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Y =C +G+ I
C = c 0 + c1Yd
T = 50 ,
G = 150 ,
I = 100
Z = C + I + G
Y = Z
.
Following the same steps as in previous exercise
Y = 10 + 0,5(Y 50) + 150 + 100
Y = 10 + 0,5Y -25 +250
0,5 Y = 235
Y = 470
C = 10 + 0,5 (470 50) = 220
S = Y T C = 470 50 220 = 200
OR
Y=
1
1
c0 + I + G c1 T
[10 + 100 + 150 (0.5 50)] = 2 235 = 470
Y=
1 c1
1 0.5
and by substitution
b) The government request entails a reduction in autonomous expenditure equal to the variation in
autonomous consumption:
1
[5 + 100 + 150 (0.5 50)] = 2 230 = 460
1 0.5
,
C ' = 5 + 0.5 (460 50 ) = 210 ,
Y'=
S = Y T C
we know that C S .
C Z Y Y d S .
Therefore, at first sight the net effect is ambiguous. However, knowing that the relation S = I + (G T )
holds and since I, G and T, are unchanged, the two effects must cancel out (savings paradox).
N.B. Since production is a linear function of autonomous expenditure, its variation could also have been
calculated using partial derivatives:
1
1
Y
Y =
A = 2 (5) = 10
=
A 1 0.5
1 0.5
Y ' = Y + Y = 470 10 = 460 .
H = M [c + (1 c)]
1
1
1
=
=
1.923
[c + (1 c)] [0.2 + 0.4 (1 0.2)] 0.52
c) To determine the variation in the reserve/deposit ratio () coherent with the objectives of the central
bank, we use the equation that relates central bank money and the overall money supply:
1
234
[0.2 + (1 0.2)]
675 [0.2 + 0.8 ] = 234
135 + 540 = 234
234 135
=
= 0.183 0.18
540
675 =
a) It is necessary to have the equilibrium in both goods market and the money market.
Equilibrium condition for goods market is Y = C + I + G (IS)
Md Ms
Equilibrium condition for money market is
=
P
P
Goods market:
Y = 400 + 0,5Yd + 700 4000i + 0,1Y + 200
Y = 400 + 0,5(Y 200) + 700 4000i + 0,1Y + 200
Y = 400 + 0,5Y 100 + 700 4000i + 0,1Y +200
0,4Y = 1200 4000i
Y = 3000 10000i IS
Money market:
0,5Y 7500i = 500 LM
We insert the IS equation we found above (Y = 3000 10000i) into the LM equation and
solve for i.
0,5(3000-10000i)- 7500i =500
1500 5000i 7500i = 500
1000 = 12500i
i = 0,08 = 8%
Then we insert the equilibrium interest rate to the IS equation to be able to find the
equilibrium Y
Y = 3000 10000(0,08)
Y = 2200
b)
Y =
f2
A (fiscal policy multiplier for Y)
f 2 (1 c1 d1 ) + d 2 f1
Y =
7,500
* 100 = 1.5 *100 = 150
7,500 (1 0.5 0.1) + 4000 0.5
OR
You can use the same methodology we used in point (a) and solve the equations again by inserting G=300
instead of G=200
An increase in G is an expansionary fiscal policy and it causes IS curve to shift right. As a result
equilibrium values for both Y and i increase.
c) T = -100
OR
You can use the same methodology we used in point (a) and solve the equations again by inserting T=100
instead of G=200
A decrease in T is again an expansionary fiscal policy and it cause IS curve to shift right. As a result
equilibrium values for both Y and i increase.
d) Both in point (b) and in point (c) we have an expansionary fiscal policy. In point (b) it is through
increasing public spending and in point (c) it is through a reduction in taxes. It can be observed that
although the amount of increase in G and decrease in T are same in absolute terms their impact on
equilibrium Y and i are different. An increase in public spending has higher impact on equilibrium
values than a reduction in taxes. This is due the fact that G enters the equation directly as an
autonomous expenditure while changes in taxes affect the equilibrium levels through the influence on
disposable income.
If the government wants to finance the change in G by increasing T same amount (T = 100),
increasing T by the same amount would not help to return to the initial equilibrium because of
the reason discussed above. Changes in T affect the equilibrium income through its impact on
disposable income, while changes in G have a direct impact. So if the government wants to
finance the change in G it should increase T more than the increase in G. In our example
c1=0,5 so the increase in T should be equal to:
G=c1T
100 = 0,5 T
T = 200