MEAP

What Have We Learnt?

Biswa Swarup Misra

Session Plan
Session

20

Numericals on IS-LM Model

Games on Economic Models
Review of Major Concepts

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Problem-1

Session

20

Assume the following IS-LM model:

expenditure sector:
money sector:
Y=C+I+G+NX
M = 500
C = 110 + (2/3)YD
P =1
YD = Y - TA + TR
md = (1/2)Y + 400 - 20i
TA = (1/4)Y + 20
TR = 80
I = 250 - 5i
G = 130
NX = -30
a. Calculate the equilibrium values of private domestic investment (I),
tax revenues (TA), and real money demand (md).
b.How much of private domestic investment (I) will be crowded out if
government purchases are increased by G = 100?

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Solution-1

Session

20
a. Y = C + I + G + NX = 110 + (2/3)(Y - TA + TR) + 250 - 5i + 130 - 30
= 460 + (2/3)[Y - (1/4)Y - 20 + 80] - 5i
= 460 + (2/3)(3/4)Y + (2/3)60 - 5i = 500 + (1/2)Y - 5i
From Y = Sp ==> Y = 500 + (1/2)Y - 5i ==>Y = 2(500 - 5i)
==> Y = 1,000 - 10i
IS-curve
From (M/P) = md ==> 500/1 = (1/2)Y + 400 - 20i ==> (1/2)Y = 100 + 20i
==> Y = 2(100 + 20i)
==> Y = 200 + 40i LM-curve
From IS = LM ==> 1,000 - 10i = 200 + 40i ==> 800 = 50i
==> i = 16 ==> Y = 840

==> I = 250 - 5*16 = 170

and
Since (M/P) = md ==> md = 500
Check: md = (1/2)840 + 400 - 20*16 = 500

TA = (1/4)840 + 20 = 230

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Session

20

Solution-1
b. If government purchases are increased by G = 100, the
IS-curve will shift by
IS = (G) = 2*100 = 200, and the new IS-curve is of the
form Y = 1,200 - 10i
Therefore, from IS1 = LM ==> 1,200 - 10i = 200 + 40i
==> 1,000 = 50i
==> i = 20 ==> Y = 1,000
Since i = 4 ==> I = - 4*5 = - 20
Check: I1 = 250 - 5*20 = 150

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Problem-2

Session

20 Assume that the money sector can be described by the

equations:
Money supply: ms = 600 and
money demand: md = (1/4)Y + 400 - 15i.
The expenditure sector can be described by the equation:
intended spending: AE = C + I + G + NX = 400 + (3/4)Y 10i.
Calculate the equilibrium levels of Y and i, and indicate by
how much the central bank will have to change money
supply if its goal is to keep interest rates constant after
government purchases are increased by G = 50. Show
your solutions graphically and mathematically.

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Solution-2

Session

20

ms = md ==> 600 = (1/4)Y + 400 - 15i ==> (1/4)Y = 200 +

15i
==> Y = 4(200 + 15i) ==> Y = 800 + 60i
LMcurve
AE = C + I + G + NX ==> Y = 400 + (3/4)Y - 10i ==>
(1/4)Y = 400 - 10i ==> Y = 4(400 - 10i) ==> Y = 1,600 - 40i
IS-curve
From IS = LM ==> 1,600 - 40i = 800 + 60i ==> 800 =
100i ==> i = 8 ==> Y = 1,280

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Solution-2

Session

20

If government purchases increase by G = 50, the IS-curve

will shift to the right by
IS = 4*50 = 200.
Therefore the equation for new IS-curve is: Y = 1,800 40i.
If the Fed wants to keep the interest rate constant, money
supply has to be increased by an amount that shifts the
LM-curve to the right by the same amount as the IS-curve,
that is, (LM) = 200.
From LM curve equation (1/4)Y = 200 + 15i ==> k=1/4
We know (Y) = (1/k) (ms) ==> (ms)= k. Y = ()*200
==> (ms) = 50, so money supply has to be increased by 50.
Check: IS1 = LM1 ==> 1,800 - 40i = 1,000 + 60i ==> 800 =
100i ==> i1 = 8 and Y1 = 1,480

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Solution-2

Session

20

i
45

IS1

40
ISo

LMo

LM1

8
0
800 1,000 1,280 1,480 1,600 1,800 Y
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Horizontal shift of the LM-curve

Session

20
When discussing the effects of monetary policy
changes in the IS-LM framework, it should be stressed
that an increase (decrease) in money supply will cause
a parallel shift of the LM-curve to the right (left). The
size of the horizontal shift of the LM-curve can be
derived as follows:
Y = (1/k)(M/P) + (h/k)i ==> LM = (1/k)[(M/P)].

