MAC 9&10

Monetary and Fiscal Policy

• What is economic policy?
• Action govt takes in economic environment to attain certain
objectives / targets
• Targets can be primary like growth, inflation, unemployment
• Or Secondary like interest rates
• Speed of implementing policy
• Internal and external lag
• Internal: decision, recognition, action
• External: time it takes to have impact
• Impact : Uncertainty
• Econometric model
• Assumptions about parameters
• How govt views
• How individuals take it

11-2
• We use the IS-LM model developed to show how monetary and
fiscal policy work
• Two main macroeconomic policies to make economy grow at
reasonable rate, with low inflation; or to shorten recessions, or to
prevent booms from getting out of hand
• Fiscal policy has its initial impact in the goods market
• Monetary policy has its initial impact mainly in the assets
markets
Because the goods and assets markets are interconnected,
both fiscal and monetary policies have effects on both the level
of output and interest rates
Expansionary/contractionary monetary policy moves the LM
curve to the right/left (raising/lowering income , lowering
/raising interest)
Expansionary/contractionary fiscal policy moves the IS curve to
the right/left( raising both income and interest rates/ lowering
both income and interest rates)
Which Targets for the Fed?
Three key points:
1. There is a distinction is between ultimate targets and intermediate
targets.
– Ultimate targets are variables such as the inflation rate and unemployment
rate whose behavior matters.
– Intermediate targets, including the interest rate, are targets the Fed aims at in
order to hit the ultimate targets more accurately
– The discount rate, RRR, and OMO are the instruments Fed has to hit the
target
Introduction
• In Great Recession, Fed aggressively cut interest rates
• Reduced to almost zero
• Continued even after official end of recession
Control of the Money Stock and Interest Rate
• The Fed cannot simultaneously
set the interest rate AND the
stock of money at any given
target levels that it may choose
• Suppose that the Fed wants to
set the interest rate at i* and the
money stock at M*, with the
demand for money at LL
• The Fed can move the money
supply around, but not LL  It
can only set combinations of i
and M that lie along LL
The history of money
• In the beginning markets operated on a barter system where
exchange of goods and the preferences for them determined
the endogenous valuation of goods.
• Because of the inefficiency of using a double coincidence of
wants, markets started relying on money as a medium of
exchange.
• Initially there was commodity money (gold and silver).
Commodity money has intrinsic value, i.e.- they had value in
themselves, based on demand and supply.
• This value governed the prices of goods. There was thus no
need for regulation by the central bank.
• Then came Fiat Money
The demand for money
•Money is a medium of exchange, unit of account and a store of
value.
• The cost of holding money is the interest forgone by not holding
other assets. The cost is estimated to be the short term interest
rate.
• The sources of money demand are the speculative or asset
demand and the transactions and precautionary demand for
money.
•Since payment occurs at discrete intervals but expenditure
occurs regularly, people may demand to hold money for
purchases and transactions. The transaction demand is usually
increasing in income.
•Precautionary demand is to meet unforeseen circumstances.
•Money may also be held speculatively as an asset, and this
demand is low in most advanced economies but not that low in
developing countries such as India. Asset demand for money is
inversely related to the interest rate
 The fractional-reserve banking system
• The money supply consists mainly of deposits at banks  Fed does not control
directly
• A key concept concerning money in the U.S. is the fractional reserve banking system: banks
required to keep only a fraction of all deposits on hand or on reserve (not loaned out)
• In the fractional banking system, banks do not keep the whole amount
that they obtain as deposits and can re-lend out at least a stipulated
amount (SLR and CRR dictate this).

• Suppose a bank has Rs. 1,000,000 in reserves. It does not need to keep
all 10 lakhs in the bank. Suppose it lends out 9 lakhs (90 percent) and
keeps one lakh for transactions etc.

• Suppose one person takes this loan and deposits it in the bank. Now
again 90 % is lent out, so the bank lends out 8,10,000 and keeps 90,000.

• So now the banking system has reserves worth 1,90,000 (1 lakh from
first lending and 90,000 from the second lending.
The money (deposit) multiplier
• Adding up all the deposit creation we get:

TD = 1,00,0000 + 0.9*1,00,0000 + (0.9)2*1,00,0000 + …

= [1/(1- 0.9)]* 1,00,0000 = 10,000,000

• So the original amount of deposits, i.e. – Rs. 10 lakhs grew to 1

cr. of deposits, because of the re-lending by the fractional
banking system. So once banks require only fractional reserves,
then the total money supply is a multiple of these reserves.

