Question 1. Explain why the aggregate demand curve slopes downward?
Answer: The summary of the IS-LM model is depicted by AD curve. AD curve slopes downward because at a lower level of price, the real money balance increases, and interest rate falls, which stimulates the investments. As a result the equilibrium income increases.
Question 2. What is the impact of an increase in taxes on the interest rate, income, consumption, and investment?
Answer: When the tax increases, it will cause the IS curve to shift towards left reaching to IS2 from IS1. As a result of this, the equilibrium point A shifts to B where the interest rate will reach to r2 by falling from r1. The income will also be reduced from Y1 to Y2. The increase in the tax will decrease the consumption as there will be less amount of disposable income. Since the consumption decreases, the income will also decrease.
Part 2: Question 2: Use the IS–LM model to predict the effects of each of the following shocks on income, the interest rate, consumption, and investment. In each case, explain what the central bank should do to keep income at its initial level.
After the invention of a new high-speed computer chip, many firms decide to upgrade their computer systems.
This will boost the investment, and the IS curve will shift towards right from IS1 to IS2 giving a positive increase in the income, output and the interest rate (from r1 to r2). With the increasing investment, the money demand increases while the supply of money remains constant. This high demand for money will force the interest rate to increase to have an equilibrium in the market. When the interest rate increases, the demand for money will be slightly decreased. Therefore, the output raises partially while the total income, interest rate, investment, and consumption will rise.
A wave of credit-card fraud increases the frequency with which people make transactions in cash.
This will increase the demand for the cash and shifts the LM curve towards left from LM1 to LM2. This shift of LM curve will result in a decrease in income from Y1 to Y2 and boost the interest rate from r1 to r2 as in the figure. The initial equilibrium at B is disturbed, and a new equilibrium is maintained at A. When the income falls, the consumption level falls, and increased interest rates will lead to fall in investment. To cope with this situation, the money supply should be increased, and the interest rate must be decreased to maintain the output and income at the initial level. In this situation, the LM curve will be restored to its original position, and no change is seen.
c) A best-seller titled Retire Rich convinces the public to increase the percentage of their income devoted to saving.
In this situation, the propensity to save increases and the propensity to consume decreases causing the IS curve to shift downward to IS1 from IS2. This will cause the fall in income, output, consumption and interest rate. But, the investment rises because of low-interest rate. A new equilibrium A is established at an intersection of IS1 and LM where income and interest rates are both less. To maintain the output at its original level by the central bank, the money supply must be increased to Higher money supply will shift the LM curve towards right where output will be maintained at original level while both consumption and interest rate will be lowered and investment will be higher.
Problems and applications:
Question 6. Use the IS–LM diagram to describe the short-run and long-run effects of the following changes in national income, the interest rate, the price level, consumption, investment, and real money balances.
a) An increase in the money supply.
When the money supply increases, it shifts the LM curve from LM1 to LM2 in the short run, and the new equilibrium is maintained at point B. The interest rate of r2 will be prevalent in the market, which is lower than r1. This will cause investment to grow and output to increase from Y to Y2. When the consumption starts to grow, in the long run, the price will start to increase thereby causing the fall in real balance. This in turn will raise the interest rate. Eventually, the LM curve falls back to LM1 position. Until the economy maintains its initial equilibrium A, the price will keep on raising. Then, the interest rate again raises to r1 and investment will fall to its original level in the long run without having any impact on the economy due to the increased money supply.
b) An increase in government purchases.
When the government purchase increases, the equilibrium point will be disturbed because IS curve will shift to IS2 from IS1, and new equilibrium will be maintained at B. In the short run, the output level reaches to Y2 from Y and the interest rate reaches to r2 from r1. This cause fall in the investment. In the long run, the price begins to rise causing the real balance of money to fall and LM curve shifts towards left resulting to higher interest rate r3 while the income and output remain in its original level in newly established equilibrium point C. In the long run, the output will reach to Y while the interest rates will rise to r2 with the higher price level and decreased the level of consumption and investment.
c) An increase in taxes.
When the tax rate increases, the disposable income reduces as a result IS curve shifts from IS1 to IS2 towards left and new short-run equilibrium is created at B reducing the income to Y2 from Y and interest rate from r1 to r2. However, in the long run, the price will fall causing the LM curve to shift towards right from LM1 to LM2. Due to this, interest rates fall to r3, and the investment increases thereby increasing the income. Eventually, new equilibrium C will be established where the output will be maintained at an original level, and interest rate will be at r3, lower than the original one.
Question 8: Suppose that the demand for real money balances depends on disposable income. That is, the money demand function is M/P = L(r, Y−T). Using the IS–LM model, discuss whether this change in the money demand function alters the following:
The analysis of changes in government purchases
There is no effect on the government purchases even when the demand for the money is made dependent on the level of disposable income rather than on the total expenditure value. When the purchases of the government increases, the IS curve will shift towards right from IS1 to IS2 while the LM curve remains in its position and is unaffected. So, the analysis remains same even after there is a change in the government purchase.
The analysis of changes in taxes
Reduction in the tax rate will increase the disposable income and consumption irrespective of the income level. The IS curve will shift towards right from IS1 to IS2. If we consider that the demand for the money depends on the disposable income, the reduction in the tax rate will boost the demand for the money and shift the LM curve towards left to LM2 from LM1. Hence, by making the money demand dependent on the disposable income, the analysis of a change in taxes is altered.
Chapter 12:
Question 2: In the Mundell–Fleming model with floating exchange rates, explain what happens to the aggregate income, the exchange rate, and the trade balance when the money supply is reduced. What would happen if exchange rates were fixed rather than floating?
