Question

Determine whether each of the following statements is true, false, or uncertain. Explain your answer carefully. Include an IS-LM diagram in your explanations for each part.

a. An exogenous increase in saving raises investment

b. An increase in government spending reduces disposable income

c. An exogenous reduction in money demand raises investment spending but reduces saving

d. Because of the crowding out effect, an increase in government spending may lead to no change in equilibrium income

e. The greater the sensitivity of investment to changes in the interest rate, the greater is the effect on monetary policy on GDP

Answer 1

(a) An exogenous increase in saving reduces consumption and hence IS curve shifts downward as shown in fig (a1). At the equilibrium, with no change in LM curve, the rate of interest falls as shown in fig (a2), which subsequently increases investment. Hence, the statement is correct.

(b) An increase in investment spending shifts IS curve outward (as shown in fig b1) and results in an increase in output and interest rate, with no change in LM curve (as shown in fig b2). As a result of increase in income (output), disposable income increase. So the above statement of decrease in disposable income is not correct.

(c) A decrease in money demand shifts the LM curve outward as shown in fig c1. Given that no change in IS curve, if LM shifts outward, output increases and rate of interest falls as shown in fig c2. A fall in interest rate helps to increase investment. On the other hand, as a result of increase in Y, saving also increases as saving is a positive function of output. Hence, the statement is partially correct in the sense that investment increases, but incorrect in the sense that saving falls.

(d) An increase in government spending has no impact on output if LM curve is vertical. In this case, an increase in investment shifts IS curve outward (as shown in fig b1), raising interest rate, but no change in output if LM curve is vertical. As a result of increase in interest rate, it dampens the expansionary effect caused due to increase in investment. The above statement is true.

(e) One of the major objectives of monetary policy is to influence rate of interest by buying and selling of bonds. We also know that investment is a function of interest rate. If the investment is more sensitive to interest rate, it shifts the IS curve and hence the aggregate demand. The above statement is true.

(e)