VII. Assume the basic three sector model: Y = C + I + G Where Tx = Tx o and I f

Question

VII. Assume the basic three sector model: Y = C + I + G
Where Tx = Tx o and I f ( Y with MPC = 0.8
Also, assume the following IS and LM schedules

For the IS, at i = 10%, Y = 1000
and at i = 8%, Y = 1200
and at i = 6%, Y = 1400
and at i = 4%, Y = 1600

And for the LM curve, at i = 10%, Y = 1800
and at i = 8%, Y = 1600
and at i = 6%, Y = 1400
and at i = 4%, Y = 1200

Now increase the level of government spending by $10 billion.

a. According to the applicable Keynesian formula multiplier, how much
should that $10 billion increase in government spending increase the level of
income?

b. According to your IS – LM curves, how much would that $10 billion
increase in government spending increase the level of income? (You may
interpolate/estimate the change in income if necessary. However, make it
a tight estimation/interpolation)

c. Is there a difference in the answer you gave for 2a versus 2b?

Explain

Explanation / Answer

Beginning in the 1930s the classical models failed to explain what was going on, hence a new model was developed -- the Keynesian Model. a. Full employment is not, because interest motivates both consumers & businesses differently - just because households save does not guarantee businesses will invest. b. Price-wage rigidity, rather than flexibility was assumed by Keynes.It showed that any government spending brought about cycles of spending that increased employment and prosperity regardless of the form of the spending. For example, a $100 million government project, whether to build a dam or dig and refill a giant hole, might pay $50 million in pure labor costs. The workers then take that $50 million and, minus the average saving rate, spend it at various businesses. These businesses now have more money to hire more people to make more products, leading to another round of spending. This idea was at the core of the New Deal and the growth of the welfare state.

Expenditures - Output Approach a. Y = C + I + G + X is the identity for income where Y = GDP, C = Consumption, I = Investment, G= Government expenditures, and X = Net exports (exports minus imports). The equilibrium level of GDP is indicated above where C + I is equal to the 45 degree line. Investment in this model is autonomous and the amount of investment is the vertical distance between the C and the C + I lines. This model assumes no government and that net exports are zero. Leakages - Injections Approach relies on the equality of investment and savings at equilibrium. a. I = S is equilibrium in the leakages - injections approach. Planned v. actual investment, the reason that the leakages - injection approach works is that planned investment must equal savings. Inventories can increase beyond that planned, hence output that is not purchased which is recessionary; or intended inventories can be depleted which is inflationary.

If there is an increase in expenditures, there will be a respending effect. In other words, if $10 is injected into the system, then it is income to someone. That first person will spend a portion of the income and save a portion. If MPC is .90 then the first individual will save $1 and spend $9.00. The second person receives $9.00 in income and will spend $8.10 and save $0.90. This process continues until there is no money left to be spent. Instead of summing all of the income, expenditures, and/or savings there is a short-hand method of determining the total effect -- this is called the Multiplier, which is: a. Multiplier M = 1/1-MPC or 1/MPS b. Significance - any increase in expenditures will have a multiple effect on the GDP. Reconciling AD/AS with Keynesian Cross the various C + I and 45 degree line intersections, if multiplied by the appropriate price level will yield one point on the aggregate demand curve. Shifts in aggregate demand can be shown with holding the price level constant and showing increases or decreases in C + I in the Keynesian Cross model.

The IS-LM (Investment Saving – Liquidity Preference Money Supply) model is a macroeconomic model that graphically represents two intersecting curves. The investment/saving (IS) curve is a variation of the income-expenditure model incorporating market interest rates (demand), while the liquidity preference/money supply equilibrium (LM) curve represents the amount of money available for investing (supply).

The model explains the decisions made by investors when it comes to investments with the amount of money available and the interest they will receive. Equilibrium is achieved when the amount invested equals the amount available to invest.

In A it is 10 and in B it is 180. Yest there is a difference between 2a and 2b. In B the increase is greater.

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