Answer to Question #219468 in Macroeconomics for Yogesh

Question

Q1. (a) Explain the role of multiplier in determining
the slope of IS- curve. Use appropriate diagram.
4
(b) What are the various stages in the monetary
transmission mechanism. 4
(c) In Keynesian model, discuss the effects of
changes in fiscal variables – increase in
government purchases, reduction in the income
tax rates and increase in transfer payments on
equilibrium level of income.

Answer 1

a

Given that the multiplier determines the slope of the IS curve, fiscal policy can have an impact on that slope. The tax rate impacts the multipliers: a higher tax rate decreases the multiplier, making the IS curve steeper.

If investors' expectations improve, the demand for capital goods rises, generating an increase in investment demand for any real rate of interest. As a result, the aggregate demand function and the IS curve change. The figure above depicts the shift of the IS function from IS₁ to IS₂. The real rate of interest necessary to maintain the level of real production at Y will change from r₁ to r₂ as a result of this adjustment. As future expectations vary, the monetary authorities will need to adjust the real rate of interest regularly to maintain the appropriate production level.

b

Monetary authorities, such as the Fed and other central banks worldwide, affect interest rates, which in turn affect employment, production, and pricing. The linkages between a central bank's activities and general economic success, on the other hand, are far from clear. The monetary transmission mechanism (shown in Figure above "The Monetary Transmission Mechanism"), which is at the center of this chapter, summarizes the process. The monetary transmission mechanism is more than just a theory created by economists to make monetary policy. It explains the Fed's perspective on its own operations.

The Fed pursues a short-term nominal interest rate through open-market operations. Changes in that interest rate have an impact on long-term nominal interest rates. Long-term nominal interest rates vary, which causes long-term real interest rates to alter. Long-term real interest rate changes have an impact on investment and durable goods consumption. Finally, changes in expenditure have an impact on actual GDP. Every step of this procedure will be scrutinized.

c

According to the Keynesian model,

i. Increase in government purchases increases business activity, and there will be more government expenditure. This model improves aggregate output and leads to the generation of more income.

ii

Reduce in tax rates

When tax rates decrease, the consumption rate goes up, leading to an increase in output/income. The increase in income increases the demand for money. Given that the money supply is fixed, the interest rate must reduce to pull down demand for money and maintain equilibrium.

iii

Increase in transfer payments

Transfer payments are negative taxes, and their increase leads to multiple aggregate demands. This is because spendable funds are transferred to consumers who may spend some of all of them. An increase in transfer payments leads to increased income, enabling the recipient to spend it on more goods.