Interest Rates Affects on the Is-Lm Model

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  • Topic: Macroeconomics, Liquidity preference, IS/LM model
  • Pages : 3 (539 words )
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  • Published : July 17, 2011
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Assignment 4
5. According to the IS-LM model, what happens to the interest rate, income, consumption and invest under the following circumstances.
a. The central bank increases money supply.
An increase in the money supple shifts the LM curve downward. The equilibrium moves from point A to point B. Income rises from Y1 to Y2 and the interest rate falls from r1 to r2. Therefore this increase in money supply causes a decrease in interest rate, an increase in income, an increase in consumption and an increase in investment.

LM

Income, output, Y
b. Government increases government purchases
An increase in government purchases result in a shift in the IS curve to the right. The equilibrium moves from point A to point B. Income rises from Y1 to Y2 and interest rate rises from r1 to r2. This increase in government purchases therefore causes interest rate to rise and income also rises. Consumption will also increase but the increase in government purchases will cause investment to decrease.

interest rate, r LM

IS2

IS1
Income, output, Y
c. The government increases taxes.
An increase in taxes shifts the IS curve to the left. The equilibrium moves from point A to point B. Income falls from Y1 to Y2 and the interest rate from r¬1 to r 2. Therefore increase in taxes will bring about a decrease in interest rate, cause income to also decrease which will decrease consumption also but will result in an increase in investment. interest rate, r

LM

IS1

IS2
Income, output, Y
d. The government increase government purchases and taxes equally

6. Consider the following economy of Hicksonia.
a. The consumption function is given by
C= 200 + 0.75 (Y - T)
The investment function is
I= 200-25r
Government purchases and taxes are both 100. For this economy graph the IS curve for r ranging 0 to 8. Interest rate,r

IS
Income...
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