• Thus when banks hold fractional reserves against their

deposits, they actually “multiply” M1.

Bank Money = total reserves * [1/reserve ratio]

Money Stock Determination
• The narrowest definition of money supply in India is the sum
total of currency held by the public and also demand deposits,
and other deposits of RBI (M1).
• Reserve Money (M0): Currency in circulation + Bankers’
deposits with the RBI + ‘Other’ deposits with the RBI

• FED: High powered money (monetary base) consists of

currency and banks’ deposits at the Fed
• The part of the currency held by the public forms part of the money
supply
• Currency in bank vaults and banks’ deposits at the Fed are used as
reserves backing individual and business deposits at banks
• Fed’s control over the monetary base is the main route through which it
determines the money supply
Money Stock Determination
• The Fed has direct control over high powered money (H)
• Money supply (M) is linked to H via the money multiplier, mm,
which is the ratio of the stock of money to the stock of high
powered money  mm > 1
The Currency Deposit Ratio
• The payment habits of the public determine how much
currency is held relative to deposits
─The currency deposit ratio is affected by the cost and convenience of
obtaining cash
─Currency deposit ratio falls with shoe leather costs
 Ex. If there is a cash machine nearby, individuals will on average
carry less cash with them because the costs of running out are
lower
─The currency deposit ratio has a strong seasonal pattern (highest
around Christmas)
• The narrowest definition of money supply in India is the sum total of
currency held by the public and also demand deposits, and other
deposits of RBI (M1).
• M1= C + DD+ OD, where DD is net demand deposits of banks
• M2 = M1 + POSB
• M3 (Aggregate monetary resources) = M1 + net time deposits of
banks
• M4 = M3 + total deposits with PO savings orgn
• Currency= 2583042
• DD= 1662928
• TD= 13361941
• OD=39964
• M3 = Rs 1,76,47,874 Cr
• 28th Aug ‘20 figs
• Reserve Money (M0): Currency in circulation + Bankers’ deposits with
the RBI + ‘Other’ deposits with the RBI
• In India as on 22nd JULY,2022 : Currency in circulation – Rs 32,03,720 Cr
Other deposits with RBI Rs 56671 cr
Bankers’ deposits with RBI Rs 8,09,343 cr
Reserve Money(high powered money) TOTAL Rs 40,69,734 cr
M3 = Rs 1,76,47,874 Cr (old figs)
The money multiplier is the ratio of stock of money to the stock of high-
powered money/ Money Multiple approx. close to 6
Income Velocity GDP/ currency = 7.41*
Money Multiple = 6* and GDP /M3= 1.5* (*old figs)

11-15
• The MPC will determine the policy rate required to achieve the inflation
target.
• The MPC will meet at least four times in a year.
• The questions which come up before the MPC will be decided by majority of
votes by the members present in voting.
• The resolution adopted by the MPC will be published after conclusion of
every meeting of the MPC.
• On the 14th day, the minutes of the proceedings of the MPC will be
published which include:
• the resolution adopted by the MPC;
• the vote of each member on the resolution, ascribed to such member; and
• the statement of each member on the resolution adopted.
• Once in every six months, the bank will publish a document called the
Monetary Policy Report which will explain:
• the source of inflation; and
• the forecast of inflation for 6-18 months ahead.
• 5.77% GS 2030
• Rs 100
• P increases =110
• Yield decreases
• P decreases= 90
• Yield increases

11-17
The Instruments of Monetary Control
• The Federal Reserve has three instruments for controlling
money supply
1. Open market operations
• Buying and selling of government bonds
2. Discount rate
• Interest rate Federal Reserve “charges” commercial banks for
borrowing money
• Federal Reserve is often the lender of last resort for commercial
banks
3. Required-reserve ratio
• Portion of deposits commercial banks are required to keep on
hand, and not loan out
Loans and Discounts
• A bank that runs short on reserves can borrow to make up the
difference
• Can borrow from the Fed or other banks

• The cost of borrowing from the Fed is the discount rate (serves
as a signal)

• The cost of borrowing from other banks is the federal funds

rate
The Reserve Ratio
• Bank reserves = deposits banks hold at the Fed and “vault
cash” (notes and coins held by banks)
• In the absence of regulation, banks would hold reserves to
meet:
1. The demands of their customers for cash
2. Payments their customers make by checks that are deposited in other
banks

