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Questions › DSE › DSE 2008 › Q48
2 marksMacroeconomics › IS-LM model › Extensions: expected inflation, endogenous money and rate targetingHardabout 4 min

DSE 2008 Question 48: IS-LM model

Setup, from Q47 of the paper:

Consider a closed economy with P‾\overline{P}P fixed: Y=C+I+GY=C+I+GY=C+I+G, C=c(Y−T)C=c(Y-T)C=c(Y−T) with 0<c<10<c<10<c<1, I=I‾−drI=\overline{I}-drI=I−dr (d>0d>0d>0), T=τYT=\tau YT=τY (0<τ<10<\tau<10<τ<1), G=G‾G=\overline{G}G=G, money market M‾/P‾=L=aY−bi\overline{M}/\overline{P}=L=aY-biM/P=L=aY−bi (a,b>0a,b>0a,b>0), and i=r+πei=r+\pi^{e}i=r+πe. In ceteris paribus, a unit increase in government expenditure has the following impact on equilibrium income:

(Same model.) In ceteris paribus, a unit increase in the expected rate of inflation has the following impact on the equilibrium value of the real interest rate:

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Answer and worked solution

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Plain-text version

Setup, from Q47 of the paper: Consider a closed economy with P̅ fixed: Y=C+I+G, C=c(Y-T) with 0<c<1, I=I̅-dr (d>0), T=τ Y (0<τ<1), G=G̅, money market M̅/P̅=L=aY-bi (a,b>0), and i=r+π^e. In ceteris paribus, a unit increase in government expenditure has the following impact on equilibrium income: (Same model.) In ceteris paribus, a unit increase in the expected rate of inflation has the following impact on the equilibrium value of the real interest rate: (A) it increases by (1-c(1-τ))/(b[1-c(1-τ)]+ad) units (B) it decreases by a/(a[1-c(1-τ)]+ad) units (C) it increases by (b[1-c(1-τ)])/(b[1-c(1-τ)]+ad) units (D) it decreases by (b[1-c(1-τ)])/(b[1-c(1-τ)]+ad) units

Also written as: Setup, from Q47 of the paper: Consider a closed economy with P_bar fixed: Y=C+I+G, C=c(Y-T) with 0<c<1, I=I_bar-dr (d>0), T=tau Y (0<tau<1), G=G_bar, money market M_bar/P_bar=L=aY-bi (a,b>0), and i=r+pi^e. In ceteris paribus, a unit increase in government expenditure has the following impact on equilibrium income: (Same model.) In ceteris paribus, a unit increase in the expected rate of inflation has the following impact on the equilibrium value of the real interest rate:

IS-LM model has come up 137 times in 7 exams since 2004.

What this question tests

This question is on Extensions: expected inflation, endogenous money and rate targeting, part of IS-LM model in Macroeconomics.

Variations on the basic model: inflation expectations, money supply that responds, and central banks that target the rate.

TestStop has 14 past-paper questions on this subtopic; the nearest in year are below.

  • GATE 2023 · Q47Consider a closed-economy IS-LM model. The IS and LM equations are Y = C(Y) + I(z) + Ḡ M̄/P̄ = kY - li…
Practise IS-LM modelMore on Extensions: expected inflation, endogenous money and rate targeting

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Question from the DSE 2008 paper. Solutions are TestStop's own. Not affiliated with or endorsed by any examination authority.