Chapter 11

The Keynesian Cross: Building the IS–LM Model

Exercises from the theory book
1. Use the Keynesian cross model to predict the impact on equilibrium GDP of the following.
In each case, state the direction of the change and give a formula for the size of the impact.

a. An increase in government purchases (G) (= increase in autonoms consumption = increase

in investments= decrease in taxes)

The equilibrium of this economy is at point A, where the planned-expenditure function

crosses the 45-degree line. An increase in government purchases raises planned expenditure
by that amount for any given level of income. The equilibrium moves from point A to point
B, and income rises from Y1 to Y2. Note that the increase in income ΔY exceeds the
increase in government purchases ΔG. Thus, fiscal policy has a multiplied effect on
income.

Budget deficit = government expenditures - government revenues

BD = (G + TR) – T
The increase in G causes an increase in the budget deficit (we don’t have the effect of the tax
rate t).

b. An increase in taxes

Homework, the same as in the lecture. The decrease in taxes causes the PE curve to decrease
(shifts downwards, as taxes lower consumption).

c. Equal-sized increases in both government purchases and taxes

We start from the initial equilibrium. G2 > G1 will cause planned expenditures PE to
increase, but the increase in taxes T2 > T1 will negatively affect the consumption.

We find the net effect:

PE = C + I + G
PE = C0 +MPC (Y – T) + I + G we have:
ΔPE = ΔC0 + MPC (ΔY – ΔT) + ΔI + ΔG
ΔC0 = ΔY = ΔI = 0

ΔPE = MPC (– ΔT) + ΔG since ΔG = ΔT we substitute:

ΔPE = MPC (– ΔG) + ΔG = (1 – MPC) ΔG
ΔG > 0 and (1 – MPC) > 0 therefore ΔPE > 0.
So, PE increases, shifts upward in the graph.

Y increases

Budget deficit = government expenditures - government revenues

BD = G– T
The increase in G and T in equal sizes causes the budget deficit to remain the same (we do
not have the effect of the tax rate t).

2. In the Keynesian cross model, assume that the consumption function is given by:

C = 120 = 0.8 (Y- T), I = 200, G = 400 and T = 400

Planned investment is 200; government purchases and taxes are both 400.

a. Graph planned expenditure as a function of income.

b. What is the equilibrium level of income?
c. If government purchases increase to 420, what is the new equilibrium income? What
is the multiplier for government purchases?
d. What level of government purchases is needed to achieve an income of 2,400? (Taxes
remain at 400.)
 e. What level of taxes is needed to achieve an income of 2,400? (Government purchases
remain at 400.)

3. The following equations describe an economy:

a. From the above list, use the relevant set of equations to derive the IS curve. Graph the
IS curve on an appropriately labeled graph.
b. From the above list, use the relevant set of equations to derive the LM curve. Graph
the
LM curve on the same graph you used in part (b).
c. What is the equilibrium level of income and the equilibrium interest rate?

Exercises from the workbook

Statements
For the following statements show whether they are true or false by making the
appropriate graphic and analytical argumentation.

1. Lowering the tax rate (t) makes the AD (PE) curve steeper (më të pjerrët) and increases
equilibrium income. t1 < t.

PE = C + I + G after we substitute:

PE = A0 + MPC (Y – t*Y)

PE = A0 + MPC (1 – t) Y where A0 = autonomous expenditure = C0 + I + G

The slope of PE = MPC (1 – t) since t decreases, we have an increase of 1-t and the slope of
PE increases thus making PE steeper.
The statement is true since Y increases and PE becomes steeper.

2. A cut in taxes will increase revenues and consequently always reduce the budget deficit.
3. The increase in government purchases to the same extent as the reduction of exogenous
taxes does not change the equilibrium level of income. (Keynesian cross).
4. An increase in marginal propensity to consume reduces Y.
5. If all disposable income goes for consumption, then the consumption curve equals the 45
° line and the multiplier is 1.
6. A decrease in investment will cause a decrease in AD and an increase in the equilibrium
of real GDP.
7. If the disposable income is 275 million ALL and APC is 0.8, we can say that the level of
savings is 55 million ALL.