When the supply of the money decreases in the Mundell–Fleming model, it will cause the fall in the real balance M/P. This will ultimately shift the LM curve towards left and a new equilibrium is created at B with a lower level of income and a higher rate of exchange in the floating exchange rates system. When the exchange rate increases, exports and trade balance falls.
In the case of fixed exchange rate, when the exchange rate shifts upwards, then it forces the government to sell the dollars and buy back the home currency. This will ultimately increase the supply of the money causing the LM curve to shift to its original position, and the equilibrium is attained at A with higher income and the lower exchange rate.
Under the floating exchange rate system, monetary policy is very useful to affect the output in an open economy but it cannot be done with fixed exchange rates.
Question 5: Describe the impossible trinity.
The Impossible trinity denotes how it is not possible to have a fixed rate of exchange, free flow of capital and the monetary policy of independent nature.
Problems and application:
Question 1. Use the Mundell–Fleming model to predict what would happen to aggregate income, the exchange rate, and the trade balance under both floating and fixed exchange rates in response to each of the following shocks.
A fall in consumer confidence about the future induces consumers to spend less and save more.
When the confidence of the consumer falls, then it will shift the IS curve and the line of planned expenditure towards the left. In the economy with the floating exchange rate system, this shift will increase the exchange rate hence the output and the income do not change. This is shown in figure a1.
However, on the fixed rate system, this shift will keep the exchange rate constant while it reduces the money supply and causing the LM curve to shift towards the left to keep the exchange rate at fixed level. At a new equilibrium point B, the output and the income falls.
The introduction of a stylish line of Toyotas makes some consumers prefer foreign cars over domestic cars.
When the sales of imported cars increase in the country, the IS curve will shift towards left. In the economy with the floating exchange rate system, this shift will cause the exchange rate to fall without having any effect on output as shown in figure b1 below. The trade balance will have growth because of the depreciation of exchange rate.
As shown in the fig b2 below, when IS curve falls towards left in the fixed exchange rate economy, it will cause LM curve to shift towards left to maintain the exchange rate at fixed level. So, in this situation, the output and the income falls.
The introduction of automatic teller machines reduces the demand for money.
When the money demand falls, then the LM curve shifts towards the right. In the economy with the floating exchange rate system, this shift of LM curve towards the right will cause the exchange rate to fall. When the exchange rate falls, the trade balance and the output increases. This is shown in figure c1.
In the country with the fixed exchange rate system, the interest rate will decrease due to the shift in LM curve. This in turn forces currency to depreciate. However, to maintain the fixed exchange rate, the money supply is reduced, and LM curve again shifts to its original equilibrium as shown in figure c2.
Question 4: Business executives and policymakers are often concerned about the competitiveness of Canadian industry (the ability of Canadian industries to sell their goods profitably in world markets).
How would a change in the nominal exchange rate affect competitiveness in the short run when prices are sticky?
If the prices are sticky, the price will remain at the nominal level. The nominal exchange rate will change only if there is an increase or decrease in price. Since the price does not change in the short run, the increase in the nominal exchange rate will lead to an appreciation of the Canadian dollar and vice versa. Appreciated dollar makes the goods expensive and reduces exports. So, the competitiveness decreases. Depreciated dollar makes the goods cheaper, and it increases the exports. Because the goods are cheaper, the competitiveness increases.
Suppose you wanted to make domestic industries more competitive but did not want to alter aggregate income. According to the Mundell–Fleming model, what combination of monetary and fiscal policies should you pursue?
Question 6: Suppose that money demand depends on disposable income so that the equation for the money market becomes M/P = L(r, Y – T).
Analyze the impact of a tax cut in a small open economy on the exchange rate and income under both floating and fixed exchange rates.
Under the floating exchange rate: If the tax rate is reduced, then the LM curve will shift to the left and IS curve shifts to the right as shown in the figure a below. This shift will create a new equilibrium point at B where the income will fall, and the exchange rate will increase. Because the tax rate decreases, the disposable income increases.
Fixed rates: Due to the tax cut, IS1 curve will shift to IS2 while LM1 will also shift to LM2 in order to make the exchange rate at a fixed level. A new equilibrium point B is created where the income Y2 exist at a higher level, but the exchange rate remains fixed without any impact on the balance of trade.
Question 8: Use the Mundell–Fleming model to answer the following questions about the state of Alberta (a small open economy).
What kind of exchange-rate system does Alberta have with its major trading partners?
The floating exchange rate must be used by Alberta. Every province has their own economy, and they control their economy with different fiscal and monetary policy. If the expansionary policy is used by Ontario referring the poor local economy, then the exchange rate of Ontario will be lower as a result of which Alberta will be benefitted.
If Alberta suffers from a recession, should the state government use monetary or fiscal policy to stimulate employment? Explain. (Note: For this question, assume that the provincial government can print dollar bills.)
The impacts of the recession can be recovered by both fiscal and monetary policy of the government. With these policies, the tax rates can be reduced as a result of which consumer and business will have more money to spend. This excess money can be injected into the economy to create jobs as peoples can be hired for different works in the growing economy. Interest rates can be reduced through expansionary fiscal policy. Reduced interest rates, in one hand, will motive business and households to spend and invest rather than save and, on the other hand, people will take a loan to invest.
If Alberta prohibited the import of wines from the province of Ontario, what would happen to income, the exchange rate, and the trade balance? Consider both the short-run and the long-run impacts.
If the Ontario wine import is not allowed by Alberta, Albertina will not find Ontario wine in Alberta. Due to this, the wine must be imported from other states or countries. As a result of this, in the short run, income and Ontario’s NX will be affected but, in the long run, both NX and income will return to normal when the import level changes.
