Assume a closed economy modeled by the following relations: (1) C = 0.75(Y - T)

Question

Assume a closed economy modeled by the following relations: (1) C = 0.75(Y - T) + 50 (2) T = 0.20Y (3) I = -5,000r + 300 (4) M(DEMAND)/P = 0.2Y - 2,500r + 100 (5) M(SUPPLY) = M* = fixed

1- Define the curves (IS) and (LM), and then derive their expressions.
The general price level is assumed constant P = 1 for the following questions.
2- Determine the equilibrium values for income and for the interest rate, when G* = 250 and M* = 200. Then, graphically represent the equilibrium of this economy, based on the (IS)and (LM) curves.
3- Following question 2-, compute the remaining endogenous variables. Explain if this country respects the fiscal rule according to which Government’s budget deficit should not be higher than 3% of GDP.

Given the state of its budget, the Government decides to decrease its public spending by 8%.

4- Without any computation, explain intuitively, by using the (IS) and (LM) curves, what are the expected effects of this reduction in public spending on equilibrium income and interest rates, and on the remaining endogenous variables of the model. Moreover, intuitively explain if this policy could allow Government to reduce its deficit-to-GDP ratio below 3%. Finally, compute the new equilibrium values of all endogenous variables following this policy (i.e. public spending is reduced by 8%).

Explanation / Answer

Answer 4. If the government spending reduces spending, then the IS curve will shift to left due to fiscal contraction.The interest rates falls and equilibrium level of income will decreses.

If government reduces government expenditure by 8%, means reduced by 20. So the new government spending is 230, Plug in the value of new G= 230 in the equation, you will get new equilibrium level of income and interest rate values.

New IS equation will be : Y= 1,856 - 16,000r

LM equation will be : r = 0.00008Y - 0.08

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