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Tom Tum Kung Crisis Exercise on Policy Effects

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Exercise on Policy Effects

  1. Use the IS-LM model to show and thoroughly explain how output and the interest rate are affected by each of the following;

  1. An increase in government spending

In goods market, no foreign sector to the economy => NX = 0

Then aggregate demand for goods and services, using the expenditure approach, is defined as:  Y = C + I + G0

  • C = demand for consumption goods
  • I = demand for investment goods
  • G0 = exogenous (taken as given) government spending on goods and services.

Government spending is function of aggregate demand (E), when government spending increase that make E shift upward from E1 to E2 and output (Y) level increase from Y1 to Y2.

 [pic 1]

[pic 2]

An increase in government spending that make Y increase in same level of r (increase from Y1 to Y2) shift rightward from IS1 to IS2. In money market when income increase that mean demand of money (L{r,Y}) increase too (L shift upward). Money demand increase in same level of money supply that make real interest rate in money market increase from r1 to r2 (move upward on LM curve)[a]

[pic 3]

  1. A decline in autonomous consumption

[pic 4][b]

        In goods market from E= C0+C1(Y-T) + I +G (IS curve) 

  • c1 is called the (marginal) propensity to consume ∂C/∂YD, or the effect of an additional (infinitesimal) unit of disposable income on consumption.
  • c0 is the intercept of the consumption function. (autonomous consumption)
  • I = demand for investment goods
  • G = exogenous (taken as given) government spending on goods and services.

A decline in autonomous consumer expenditure shifts aggregate demand(E) [c]downward (from E1 to E2) and shifts the IS curve to the left (from IS1 to IS2) in same level of interest rate r1.

In money market  Md(Y,r) =M/P  

  • Md = Money demand
  • M/P = Real Money supply

A decrease of Y from (Y1 to Y2)  that make money demand shift upward in same level of money supply that make real interest rate decrease (LM move down in curve).

[pic 5]

  1. An increase in cash ratio

[pic 6][d]

An increase in cash ratio that mean people would like to hold more cash. People hold more cash that make deposit in account decrease, deposit decrease that make money in money market (Money supply) decrease[e]. Money supply (Ms) shift leftward from Ms1 to Ms2. Decrease in money supply but same level of money demand (Y) that make LM curve shift upward from LM1 to LM2. LM curve shift upward that make real interest rate increase. On IS curve if real interest rate increase that make IS curve move upward in curve.[f]

[pic 7]

  1. An increase in taxes[g]

[pic 8]

In goods market increase in taxes that make aggregate demand decrease because from this formula Y = C(Y - T) + I(r) + G 

  • Y= Out put
  • E = Aggregate demand
  • C = demand for consumption goods
  • Y = Income
  • T = Taxes
  • I = Demand for investment
  • G = Government spending

When taxes increase that make income decrease when income decrease that [h]make we will consume less. Taxes is inverts function of consumption when taxes increase that make consumption decrease so aggregate demand will decrease shift downward from E1 to E2. In IS curve taxes increase that make IS curve shift leftward from IS1 to IS2. 

In money market when taxes increase people would like to save more that mean bank will decrease interest rate so in LM curve LM will move downward along curve.[i]

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