• In the U.S. banks hold reserves primarily because the Fed

requires them to (required reserves)
• In addition to required reserves, banks hold excess reserves to meet
unexpected withdrawals
The Money Multiplier and Bank Loans
• An increase in H produce a multiple expansion of M
• A Fed open market purchase increases H, and increases bank reserves
• The bank in which the original check was deposited has a reserve ratio
that is too high (has excess reserves)  increase lending
• When bank makes loan, person receiving a loan gets a bank deposit of
the amount of the loan  money supply has increased by more than
the amount of the open market operation
• The expansion of loans (and money) continues until the reserve-deposit
ratio has fallen to the desired level and the public has achieved its
desired currency deposit ratio
Open Market Operations
• Table 17-1 illustrates the impact of the Fed buying $1 million of government bonds on the Fed’s balance sheet :
• Fed’s ownership of securities increases by $1 million
• Fed writes a check for the purchase, which is deposited by the seller, and then deposited with the Fed  Bank deposits at the Fed increases by $1
million

Table 17-1 Effects of an Open Market Purchase on the Fed Balance Sheet
(Millions of Dollars)
ASSETS LIABILITIES
Government securities +1 Currency 0
All other assets 0 Bank deposits at Fed +1
Monetary base (sources) +1 Monetary base (uses) +1
The Fed’s Balance Sheet
• Table 17-2 shows the principal assets and liabilities of the Fed

Table 17-2 Main Assets and Liabilities of All Federal Reserve Banks, Nov. 16, 2016
(Billions of Dollars)
ASSETS (SOURCES) LIABILITIES (USES)
Gold and special drawing rights $18 Federal Reserve notes $1,445
U.S. government securities $2,482 Deposits $2,608
Mortgage-backed securities $1,748
Source: Federal Reserve Board, Factors Affecting Reserve Balances, November 17, 2016.
Monetary Policy
• Increase in quantity of money affects
economy : increasing output by
lowering interest rates [Insert Figure 11-3 here]
• The Reserve Bank of India (RBI) is
responsible for monetary policy in
India.
• Monetary policy is conducted through
various means, such as :
• Open market operations: buying
and selling of government bonds
RBI buys bonds in exchange for
money  increases the stock of
money (Fig.) to pursue an
expansionary monetary policy
(EMP).
RBI sells bonds in exchange for
money paid by purchasers of the
bonds  reducing the money
stock to pursue a contractionary
monetary policy (CMP).
• Consider the process of adjustment to the
monetary expansion
• At the initial equilibrium, E, the increase in
money supply creates an excess supply of
money
• Public adjusts to excess supply by buying [Insert Figure 11-3 here, again]
other assets
• Asset prices increase, and yields (i.e., i )
decrease  move to point E1( new LM
schedule which shifts to right)

• The public adjusts by holding less bonds and

more money (because i has fallen)
• Money market clears, with lower interest
rate
• Decline in interest rate results in excess
demand for goods(inventories run down:
Investment increases)
• Output expands and move up LM’
schedule
• Final position is at E’
• Interest rate rise because increase in output
( income) raises demand for money
• Increase in money stock first causes interest
rates to fall and then increases aggregate
demand
• Steeper the LM schedule , larger the change in income
• If money demand is very sensitive to interest rate(flat LM
curve), given change in money stock can be absorbed in
assets market with small change in interest rate
• Effects of open market operation on investment spending
would be small
• If demand is not very sensitive to interest rate(steep LM
curve), given change in money supply will cause large
change in interest rate
• Big effect on investment demand
• Similarly if demand for money is very sensitive to income,
given increase in money stock can be absorbed with small
change in income
 1 M
i   kY  
h P 

11-27
Transmission Mechanism
• Two steps in the transmission mechanism (the process by which changes in
monetary policy affect AD):
1. An increase in real balances generates a portfolio disequilibrium
• At the prevailing interest rate and level of income, people are
holding more money than they want
• Portfolio holders attempt to reduce their money holdings by buying
other assets  changes asset prices and yields
• The change in money supply changes interest rates
2. A change in interest rates affects AD

[Insert Table 11-1 here]

