded (liquidity preference).g. How to explain the effectiveness of the policy? Any relationship between interest elasticity and the effectiveness of the policy? By effectiveness, we mean the size of the effect on income of a given change in the policy variable. The effectiveness of each type of policy will be shown to depend n the slope of the IS and LM curves (elasticity).Analyze the effectiveness for the following cases:i. Fiscal policy 1. Flat vs. steep ISSteep IS is effectiveFlat IS is ineffective2. Flat vs. steep LMSteep LM is ineffectiveFlat LM is effectiveii. Monetary policy1. Flat vs. steep ISSteep IS is ineffectiveFlat IS is effective2. Flat vs. steep LMSteep LM is effectiveFlat LM in ineffectiveh. What is the liquidity trap?According to the IS-LM model, expansionary monetary policy works by reducing interest rates and stimulating investment spending. But if interest rates have already fallen to almost zero, then perhaps monetary policy is no longer effective. Nominal interest rates cannot fall below zero: rather than making a loan at a negative nominal interest rate, a person would just hold cash. In this environment, expansionary monetary policy raises the supply of money, making the public’s assets portfolio more liquid, but because interest rates can’t fall any further, the extra liquidity might not have any effect. Aggregate demand, production, and employment may be “trapped” at low levels. i. What are


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