Question

coG+{Y-T) Elbi M PYL) (i) = L-ci G=G T-T MEM Where T.G.L.M.c.7.b.cc. are all non-negative variables, whose values are determined exogenously, outside of the model (1) Suppose b=0. draw the IS curve in this case. Explain brietly your result. (4 points) Now suppose there is a decrease in G by AG <0. (2) Consider the IS relation only. How much is the impact on y G by AGCO under two scenarios b = 0 and b>0. Show ion only. How much is the impact on Y (output) of the decrease in scenarios: b =0 and b>0. Show your work. (4 points)

Answer 1

a) IS curve is given by aggregate expenditure Y = C+I+G

or, Y=C₀+C₁(Y-T₀)+I₀+G₀ (when b=0)

or, Y(1-C₁)=C₀+C₁T₀+I₀+G₀

or, Y = (C₀+C₁T₀+I₀+G₀)/(1-C₁)

b) If G₀ decreases to G₁ such that $\Delta$G<0 and b=0,

Y=(C₀+C₁T₀+I₀+G₁)/(1-C₁)

Thus, Y decreases by the amount of$\Delta$G.

Again, if b>0, Y=(C₀+C₁T₀+I₀-bi+G₁)/(1-C₁)

Thus, Y decreases by the amount ($\Delta$G+bi).