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Session

20

Problem-3
Assume the equation for the IS-curve is: Y = 1,200
40i and the equation for the LM-curve is: Y = 400 +
40i.
a. Determine the equilibrium value of Y and i.
b. If this is a simple model without income taxes,
by how much will these values change if the
government increases its expenditures by G = 400,
financed by an equal increase in lump sum taxes
(TAo = 400)?

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Solution-3

Session

20

a. From IS = LM ==> 1,200 - 40i = 400 + 40i ==>

800 = 80i ==> i = 10 ==> Y = 400 + 40*10 ==> Y =
800
b. According to the balanced budget theorem, the IScurve will shift horizontally by the increase in government
purchases, that is, IS = G = TAo = 400.
Therefore the new IS-curve is of the form: Y = 1,600 40i.
From IS1 = LM ==> 1,600 - 40i = 400 + 40i ==>
1,200 = 80i ==> i = 15 ==> Y = 400 + 40*15 ==> Y =
1,000

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Problem-4

Session

20

Assume the following IS-LM model:

expenditure sector:
sector:
AE = C + I + G + NX
I
C = 100 + (4/5)YD
YD = Y - TA
200 - 10i
TA = (1/4)Y

= 300 - 20i
G = 120
NX = -20

money
M = 700
P =2
md = (1/3)Y +

a.Derive the equilibrium values of consumption

(C) and money demand (md).
b.How much investment (I) will be crowded out
if the government increases its purchases by G = 160
and nominal money supply (M) remains unchanged?
c. By how much will the equilibrium level of
income (Y) and the interest rate (i) change, if the Fed
responds to this increase in government purchases by
increasing nominal money supply to M' = 1,100?
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Solution-4

Session

20
a.

AE = 100 + (4/5)[Y - (1/4)Y] + 300 - 20i + 120 - 20

= 500 + (4/5)(3/4)Y 20i = 500 + (3/5)Y - 20i
From Y = AE==> Y = 500 + (3/5)Y - 20i ==> (2/5)Y = 500 -

20i
==> Y = (2.5)(500 - 20i) ==> Y = 1,250 - 50i

IS-curve

From M/P = md ==> 700/2 = (1/3)Y + 200 - 10i ==> (1/3)Y = 150 +
10i
==> Y = 3(150 + 10i) ==> Y = 450 + 30i LM-curve
I
IS = LM ==> 1,250 - 50i = 450 + 30i ==> 800 = 80i ==> i = 10
==> Y = 1,250 - 50*10 ==> Y = 750
C = 100 + (4/5)(3/4)750 = 100 + (3/5)750 ==> C = 550
Since ms = md ==>
M/P = 700/2 = 350 = md
Check: md = (1/3)750 + 200 - 10*10 = 350
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Solution-4

Session

20
b.

Since G = 160, the IS-curve will shift to the right by

IS = (2.5)160 = 400 ==> so the new IS curve is of the

form: Y = 1,650 - 50i

= 15

IS1 = LM ==> 1,650 - 50i = 450 + 30i ==> 1,200 = 80i ==> i

==> Y = 1,650 - 50*15 ==> Y = 900

Since i = + 5 ==> I = - 20*5 ==> I = - 100
Check: AE = G + I = 160 100 = 60 ==> Y = (AE)
= 2.5*60 =150

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Solution-4

Session

20
c.
If money supply is increased, then the LM-curve will shift
to the right.
From M1/P = md ==> 1,100/2 = (1/3)Y + 200 - 20i
==> (1/3)Y = 350 - 20i ==> Y = 3(350 - 20i) ==> Y =
1,050 + 30i
IS1 = LM1 ==> 1,650 - 50i = 1,050 + 30i ==> 600 = 80i
==> i = 7.5
==> Y = 1,275.
When we compare this result with the result in b., we can
see that i = - 7.5 and Y = 375

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Session

20

What Have We Learnt?