Transmission Mechanism
• Open Market Purchase of Bonds by the Central Bank => Increase in Money Stock =>
Decline in Interest Rate
• More specifically, the process unfolds as follows :
• The Central Bank pays for the bonds it buys with money that it can create =>
Higher Demand for Bonds => Increase in the price of Bonds => i.e., Yield on Bonds
decline => i.e., Interest rate declines
[ Only at a lower interest rate will the public be prepared to hold a
smaller fraction of its wealth in the form of bonds and a larger
fraction in the form of money].
• Decline in Interest Rate => Rise in investment (and consumption like car loans)
spending => Increase in AD => Increase in Y
• So there are two linkages through which change in money stock changes output:
•first, change in real balances leading to change interest rates
•Second change in interest rates must change aggregate demand.
• If portfolio imbalances do not lead to significant changes in interest rates, or if
spending does not respond to changes in interest rates, the link between money
and output would not exist.
The Liquidity Trap
• Two extreme cases arise when discussing the effects of
monetary policy on the economy  first is the liquidity trap
• Liquidity trap = a situation in which the public is prepared,
at a given interest rate, to hold whatever amount of
money is supplied.
(i.e., demand for money is highly – infinitely – sensitive
to the
interest rate )
• Implies the LM curve is horizontal  changes in the
quantity of money do not shift it
• Monetary policy has no impact on either the interest
rate or the level of income  monetary policy is
powerless
• Possibility of a liquidity trap at low interest rates is a
notion that grew out of the theories of English
economist John Maynard Keynes
 Banks’ Reluctance to Lend
• Second is the reluctance of banks to lend
• Another situation in which monetary policy is powerless in
stimulating the economy is when there is a break down in the
transmission mechanism at the point of lower interest rates
leading to rise in investment spending.
• Despite lower interest rates and increased demand for
investment, banks may be unwilling to make the loans necessary
for the investment purchases
• If banks made prior bad loans that are not repaid, may become
reluctant to make more, despite demand  prefer instead to
lend to the government (safer)
• Happened in USA, and responded by further cut in interest rates
through open market operation
• By 1992 bank lending picked up
The Classical Case
• The opposite of the horizontal LM curve (implies that monetary policy
cannot affect the level of income) is the vertical LM curve
• If LM is vertical = demand for money is entirely unresponsive to the
interest rate M
• Recall, the equation for the LM curve is P  kY  hi (1)
• If ‘h’ is zero, then there is a unique level of income corresponding
to a given real money supply  VERTICAL LM CURVE
• The vertical LM curve is called the classical case
• Rewrite equation (1), with h = 0: M  k ( P  Y ) (2)
• Implies that Nominal GDP, P x Y, depends only on the quantity of
money  classical quantity theory of money
• Theory believed that people would hold money in a quantity
proportional to total transactions P x Y( nominal income) ,
irrespective of rate of interest.
• When the LM curve is vertical
1. A given change in the quantity of money shifts the LM curve
and, thereby, produces a maximal effect on the level of income.
[ Increase in M will shift LM curve to the right , and decrease in
M will shift LM curve to the left. ]
2. Shifts in the IS curve do not affect the level of income when
LM curve is vertical.
• Vertical LM curve implies the comparative effectiveness of monetary policy over
fiscal policy.
• “Only money matters” for the determination of output.
• Requires that the demand for money be irresponsive to i (i.e., h = 0) 
important issue in determining the effectiveness of alternative policies.
• However, if Y = Yf or Y > Yf , then monetary policy will have no effect on Y ,
but will have instead an impact on P only.
• That is, increase in M will lead to only an increase in prices.
• A decrease in M will lead to only a decrease in prices.
• When LM curve is vertical monetary policy has maximal effect on
income, and fiscal policy has no effect on income. Since LM curve is
vertical only when demand for money does not depend on i , interest
sensitivity of demand for money turns out to be an important issue in
determining the effectiveness of alternative policies.
Fiscal Policy and Crowding Out
Y  G ( A  bi )
AD  C  I  G  NX
 
 C  cT R  c(1  t )Y  ( I  bi )  G  N X
 A  c(1  t )Y  bi
•The equation for the IS curve is: (3)
• The fiscal policy variables, G and t, are within this definition
• G is a part of A
• t is a part of the multiplier
Fiscal policy actions, changes in G and t, affect the IS curve
•Suppose G increases
• At unchanged interest rates, AD increases
• To meet increased demand, output must increase
• At each level of the interest rate, equilibrium income must rise by
 G G
Fiscal Policy and Crowding Out
• If the economy is initially in
equilibrium at E, if government [Insert Figure 11-4 here]
expenditures increases,
equilibrium moves to E”
• The goods market is in equilibrium
at E” (at unchanged interest rate),
but the money market is not:
• Because Y has increased, the
demand for money also
increases  interest rate
increases
• Firms’ planned investment
spending declines at higher
interest rates and AD falls off
 move up the LM curve to E’
• At E’ planned spending equals
income and the quantity of
real balances demanded equal
to the given real money stock.
Fiscal Policy and Crowding Out