APC=C/Yd, Yd=C+S; C=0.8*275=220; S=Yd-C= 275-220= 55 million ALL

The statement is true.

8. Increasing government purchases, simultaneously increases budget expenditures and

budget revenues in the presence of the tax rate.

The increase of G, increases PE and Y.

Budget expenditures = G + TR, increase because of the increase in G

Budget revenues = To + tY; Y has increased because of G (as in the graphic presentation), so
budget revenues will increase.

The statement is true.

9. In the absence of an income tax an increase in government spending (G), followed by a
decrease in the same amount of transfers (TR), will increase GDP to the same extent as
an increase in government spending.

10. The greater the marginal propensity to save, the smaller is the effect of increasing G on
the income level. (Increasing MPS decreases the multiplier)

We know that MPS + MPC = 1, so if MPS increases, MPC will decrease.

MPS increases; the effect of the increase in G in Y = ΔG/ ΔY

Increasing MPS decreases the multiplier. The statement is true. The effect of increasing
G on the income level is lower.

11. If we have an increase in the marginal propensity to save, then the IS curve becomes
flatter and the level of equilibrium income increases.

The slope of IS = -1/ (αG*b), (I= Io-b*r) if MPS increase and αG is:

MPS + MPC =1 so MPC decreases and αG decreases and the slope of IS = -1/ (αG*b)
increases. The equilibrium level is IS = LM.
Y increases and r decreases

12. The increase in money supply shifts the LM curve to the right.
13. Increasing sensitivity of money demand (L) to income Y, makes the LM curve steeper.
14. The increase in government purchases, shifts the IS curve upward to the right. The
statement is true.
15. Reducing the money supply shifts the LM curve downward to the left. The statement is
true.

16. The same increase in government purchases and transfers has the same effect on the IS
curve. (similar to statement no. 18, transfers are affected by MPC, meanwhile government
purchases are not).
17. If consumption increases, then the IS curve becomes flatter.

The change in autonomous consumption causes a shift in the IS curve but does not change its
slope. Thus, the statement is false.
18. In the absence of an income tax (t) an increase in government spending accompanied by a
decrease in the same amount of transfers, will increase GDP to the same extent as the
increase in government spending.

From the statement we have: ΔG = - ΔTR

ΔY = αG* A0
ΔY = αG* (ΔG- MPC*ΔTR)
ΔY = αG* (ΔG- MPC* ΔG)
ΔY = αG* (1- MPC) ΔG

The statement is false. GDP (ΔY) does not increase to the same extent as the increase in
government spending.
Exercices with calculations
1. Suppose an economy has the following data: C = 500 + 0,9 Yd, t = 1/3, I = 150, TR = 100,
G = 260. Find:

a) How much should government spending G increase to make the revenue level reach
3,000?
b) How much should transfers change for the income level to reach 2,950?

2. Suppose an economy has the following data:

C = 0,8 Yd + 50
I = 70
G = 200
TR = 100
t = 0,2

a) Calculate the multiplier and the equilibrium level of income.

b) What is the surplus of the government budget?
c) Suppose t’= 0,25. Calculate the equilibrium income and the multiplier for the new level
of taxes.
d) How much will the budget surplus change?

3. Suppose an economy has the following data:

C=85+0 , 75 YD
Ī =50
Ḡ=150
T R̄=100
t=0 , 20
a) Find the multiplier, autonomous expenditures, equilibrium revenues and state budget
surplus.
b) Assume that government purchases (G) increase by 250 units, while the tax rate is
t=0 .28 . Find the multiplier and autonomous expenditures.

c) How much is ΔTA , ΔG, Δ BS ?

