Question 1

Given below is a Keynesian model of income determination (figures are in millions of dollars; interest rate (i) is in percent per annum. Assume that the price level (P) is fixed).

Goods Market

C = 300 + 0.9YD (Private consumption)

YD = Y + TR T (Disposable income)

T = 80 +0.1Y (Total taxes)

I = 400 (Private investment)

G = 200, TR = 100 (Gov. Expenditure and Transfers, respectively)

X=200 (Exports)

IM = 120 + 0.2Y (Imports)

Y = C + I + G + NX (Goods mkt. equilibrium condition)

Endogenous Variables: C, YD T, I, Y, IM

Exogenous Variables: Co, To, Io, Go, TRo, Xo, IMo

Parameters: c, t , m

Policy variables: Fiscal policy: (G, t and TR) Monetary policy: (N/A)

a) Compute the equilibrium values Y, C and T in the above model. (4 marks)

b) Calculate the expenditure multiplier in the model. (1 mark)

c) Calculate the change in Y given an increase in I by $50m and show using a well labelled Keynesian cross diagram (3 marks)

d) If Investment now includes an interest induced component, the IS relation now is

Y = [A_o bi].

Explain the role of parameters and b in the IS relation. (2 marks).

Question 2

Suppose the money demand is given by Md = $Y (0.25-i) where $Y = $200 and the supply of money is $40. Assume equilibrium in the financial markets.

a) Calculate the equilibrium interest rate. (2 marks)

b) If the Reserve Bank wants to increase interest rate by 10 per cent, at what level should it set the supply of money? (2 marks)

c) M/P = kY hi is also a LM relation. Explain the role of parameters k and h in the LM relation. (2 marks)

Question 3

The following equations describe a small, closed economy. Figures are in millions of dollars; interest rate (i) is in percent per annum. Assume that the price level is fixed.

The IS-LM Model

Goods Market Money Market

C = Co + cYD (Private consumption) (M/P) ^d = kY hi (Demand for real balances)

YD = Y + TR - T (Disposable income) (M/P) ^s = Mo/P (Real money supply)

T = To + tY (Total taxes) (M/P) ^d = (M/P ^s (Money mkt. eq. condition)

I = Io bi (Private investment)

G = Go, TR = TRo (Govt. Expenditure &Transfers)

Y = C + I + G (Goods mkt. eq. condition)

Endogenous Variables: C, YD, T, I, Y, i, M^d and M^s

Exogenous Variables: Co = 350, To = 80, Io = 250, Go = 150, TRo =50,

Mo =400 and P =1

Parameters: c = 0.80, t = 0.2, b = 50, k = 0.25 and h =50

Policy variables: Fiscal policy: (G, t and TR), Monetary policy: (Mo, P)

a) Solve for Y* and i* (4 marks)

b) Compute the impact of a rise in G to 200 on Y and I and determine the level of crowding out. (3 marks)

c) Calculate the new Y and i resultant from the fiscal expansion above. (4 marks)

d) Determine the accommodative change in money supply required to deal with the crowding out effect in b above and sketch in an IS-LM space with correct values. (5 marks)

Question 4

According to the IS-LM model, what happens in the short run to the interest rate, income, consumption, and investment under the following circumstances? Be sure your answer includes an appropriate graph.

a) The government increases taxes.

b) The price level decreases.

c) An increase in investor confidence

d) Explain a policy mix to fight a prolonged recession. (8 marks)