Assignment 3:

A IS-LM model:

We consider a economic system, where our GDP, which is given by:

Z = C(Y T) + G + I(r),

C(Y T) = C0 + C1(Y T),

I(r) = I0 I1r,

Where Z is planned expenses, our Y is our GDP, T our taxes, G is our government purchases, I is our investments, r is interest rates.

C0, C1, I0, I1 > 0 are all paramters and C1 < 1.

Our T and G is Exogenous variables. Also in this part of the assignment r is Exogenous

Now for the question:

Explain why our function: C(Y - T) looks the way it does and why 0 < C1 < 1 is a fair assumption?

C(Y-T) looks like the way it does because level of consumption depends on disposable income (Y-T), or the total personal income that they have after income taxes have been deducted.

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for every additional income, there will be proportionately smaller changes in marginal propensity to consume (c1). Hypothetically, we cannot increase our marginal propensity to consume (c1) more than what our income (Y) allows us.

Explanation:

C(Y-T) looks like the way it does because level of consumption depends on disposable income (Y-T), or the total personal income that they have after income taxes have been deducted.

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for every additional income, there will be proportionately smaller changes in marginal propensity to consume (c1). Hypothetically, we cannot increase our marginal propensity to consume (c1) more than what our income (Y) allows us.

So if, for instance, we assume that c1=0.7, when income(Y) increases by a dollar, then marginal propensity to consume (c1) increases by 70 cents. The additional change in consumption is less than the additional change in income.

The new question is now:

How do you deduce the IS Curve, i.e. deduce the Y as a function of r, G, and T.