• Comparing E to E’: increased [Insert Figure 11-4 here]

government spending
increases income and the
interest rate
• Comparing E’ to E”: adjustment
of interest rates and their
impact on AD dampen
expansionary effect of
increased G
• Income increases to Y’0 instead of
Y”: Why ? Because rise in i lowers
investment
• Govt spending crowds out
investment spending
• Crowding out occurs when expansionary fiscal policy causes
interest rate to rise, thereby reducing private spending,
particularly investment
• What factors determine how much crowding out takes place
• What determines extent to which interest rate adjustments
dampen the output expansion induced by increased govt
spending
• Income increases more, and interest rates increase less,
the flatter the LM schedule
• Income increases less, and interest rates increase less, the
flatter the IS schedule
• Income and interest rates increase more the larger the  G
multiplier and thus the larger the horizontal shift of the IS
schedule
• In each case the extent of crowding out is greater the more
the interest rate increases when G rises.
• If the economy is in liquidity trap, the LM curve is horizontal
• Increase in govt spending has its full multiplier effect on income
• No change in interest rate and so no cutting of investment; no dampening
effects of increased G
• Monetary policy has no impact on income and fiscal policy has maximal
impact
• That is if demand for money is very sensitive to interest rate, and
thus LM curve is almost horizontal, fiscal policy changes have a
relatively larger effect on output and monetary policy changes have
little effect on output
• If the LM curve is vertical, an increase in G has no effect on income
and increases only the interest rate
• If the demand for money is not related to interest rate the LM curve is
vertical ( and there is unique level of income at which money market is in
equilibrium)
• With vertical LM curve G only raises the interest rate and so the increase in G
is offset by fall in Investment, leaving output unchanged
• Increase in interest rates crowds out an amount of private investment
spending equal to increase in govt spending. THERE is FULL CROWDING OUT
• How seriously should one take the possibility of crowding out?
• If economy is at full employment, then any increase in demand because
of fiscal expansion will raise prices, and reduce the real balance
• LM curve will shift to the left raising interest rates until the increase in aggregate
demand is fully crowded out; crowding out occurs through a different
mechanism
• If resources are unemployed, then LM curve would not be vertical and
fiscal expansion will raise interest rates, but income will also rise
• Crowding out would be matter of degree: with rise in income, savings
will rise which will make it possible to finance larger deficit without
completely displacing private spending
• Even with unemployment, interest rates need not rise with increase in
G if monetary authorities can accommodate fiscal expansion by an
increase in money supply: Monetary accommodation
• That is monetize the budget deficits. Money may be printed to buy the bonds
with which the govt pays for its deficit
• Both IS and LM schedules shift to right, output will increase but interest rates
need not rise; so no adverse effects on investment.
The Composition of Output
and the Policy Mix
• Table summarizes analysis of the effects of expansionary monetary and fiscal policy
on output and the interest rate (assuming not in a liquidity trap or in the classical
case)
• Policy makers can use either monetary or fiscal policy to affect the level of income,
depending on speed and flexibility with which these policies can be implemented
• Monetary policy operates by stimulating interest-responsive components of AD
• Fiscal policy operates through G and t  impact depends upon what goods the
government buys and what taxes and transfers it changes
• Increase in G  increases C along with G; reduction in income taxes increases C;
investment subsidy increases investment spending.

[Insert Table 11-2 here]

• With investment subsidy , investment schedule will shift to right
• IS curve will shift to right
• Income will increase and so also rate of interest
• But even with increase in rate of interest, there would still be higher
investment as compared to earlier
• Interest rate dampens but does not reverse the impact of investment
subsidy
• An instance when both consumption induced by higher income and
investment rise as a consequence of expansionary fiscal policy

