Sharif University

Department of Mangement and Economics

Advanced Macroeconomics I
PS#1: IS-LM Model
Deadline: 1389/12/01
Advanced Macroeconomics, PS #1 1

“The long run is a misleading guide to current affairs. In the long

run we are all dead. Economists set themselves too easy, too useless
a task if in tempestuous seasons they can only tell us when the storm
is long past, the ocean will be flat.”
—John Maynard Keynes

Problem 1
According to the IS − LM model, what happens to the interest rate, income,
consumption, and investment under the following circumstances?

(a) The central bank increases the money supply.

(b) The government increases government purchases.
(c) The government increases taxes.
(d) The government increases government purchases and taxes by equal amounts.

Problem 2
Suppose the population in the economy is divided into two groups. Although
the two groups have equal amount of people, the richer one (Group A) gets 70%
of total income and the poorer one (Group B) gets the remaining 30%. The
economy is represented by the following equations.
M d = 5Y − 120r

M s = 10000

I = 296 − 20i + 0.1Y

CA = 120 + cA (YA − TA )

CB = 60 + cB (YB − TB )

G = 500

(a) Assuming cA = cB = 0.6 and TA = TB = 200, derive the IS and LM curve

and find the equilibrium level of output and interest rate and compute the
fiscal budget. Use graphs and math.

(b) The government wants to reduce the fiscal deficit, but it is worried about
the negative consequences such a policy might have on the level of output.
What combination of monetary and fiscal policies would you recommend
to decrease the deficit without provoking a recession? Explain graphically
and give the intuition.
(c) Assume now cA = 0.4 and cB = 0.8. Derive the IS and LM curve and
find the equilibrium level of output and interest rate. Use graphs and
math.
Advanced Macroeconomics, PS #1 2

(d) Explain the effect on output, interest rate, demand of money, amount of
money and investment of a public transfer to Group B financed by an
increase in the tax leveraged to Group A.
(e) Explain the effect on output and interest rate of a more equal distribution
of income.

Problem 3
The Keynesian Cross Model. Consider a closed economy described by the
following equations:
Y =C +I +G

C = C0 + c(Y − T ), 0<c<1

where Y , C, I, G, and T are, respectively, output, consumption, investment,

government consumption, and taxes. C0 represents the exogenous part of con-
sumption and c is the marginal propensity to consume. Assume that prices are
fixed and that I, G, and T are all exogenous.
(a) Recall that Y = C + S + T . Derive the saving equation, i.e. the expression
relating S to the aggregate income and parameters of the model.
(b) Derive an expression for the equilibrium condition involving the saving
equation.
(c) Demonstrate the so-called paradox of thrift by computing the effects on
output, saving, and consumption, of a decrease in C0 . Why do we call
this phenomenon a paradox of thrift?
(d) Compute the output multiplier with respect to government consumption,
dY /dG, under the assumption that the government finances its additional
spending by raising the tax (i.e. dT = dG). Explain the intuition behind
this so-called Haavelmo (balanced-budget) multiplier. Show the different
rounds of the multiplier process.
(e) Now assume that taxes depend positively on output, i.e. T = tY , where
t is the marginal (and average) tax rate (it is assumed that 0 < t < 1).
Compute the output multiplier with respect to government consumption,
dY /dG, under the assumption that government finances its additional
spending by selling bonds. Is the multiplier obtained here greater or
smaller than the Haavelmo multiplier? Show what happens to consump-
tion and the government deficit (G − T ). Explain your answers both
formally and intuitively.

Problem 4
Stability of the keynesian Cross Model. Consider the following Keynesian
cross model for the closed economy:
Y =C +I +G
Advanced Macroeconomics, PS #1 3

C = C0 + c(Y − T ), 0<c<1

I = I0 + Ż

Ẏ = −γ Ż γ>0

Where Y is output, C is consumption, I is actual investment, G is government

consumption, T is taxes, I0 is planned investment, and Z is the stock of inven-
tories. A variable with a dot denotes that variables rate of change over time,
i.e. Ż ≡ dZ/dt and Ẏ ≡ dY /dt. C0 and I0 represent the exogenous parts of,
respectively, consumption and investment, and c is the marginal propensity to
consume. Assume that prices are fixed and that G and T are all exogenous.

(a) Interpret the equations of the model.

(b) Show that the model is stable. Illustrate your answer graphically by de-
veloping the phase diagram for the model.
(c) Show the effects over time on output, consumption, actual investment,
and inventories, of a tax-financed increase in government consumption. Is
the short-run output multiplier smaller or larger than the long-run output
multiplier? Explain.