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Session

20

Major Concepts/Issues Discussed

Session 1:
What Macroeconomics is all about
Distinction between Micro and Macro economics
Why we should be studying macroeconomics
Distinction between Output and Wealth
Session 2:
What is more Important- Output or Wealth
Measurement of Wealth of Nations
Circular Flow of Income
What is GDP

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Session

Major Concepts/Issues Discussed

20 Session 3-4:
National Income Accounting:
Various measures of economic activity: GDP, GNP,NNP,
NDP,
Real versus Nominal GDP
Distinction between economic aggregates measured at
market prices and factor cost,
National Income,
Personal Income,
Personal Disposable Income

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Major Concepts/Issues Discussed

Session

20

Session-5
GDP as a measure of economic Welfare
Measurement of Inflation
Inflation Measurement in India- GDP Deflator, WPI, CPIIW,CPI-AL, CPI-UNME, CPI-Rl
Biases in measurement of Inflation
Sessions 6-7
Unemployment-Measurement
Unemployment : Frictional, Structural and Cyclical
Natural rate of unemployment
Unemployment Measurement in India - Usual Status,
CDS, CWS
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Major Concepts/Issues Discussed

Session

20

Session-8
Long run determinants of Growth
Concept of Natural Rate of Output
Catch up effect and Convergence of Income across
nations
Sessions 9
Proximate versus ultimate Sources of Growth
Income-Expenditure model
Concept of Equilibrium Income
Multiplier

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Session

Major Concepts/Issues Discussed

20 Session-10
Tax multiplier
Balanced Budget Multiplier
Fiscal Policy
Limits to fiscal policy
Sessions 11-14
Discussion of Caselet-2
Frameworks for Growth Forecasting
Introduction to Business Cycles
Real Business Cycle Theory
Stylised facts about Short run economic fluctuations
Framework of Aggregate Demand and Aggregate supply to
study business cycles.
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Major Concepts/Issues Discussed

Session

20

Sessions 11-14
Slope of aggregate demand curve( Wealth effect, interest
rate effect and exchange rate effect)
Short run aggregate supply curve (Sticky wages, Sticky
Prices and Misperception theory)
Shrot run vs long run aggregate supply curve
Derivation of Aggregate supply curve under the classical
and Keynesian assumptions
Analysis of impact of shocks on short run equilibrium and
restoration of long run equilibrium through self correcting
mechanism and through Government intervention
Characteristics of Overheating

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Major Concepts/Issues Discussed

Session

20

Sessions 11-14
Speculative Asset Price Bubbles and overheating
Hard Landing vs. Soft Landing
Demand pull vs Cost push Inflation
Session-15
Inflation and Unemployment relationship
Phillips Curve-Short run vs. Long run
Friedman-Phelps Expectation Augmented Phillips Curve
Rational Expectations and the Phillips Curve

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Session

20

Major Concepts/Issues Discussed

Session-16
Money-Functions
Components of Monetary Aggregates
Banks and Money Supply-Deposit Multiplier
Central Bank and Reserve Money
Money Multiplier
Session-17

Balance of Payment
Classification of various accounts:
Current, Capital and Financial,
Meaning of Capital Account Convertibility.
What is meant by Sustainable Current Account Deficit
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Major Concepts/Issues Discussed

Session

20

Session- 18
Derivation of IS and LM Curves
Liquidity Preference Theory of Interest Rate
determination
Positions off the IS and LM curves
The Path from Disequilibria to Equilibrium
Factors affecting Slope of IS curve and LM curve
Shift of IS and LM curves
Analysis of effectiveness of monetary and Fiscal policy
in the IS-LM framework
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Major Concepts/Issues Discussed

Session

20

Session-18
Derivation of the aggregate demand curve from the ISLM framework
Impact of monetary contraction on interest rate prediction of the LP theory and Fisher Effect
Session-19
Mendel-Flemming model - IS-LM model in an small open
economy
Derivation of IS and LM curves
Effectiveness of Monetary, Fiscal and Trade policy under
fixed and flexible exchange rate systems

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Session

20

Wish You All the Best

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