11-41
 INTEREST CONSUMP INVESTME GDP
RATE TION NT

INCOME + + - +
TAX CUT
GOVT + + - +
SPENDING
INVESTME + + + +
NT
SUBSIDY
The Composition of Output
and the Policy Mix
• Figure shows the policy problem of [Insert Figure 11-8 here]
reaching full employment output, Y*,
for an economy that is initially at
point E, with unemployment
• Should a policy maker choose:
Fiscal policy expansion, moving to
point E1, with higher income and
higher interest rates
Monetary policy expansion,
resulting in full employment with
lower interest rates at point E2
A mix of fiscal expansion and
accommodating monetary policy
resulting in an intermediate
position
The Composition of Output
and the Policy Mix
• All of the policy alternatives increase [Insert Figure 11-8 here]
output, but differ significantly in their
impact on different sectors of the
economy  problem of political
economy
• Given the decision to expand
aggregate demand, who should get
the primary benefit?
• An expansion through a decline in
interest rates and increased
investment spending?
• An expansion through a tax cut and
increased personal
consumption/spending?
• An expansion in the form of an
increase in the size of the
government?
• Speed and predictability, flexibility are given due consideration
• Also political preferences
• Conservatives for tax cut regime in recession, and cut in govt spending in
boom
• Would like to make govt sector small
• Other view favour govt spending on education, health, infrastructure and so
expansionary policies; and higher taxes to curb boom
• Growth minded people would like to focus on investment subsidies and
expansionary policies that operate through low interest rates
• Policy makers can choose policy mix of monetary and fiscal policies to attain
full employment, which can also make contribution to solving other policy
problems like literacy, health , etc.
The following describes an economy :

(M / P) = 0.5 Y - 20 i , where (M / P ) = 800

IS curve : Y = 4000-80i , assume αG = 3

(i) What is the effect of an increase in government expenditure by Rs 400 , on income and interest rate ?

(ii) How much is the crowding out of investment by the increase in government expenditure ?

(iii) If the LM curve changes to : 800 = 0.5 * Y , how would your answer to (i) and (ii) change ?

11-46
LM curve : 800 = 0.5Y-20i LM curve : 2Y = 3200 + 80i

LM curve : 2Y = 3200 + 80i shifted IS curve, IS' : Y = [ 4000 + (3*400) ] - 80i

IS curve : Y = 4000 - 80i IS' : Y = 5200 - 80i

solve the simultaneous equation system to get : solve the simultaneous equation system to get :

Y = 2400 and i = 20 Y = 2800 and i = 30

11-47
 (ii) (iii)

LM curve : 2Y = 3200 + 80i

IS curve can be written in the form : LM curve : 800 = 0.5Y

IS : Y = αG[A - bi]

IS : Y = 3[(4000/3) - (80/3)i] LM curve : Y = 1600

IS' : Y = 3[{(4000/3) + (1200/3)} - (80/3)i]

IS' : Y = 3[(5200/3) - (80/3)i] IS curve : Y = 4000 - 80i

it follows that, I = IBAR - (80/3)i

ΔI = [IBAR - (80/3)*30) ] - [IBAR - (80/3)*20) ] solve the simultaneous

ΔI = - (80/3)*30) + (80/3)*20) ] equation system to get

ΔI = - (80/3)*(30-20)

ΔI = - (800/3) Y = 1600 and i = 30

11-48
LM curve : 800 = 0.5Y

LM curve : Y = 1600

IS' curve : Y = 5200 - 80i

solve the simultaneous

equation system to get

Y = 1600 and i = 45

ΔI = [IBAR - (80/3)*45) ] - [IBAR - (80/3)*30) ]

ΔI = - (80/3)*45 + (80/3)*30

ΔI = - (80/3)*(45-30)

ΔI = - (80/3)*15

ΔI = - 400

11-49
The following describes an economy :

L = 0.20 Y - 60 i , and (M / P ) = 500

C = 100 + 0.75*(1-0.25)*Y , I = 1000 - 40 i , G = 500

(i) What is the equilibrium income and interest rate ?

(ii) To make the equilibrium income equal to 5000, without any change in the interest rate,
how much should be

the increase in government expenditure and the supply of real balances ?

11-50
(i) (ii)

Y=C+I+G Y=C+I+G

5000 = [ 100+ 0.75*(1-

0.25)*5000 ] + [ 1000
Y = [ 100+ 0.75*(1-0.25)*Y ] + [ 1000 - 40 i ] + [ 500 ] - 40 * 2.9562 ] + [ G ]

IS : (7/16)Y = 1600 - 40i solve for G

LM : 500 = (1/5)Y -60i G = 1205.748

(M / P) = (1/5)*5000 -
LM : (1/5)Y = 500 + 60i 60*2.9562

IS : (7/16)Y = 1600 - 40i (M / P) = 822.6277

solve the simultaneous equation system to get : ΔG = 1205.7482 - 500

Δ(M/P)
Y = (14500 * 64) / 274 = 822.6277-500

i = (1/60)*[(1/5)*{(14500*64)/274}-500] ΔG = 705.7482

Y = 3386.861 Δ(M/P) = 322.6277

11-51
i = 2.956204