4. Suppose an economy has the following data:

C = 100 + 0,8 Yd
I = 200 – 1.000 i
L = Y – 10.000 i
G = 550
TA = 500
M/P = 900
a) Find the IS and LM equations.
b) Find the equilibrium level of income, real interest rate, consumption, and investments.

5. Now, we look at the role of taxes in determining equilibrium income. Suppose we have an
economy that is described by the following functions:

C = 50 + 0.8YD
= 70
= 200
= 100
t = 0.20
a) Calculate the equilibrium level of income and the multiplier in this model.
b) Also calculate the budget surplus, BS.
c) Assume that t increases to 0.25. How much is the new equilibrium income? What about the
new multiplier?
d) Calculate the change in the budget surplus. If. MPC = 0.9 instead of 0.8, would you expect
the difference to be larger or smaller?
e) Can you explain why the multiplier is 1, when t = 1?

*Solution:

a) We know that Yd = Y + TR – T. The equilibrium is where PE = Y. First, we find PE.

PE = C + I + G = 50 + 0.8 * YD + 70 + 200 = 320 + 0.8*(Y - 0.2*Y + 100)

PE = 320 + 0.8*Y - 0.16*Y+0.8*100; PE = 320 + Y* (0.8-0.16) + 80.

PE =400 + 0.64* Y.

From the equilibrium condition (Y = PE) we have Y = 400 + 0.64Y and 400 = 0.36Y

Yo = 400/0.36 = 1111.11

The multiplier is:

MPC = 0.8 dhe t = 0.2

In this case the multiplier is 2.78

b) BS = t*Y - TR - G = 0.2*1111.11 - 100 - 200 = 222.22 - 300 = -77.78

The state budget is in deficit.

c) PE’ = C’ + I + G = 50 + 0.8 * YD’ + 70 + 200 = 320+ 0.8*(Y - 0.25*Y + 100) =>

PE’ = 320+ 0.8*Y-0.8*0.25*y+0.8*100 = 320+0.8*Y-0.2*Y+80 =>

PE’ =400 + 0.6* Y.

Y = PE’ => Y = 400+ 0.6Y and Yo = 400/0.4 = 1000

In this case the multiplier is = 2.5

BS’ = t’*Y’ - TR - G = 0.25*1000 - 100 - 200 = 250 - 300 = -50

BS = BS’ - BS = -50 - (- 77.78) = + 27.78

d) Increasing the marginal propensity to consume from 0.8 to 0.9 causes the growth of the
multiplier and the equilibrium income. As a result, tax revenues and budget surplus would
increase.

e) If t = 1, then it is clear from the multiplier formula that the multiplier is 1.

This is because an increase in autonomous spending would increase revenue by the same
amount that will all be paid as tax, so we will not have further revenue growth due to
consumption induced growth. So, a unit of exogenous expenditure growth leads to a unit of
revenue (Y) growth and therefore the multiplier is 1.

6. Suppose an economy has the following equations: (suppose C. I. G. ect are measured in
billions and not in %; r = 5 implies that the real interest rate is 5%).
C = 0.8 (l-t) Y
t = 0.25 (P2)
I = 900 – 50r
G = 800
L = 0.25Y - 62.5r
M/P = 500
M = 1000 dhe P = 2

a. Find the equation of the IS curve and the LM curve. Find the equilibrium level of income
and interest rate.
b. If G increases by 110, find how much is the effect on Y and r. Find the crowding out
effect.
c. If M / P decreases by 50 find how much is the effect on Y and r.
d. Considering point b, find how much M/P must change (M/P) so that r does not change?
(same request can be made for Y).

