QUESTION - 01

The following information describes an open economy. Answer all questions using the IS-
LM model.

C = 60 + 0.8Yd

C = consumption;

Yd = disposable income = (Y – T + TR)

I = 100 – 5i (I = investment)

i = 6 (i = interest rate)

G = 76 (G = government spending)

T = 15 (lump sum tax)

TR = 60 (transfer payments)

X = 70 (exports)

M = 12 + 0.2Y (M = imports), All figures are in billion US dollars

i. Derive the IS equation

The basic equation for the income is

Y = C + I + G + (X - M)

Y = 60 + 0.8 Yd + 100 – 5 i + 76 + (70 - ( 12 + 0.2Y ) )

Y = 60 + 0.8 Yd + 100 – 5 i + 76 + 70 - 12 - 0.2 Y

Y = 294 + 0.8 Yd – 5 i – 0.2 Y

According to the theory,

Yd = Y – T + TR

Hence derived that,

Y = 294 + 0.8 (Y – T + TR) – 5 i - 0.2 Y

Y = 294 + 0.8 (Y – 15 + 60) – 5 I - 0.2 Y

 Y = 294 + 0.8 Y – 12 + 48 – 5 I - 0.2 Y

Y - 0.8 Y + 0.2 Y = 330 -5 i

Y (1 - 0.6) = 330 – 5 i

Y = 1/ (1 - 0.6) X ( 330 – 5 I )

Accordingly, the multiplier is 2.5

Hence the IS Equation is derived as

Y = 825 - 12.5 i

ii. Calculate equilibrium level of income

The given rate for the interest i = 6

Accordingly,

Y = 825 – 12.5 (6)

Y = 825 – 75

Y = 750

Hence the equilibrium level of income is 750 Billion US dollars

iii. Calculate foreign trade multiplier

According to the theory the Savings (S) = Y – C
S = 750 – 60 + 0.8 Yd
S = 690 - 0.8 (Y-T+TR)
S = 690 - 0.8 (750 – 15 + 60)
S = 690 - 0.8 (795)
S = 690 - 636
S = 54

Imports, M = 12 + 0.2 Y

M = 12 + 0.2 (750)

M = 12 + 150
 M = 162

According to the theory, Foreign Trade multiplier (Kf) = 1 / (s+m)

s =ΔS/ΔY = 54/750= 0.072

m = ΔM/ΔY= 162/750 =0.216

Hence Kf = 1 / (0.072+0.216) = 1/0.288 = 3.47

Foreign Trade multiplier (Kf) = 3.47

iv. Calculate the balance budget multiplier

According to the previous calculations and assuming the budget is balanced

ΔY (1-b) = -b (ΔT) + ΔG
As the budget is balanced ΔG = ΔT
Accordingly,
ΔY (1-b) = -b (ΔT) + ΔT
ΔY (1-b) = ΔT (1-b)
ΔY/ ΔT = 1

Hence the balanced budget multiplier = 1

v. At equilibrium whether the country enjoy a trade surplus or deficit? What is the size
of trade surplus/deficit?

In an open economy, at the point of equilibrium level of income, aggregate supply

(AS) is equal to aggregate demand (AD). Hence in this case, aggregate supply (AS) =
aggregate demand (AD) at USD 750 Billion. In this point supply and demand is
balanced and external influences are not affected to change the values of economic
variables such as supply and demand. Hence the country is not required to import
goods and services to fill the excess demand in the country or to export goods and
services as a solution for excess supplying from the local suppliers. A trade deficit is
arisen as a result of high value of imports of goods and services than exports of goods
and services. Conversely, a trade surplus is arisen, when the value of export trading is
higher than the import trading within the country. Since there is not occurred import
 or export trading at the equilibrium level (USD 750 Billion), particular country will
not enjoy a trade surplus or deficit.

vi. If the government’s expansionary monetary policy reduces the interest rate to 4
percent; what would be the impact of this policy change on the economy?

