Question

(a) . Given that in an economy

C = 0.8 (1-t) Y

t = 0.25

I = 900 - 50i

𝐺̅ = 800

L = 0.25Y - 62.5i

(𝑀̅/𝑃̅) = 500

(a) Derive the equation for the IS curve.

(c) What are the equilibrium levels of income and

the interest rate?

(d) Monetary & fiscal policy multiplier. 6

b) State whether the following statements are

TRUE or FALSE. Give reason(s) in support

of your answer. 5

i. Higher the marginal propensity to consume,

higher is the size of multiplier

ii. If investment is very sensitive to interest rate,

then we have a flat IS curve

(c) Use the following information (in rupees):

Income (Y) = 1,00,000

Nominal Money Supply (M) = 80,000

Price Level (P) = 20

Calculate the money growth rate required to

finance the budget deficit of Rs.10,000 in an

economy.

Answer 1

A. (a) Equation of IS curve.

$c=0.8(1-t)Y$

$t=0.25$

$I=900-50i$

$L=0.25Y-62.5i$

$y=c+I$

$y=0.8(1-t)y+(900-50i)$

$y(0.8t-0.8)=900-50i$

$y=\frac {900-50i}{0.8t-0.8}$

(b) Equilibrium level of income

$Y=C+I+G$

$Y=0.8(1-t)Y+900-50i+800$

$Y=0.8(1-t)Y+1700-50i$

(c)

Fiscal multiplier

Given by $\frac{\Delta Y}{\Delta G}$

$=\frac{0.8(1-t)Y+1700-50i}{800}$

Monetary multiplier - driven by the central bank which controls the money supply via the interest rates.

monetary multiplier$=\frac{1}{Reserve Ratio}$

B.

1.TRUE - The higher the marginal prospensity to consume, the higher the size of the multiplier. This is because changes in income levels lead to proportionately larger changes in the consumption of a particular good.

2.TRUE- If investment is very sensitive to interest rate, then we have a flat IS curve. This is because a reduction in interest rate causes a big increase in national income and product, hence IS curve is flat.

C.

$Y=100,000$

$Money Supply(M)=80,000$

$Price Level (P)=20$

Money Growth Rate =$\frac {P\times Y}{M}$

$=\frac {20\times100,000}{80,000}$

=25%.