Question

IS-LM Model (Closed Economy)

The following equations describe a small open economy.

[Figures are in millions of dollars; interest rate (i) is in percent]. Assume that the price level is fixed.

Goods Market                                            Money Market

C = 250 + 0.8YD                                      L = 0.25Y – 62.5i

YD = Y + TR – T                                      Ms/P = 250

T = 100 + 0.25Y

I = 300 – 50i

G = 350; TR = 150

Goods market equilibrium condition: Y = C + I + G + X-M

Money market equilibrium condition: L = Ms/P

a) What is the equation that describes the IS curve (Y_IS)?

b) What is the equation describing the LM curve (Y_LM)?

c) What are the equilibrium levels of income (Y_o) and interest rate (i_o)

d) Suppose Government reduces the marginal tax rate (t) from 25% (as given in the model) to 15%.

i) Calculate the change in the level of income (Y) and interest rate (i) that results from this fiscal expansion whilst nominal money supply remains the same.

ii) Calculate the magnitude of crowding out that will result from the above fiscal

expansion.

Answer 1