*Solution
a. Each point on the IS curve represents equilibrium in the goods market, and the curve
illustrates how the equilibrium level of income depends on the interest rate. It can be derived
from the equilibrium condition IS: Y = PE
Y= C + I + G = 0.8*(1- 0.25)*Y + 900 - 50*r + 800 = 1700 + 0.6*Y -50r;
IS: Y = PE=> 1700 + 0.6*Y -50r = Y
0.4*Y = 1700 - 50*r; Y= 2.5*(1700-50*r) = 4250 – 125r
IS: Y = 4250 – 125r
Each point on the LM curve represents equilibrium in the money market, and the curve
illustrates how the equilibrium interest rate depends on the level of income. The higher the
level of income, the higher the demand for real money balances, and the higher the
equilibrium interest rate. For this reason, the LM curve slopes upward. LM can be derived
from the equilibrium condition in the money market:
M/P = L 500 = 0.25*Y - 62.5*r
Y = 4*500 - 62.5*r LM: Y= 2000 + 250r
To find the equilibrium level of income and interest rate, we find the intersection of the
respective equations:
IS = LM

Y = 4250 - 125*r
Y = 2000 + 250*r

4250 - 125*r = 2000 + 250*r => 2250 = 375*r => r = 6

To find the equilibrium level of income, we substitute the equilibrium interest rate in the IS
equation or the LM equation.
If we substitute in IS {Y = 4250 - 125*6 => Y = 4250 - 750 = 3500

b. G increases by 110 so G1 = G +110 = 800+110=910

IS1: Y = C + I + G1= 0.8*(1 - 0.25) *Y + 900 - 50*r + 910 = 1810 + 0.6*Y -50r; 0.4*Y =
1810 - 50*r; Y= 2.5*(1810-50*r) = 4525 – 125r So,
IS1: Y = 4525 – 125r
We find Y1 and r1.
So, IS1= LM

Y = 4525 - 125*r 4525 - 125*r = 2000 + 250*r

Y = 2000 + 250*r 2525 = 375*r pra r1 = 6.7

 We find Y1 = 2000 + 250 * 6.7 = 3683

 The change in Y = Y1 – Y = 3683 – 3500 = 183; Y= 183
 The change in r = r1 – r = 6.7 – 6 = 0.7
Crowding out = I1 – I = 600 – 565 = 35; I=35
C.O. is the reduction in investment that results when expansionary fiscal policy raises the
interest rate.
I1 = 900 – 50r1 = 900 – 50 * 6.7 = 9000-335= 565
I = 900 – 50r = 900 – 50* 6 = 900- 300= 600

c. We try and find the new LM (homework).

d. In point b, IS shifts upward to the right:

At first, we find Y.
Y = 4525 - 125*r = 4525 – 125 *6 = 3775
We substitute the new equilibrium point in
LM.
L = M/P pra 0.25*Y - 62.5*r = (M/P)1
0.25*3775 - 62.5*6 = (M/P)1
(M/P)1 = 568.75

The change in M/P = 568.75 – 500 = 68.75.

Money supply should increase by 68.75

7*. Suppose the Parliament decides to reduce transfers (for example, social assistance) and
increase government purchases of goods and services by an equal amount between them, a
fiscal policy changes such that G = - TR
a) Would you expect that because of this change, equilibrium incomes would increase or
decrease? Why? Check the answer using the following example: First assume that që c = 0.8,
t = 0.25 and Yo = 600. Then, take G = 10 and TR = - 10
b) Find how much does equilibrium income change, Yo.
c) What is the difference in the budget surplus, BS? Why has the budget surplus changed?

*Solution:

a) When the size of the multiplier is the same, the effect of an equal change is in the opposite
direction in autonomous expenditures is expected to be zero. But since transfers do not affect
entirely but only to the extent of MPC* TR, then their negative effect is smaller than the
positive effect of increase in government purchases. Therefore, equilibrium income would
increase, because the effect of G is higher than the effect of transfers (TR).

Let’s take an example. We know that Y = G  A0. In our case  A0 = G - cTR thus
we have Y = G (10 - 0.8*10) = G *2. Calculate G = 1/ 1- 0.8 *(1- 0.25) = 1/ 1-
0.8*0.75 = 1/0.4 = 2.5 Thus, Y = 2* 2.5 = 5
b) Y = 2* 2.5 = 5

c) BS = t*Y - TR - G = 0.25*5 - (-10) - 10 = 1.25