Analysis of IS/LM curves
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1 Carefully explain and show graphically how each of the following changes would effect the shape of the IS curve:
a) The MPC becomes bigger.
b) Investment becomes more sensitive to changes in the real interest rate.
2 In the State of the union address in January 2002, President Bush announced that he would ask Congress to approve substantial increases in defense spending to counter terrorism and significant reductions in taxes. Show:
a) The short-run effects of his policy on aggregate Expenditure curve and the equilibrium level of GDP.
b) What the effects would be on IS/LM curves.
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Question 1
The IS line comes from the graph above, which is usually called "Keynesian cross". Aggregate expenditure, in a closed economy, is Consumption (C) + Investment (I) + Government Spending (G), where C is a function of the MPC, Y and T (taxes), I is a function of the interest rate (higher interest rates means lower investments) and G is just a government decision.
The black line in the graph above depicts the "original" situation, and the red line shows what happens when the MPC rises. The MPC (marginal propensity to consume) is the proportion of each extra $1 in GDP that is spent as consumption. Therefore, if MPC rises, then the slope of the Aggregate Expenditure rises as well, because for higher levels of GDP, consumption becomes higher. Mathematically, the consumption function is usually written as:
C = a + MPC*(Y-T)
Therefore, the aggregate expenditure function, which is basically C + I + G, becomes:
Expenditure = a + MPC*(Y-T) + I(i) + G
[I wrote I(i) to denote that the investment is a function of the interest rate (i)]
As you can see in the function above, the aggregate expenditure as a function of Y (as shown in the Keynesian cross graph) is a line, whose slope is the MPC. So as the MPC rises, so does the ...
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