The expansionary monetary policy of the government is referred as the

macroeconomic monetary policy which lowers interest rates and encourages the
borrowings. Since the borrowings are offered for investors at lower interest rates, they
attempt to borrow funds and to start new businesses and capital investments. It will
lead to grow the economy.

Figure 1: Expansionary Monetary Policy

Due to the increase of the money supply, interest rate is lowered from 6% to 4%.
Lowering the interest rate is affected to increase the spending on investments.

As per given case, when the interest rate is reduced to 4% from 6%, the equilibrium
level of income is increase from USD 750 Billion to USD 775 Billion as follows.

Y = 825 – 12.5 (i)

Y = 825 – 12.5 (4)
 Y (Equilibrium level of Income) = 775

Expansionary policy can consist fiscal policy or monetary policy or the policy traits of
the combination of the two policies. In an economic recession a government may follow
this economic policy to reduce the economic downturns. When the interest rate is
reduced to 4% from 6%, it can be identified following changes in the economy.

 It encourages borrowings and resultant investments will be increased. Finally, it will

lead to an economic growth
 It will increase the demand and it will stimulate the economic growth.
 It will prevent or reduce the adverse impact of economic downturns
 The government may face economic risks and political issues as well it will have to
incur a significant cost.

vii. The government’s export promotion industrialization strategies result in double the
size of exports and increases autonomous investment by 50%. What would be the
impact of this policy changes on economic growth? (Consider the original interest rate
of 6%)

A government expects to accelerate the economic development (industrialization) in

the country by following export-promotion industrialization strategies.

In this case due to this economic policy exports has been doubled and investments has
been increased by 50% and the impact is explained below.

X (Exports) = 70 *2 =USD 140 Billion

M (Imports) = 12 + 0.2 Y

M = 12 + 0.2 (750)

M = 12 + 150

M = 162

Trade deficit previously = 70-162 = USD 92 Billion

Trade deficit after the new policy implementation =140-162 = USD 22

Billion
 Trade deficit is reduced from USD 92 Billion to USD 22 Billion

I (Investment) = 100 – 5(i)

I (Investment) = (100 – 5*6) = 100-70 =USD 70 Billion

I , after the new policy implementation = 70 *1.5 =USD 105 Billion

Autonomous investment has been increase from USD 70 Billion to USD 105 Billion

In response to an economic recession; the government implements a stimulus package

worth of 10 billion Dollars. How would this impact on the government budget?
Explain.

This trade and economic policy encourages the export trading which the country can
achieve a comparative advantage. It will affect positively for trade balance for entire
economy. In government’s export promotion industrialization strategies, it can design
incentive programs to influence business organizations for exporting and to enable the
local products and service to be competitive in international markets. These export
incentives include loans on low cost, tax exemptions on profits earning form
exporting, advertising in international context, export subsidies, etc. It will affect to
expand the goods manufacturing for foreign markets and related foreign exchange
earnings can be used for the development of the country. It is appeared that these
export promotion industries are having broader market opportunities for their goods
and service in local and foreign markets.

viii. Implementing a stimulus package is an action of a government to stimulate the

economy in a period of economic recession. Government expects through this action
to reverse the economic downturn or to reduce the impact of economic recession by
increasing employments and disbursements.

Example: Increasing aggregate demand, compensating the decreased private

spending and minimizing the output gap in the economy

Government expects to encourage the economic activities of private sector to recover

the losses of aggregate demand by implementing a USD 10 Billion stimulus package
in this case.
It is caused to cut taxes. Then the people will be able to spend more, since their
disposable income will increase. It is affected to increase demand, production and
economic growth in the country. When it is evaluating the impact on government
budget, it can be said that it will increase the government spending, reduces the taxes
and interest rates. Through the entire process, it expects to stimulate the economy to
reduce or reverse the impact of economic downturn.