Q1. How the following change will affect LM curve: a) increase in money supply b) increase in output c)a one time increase in price level d) a decrease in money demand due to increased use of ATM machines (people demand less money at any given interest rate)
a) When money supply increases, rate of interest falls and eventually LM curve shifts downwards.
b) When output increases, money demand also increases which in turn raises interest rates. So we simply move along the LM curve.
c) When price level increases the real money supply falls which in turn raises interest rate and LM curve shifts upward.
d) A decrease in demand for money caused by the increased use of ATM machines is illustrated by an inward shift of the money demand function in real money equilibrium graph. This will lower the interest rate and LM curve will shift downwards.
Q2. Why tax multiplier is smaller than Govt. purchase multiplier?
The tax multiplier is smaller than the Govt. purchase multiplier because of the initial effect on the economy. When Govt. spends an additional $100, the entire amount contributes to output (Y = C+I+G). When taxes are reduced by $100; the effect on output depends on change in consumption. If marginal propensity to consume is 0.8; that means only $80 of the $100 tax cut will be spent. The $20 used for saving does not contribute to the output. Therefore, Govt spending impact on the economy = 100/(1-0.8) whereas tax cut contributes ($100 * 0.8) /(1-0.8).
Q3. Assume that the economy is at full employment. The Govt. decides to cut taxes to give the economy an extra boost. a) Show the short run effect of this tax cut using the IS-LM model. What will happen to output and interest rate? b) what will happen in long run? c)If the Fed is following a policy of price stability how should they react to the tax increase? If the Fed action is implemented will the tax cut succeed in boosting output?
a) Tax cut will shift IS curve which implies that output and interest rate will rise.
b) In the long run prices will rise as the output is above full employment level. This decreases money supply and results in leftward shift of LM curve.
c) If the Fed wanted to avoid the price increase, then it should decrease the money supply in the short run. This will raise interest rate and LM shifts to the left. As a result, output will return to full employment level. Thus there is no boost to output.
Q4. In IS-LM framework, the multiplier effect is larger or smaller than it is in Simple Keynesian Model?
In IS-LM, multiplier effect is smaller due to crowding out of investment demand. If the interest rate is held constant by a flat LM curve then increase in Govt expenditure will have a large effect on output. If LM curve is steeper, the output boosts as the Govt expenditure is diminished by an increase in interest rate.
Q5. Describe how the changes will affect AD curve? a) a decrease in money demand caused by introduction of a new electronic money card. b) a decrease in money supply c) an increase in price level d) an increase in Govt taxes.
a) A decrease in money demand will shift the LM curve outward. Therefore, AD curve should also shift outward because there will now be a higher output level at any given price.
b) A decrease in money supply shifts the LM curve leftwards which in turn decrease the output and hence, AD curve shifts leftward.
c)An increase in price level implies a movement along the AD curve.
d) An increase in Govt taxes will shift the IS curve and reduce output.AD curve will shift inwards to reflect lower output at any given price.
Part 1 Solved answers here.