Question

Suppose you are given IS: Y = 1250-50r and LM: Y = 450 + 30r , α = 2.5 M = 700 and P-2, Md (1/3) Y + 200-10r, Initial equilibrium Y 750, r-10 and 1=0 a) Evaluate numerically only the impact of fiscal policy on the income level (Y) when government expenditure is increased by $5 billions, under the conditions when: i Seitivity of investment demand to the interest rate is 0.001 and 100 Less sensitivity of Investment to the interest rate causes fiscal policy more effective than more sensitive investment to the interest rate. ii Sensitivity of money demand to the interest rate 0.001 and 100. b) Use the above model. How much of investment demand (T) will be crowded out if the government increases its purchases by 100 (i.e. AG-100). Answer numerically and graphically. Also Check through ΔAD-> ΔΥ-α(AAD), what is crowded-out income (Y)

Answer 1

IS: Y = 1250 - 50r LM: Y = 450 + 30r alpha = 2.5 = 700 and = 2 Md = (1/3)Y + 200 - 10r Initial equilibrium, Y = 750, r = 10 and 0 i) We first derive the fiscal policy multiplier, which is given as: sigma/[1 + alpha bK/h] where 'b' denote sensitivity of investment demand to in�terest rate = 100, 'h' denote sensitivity of money demand to interest rate = 100 and 'k' denote sensitivity of money demand to output = (1/3) Hence, fiscal policy multiplier (sigma) = 2.5/(1 + (2.5 times 100 times (1/3)/100)) = 1.3636 \r\n So, change in Y when government expenditure increases by $ 5 billion = fiscal policy multiplier x change in government expenditure = 1.3636 x 5 = $ 6.818 This means when government expenditure increases by $ 5 billion, output (Y) will increase by $ 6.818 billion. ii) Suppose (as in part a) sensitivity of investment demand