Here are some practice problems and questions:

Macroeconomics PROBLEM Set #3:

Due Monday February 17, 2003

1) Explain the effect of the following on the IS curve:

increase in the tax rate
business become more optimistic about future profit opportunities
the Central Bank lowers interest rates
Government spending increases
interest sensitivity of A_p
increase in the marginal propensity to import

2) Suppose:

C = .9(Y-T)

T = 300 [all autonomous taxation]

G= 280

I = 400 at initial equilibrium Y and also is defined by I = 800 - 50r

NX = 0

NOTE: t=0 and C_a=0 and don’t worry about decimal places for the interest rate. That is, let an interest rate of 2% simply be the number 2.

a) Derive the IS curve from the above information. Note, you will need to solve for Y to do this. What are the equilibrium values of Y and r in this economy? Graph the income/expenditure relationship (Keynesian cross) and the IS curve.

b) Now suppose that the Federal Reserve Bank lowers r by 2% to stimulate the economy. Show graphically the impact of this interest rate cut and the new level of Y*.

c) Now suppose that instead of cutting interest rates by 2%, the Government had decided to engage in a stimulative fiscal policy to achieve the same increase in Y you showed in part b. How much would G have to rise to achieve the same stimulus?

d) Imagine we are back in the economy represented by the solution to part a and that people were worried about the future and that business confidence fell. Show the impact on the IS framework with and without a decrease in the parameter b. What parameter would change to indicate a change in business confidence? [Suppose it went down by 50%.]

e) How suppose that there was a decline in business confidence AND and increase in the savings rate from .1 to .2. Show the impact on Y* at the original interest rate. Now how much would the interest rate need to be cut to keep the economy at the original level of Y?

3) Suppose the Governement and Central Bank want to work together to stimulate INVESTMENT but leave the total level of GDP constant. How might they do this?

4) Show the derivation of the LM curve.