IS-LM: Assume that an economy is described by the IS curve Y = 3,600 + 3G - 2T -

Question

IS-LM: Assume that an economy is described by the IS curve Y = 3,600 + 3G - 2T - 150r and the LM curve Y = 2M/P + 100r [or r = 0.01Y - 0.02(M/P)]. The investment function for this economy is 1,000 - 50r. The consumption function is C = 200 + (2/3)(Y - T). Long-run equilibrium output for this economy is 4,000. The price level is 1.0 and M = 1,200.

a) Assume that government spending is fixed at 1,200. The government wants to achieve a level of investment equal to 900 and also achieve Y = 4,000. What level of r is needed for I = 900? What levels of T and M must be set to achieve the two goals? What will be the levels of private saving, public saving, and national saving? (Hint: Check C + I + G = Y.)

b) Now assume that the government wants to cut taxes to 1,000. With G set at 1,200, what will the interest rate be at Y = 4,000? What must be the value of M? What will I be? What will be the levels of private, public, and national saving? (Hint: Check C + I + G = Y.)

c) Which set of policies may be referred to as tight fiscal, loose money? Which set of policies may be referred to as loose fiscal, tight money? Which "policy mix" most encourages investment?

Explanation / Answer

a)
For I = 900:
I = 1000 - 50r
900 = 1000 - 50r
50r = 100
r = 2 [This is the level of r needed for investment to be 900]

Y = 3600 + 3G - 2T - 150r
4000 = 3600 + 3(1200) - 2T - 150(2)
4000 = 3600 + 3600 - 300 - 2T
4000 = 6900 - 2T
2T = 2900
T = 1450 [levels of T needed]

r = 0.01Y

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