Assume that an economy is described by the IS curve Y = 3,600 + 3G – 2T – 150r a

Question

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) (3pts) 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) (3pts) 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) (2pts) 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) (3pts) 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?
Investment function = 1,000 – 50r
900 = 1,000 - 50 r
r = 100/50
r = 2
What levels of T and M must be set to achieve the two goals?
IS curve Y = 3,600 + 3G – 2T – 150r
4,000 = 3,600 + 3 x 1200 - 2T - 150 x 2
3600 + 3600 - 300 - 4000 = 2T
2900 = 2 T
T = 1450
LM curve Y = 2M/P + 100r
4000 = 2M/1 + 100 x 2
3,800 = 2M
M = 1900
What will be the levels of private saving, public saving, and national saving? (Hint: Check C + I + G = Y.)
Private Saving = Disposable Income - Consumption
Disposable income = Y - T = 4,000 - 1,450 = 2550
Consumption function is C = 200 + (2/3)(Y – T)
C = 200 + (2/3) x 2550 = $1900
Private savings = 2550 -1900 = 650
Public Savings = T- G = 1,450 - 1200 = 250
National savings = Private savings + Public Savings = 650 + 250 = 900


What will be the levels of private saving, public saving, and national saving? (Hint: Check C + I + G = Y.)

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