Adas Model and Islm Model

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Birmingham Business School

Student ID Number:          1773693        

Programme of Study:          Economics

Module:          Principles of economics

Assignment Title:          ECON101 Assignment 2 2017

Date and Time of Submission:          06th March, 2017 02:00 am

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Introduction

In 2016, some policies are set out by The Autumn Statement in order to support the United Kingdom economy in the transition that sees the country leaving the European Union. The main purposes are to enhance investment as to improve productivity. Therefore, the main actions are a cut in corporate tax and a raise in the personal allowance. In the following, this essay will be discussing the aftermaths of those policies, the behavior of the main macroeconomic variables, in the short-run and the long-run. Diagrams and graphs will also be used to help illustrating the description as well.

Effects of the policies in IS – LM model

For IS curve, it is defined as the combinations of interest rate and income where the goods & services market is in equilibrium. As for the LM curve, it is the combinations of interest rate and income where the money market is in equilibrium. The IS curve is drawn for a given fiscal policy while the LM curve is for monetary policy.[pic 2][pic 3]

First of all, in the given case, reduction in corporate tax is an expansionary fiscal policy. As an investment shifter, it increases the incentive of investment and hence the investment increase. It shifts I rightwards.

As total tax = corporate tax + personal tax. Reduction in corporate tax and personal tax will bring a reduction in total tax. Therefore, IS curve, as a result, will shift from IS1 to IS2, as shown in figure 1.

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Figure 2. Movement on LM curve due to reduction in total tax.

For LM curve, As people’s consumption increase, the money demand increases as a consequence. The money demand curve shifts from Md1 to Md2 in figure 2 (a). The shift of money demand leads to increase in interest rate and increased total output, which is shown in figure 2 (b).

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Figure 3. case study in IS-LM model.

Combining IS and LM curve, we will get a graph as shown in figure 3. IS curve shifts from IS1 to IS2. The interest rate increase from r1 to r2. The output increases from y1 to y2. Therefore, it can also explain why the real interest rate is predicted to increase continuously in the following years from 2017 to 2029, as shown in figure 4.

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Figure 4. The real interest rate increase from 2017 to 2029

Effects of the policies in AD-AS model

With given data, suppose that the economy was initially in a long-run equilibrium and that no other policy has been introduced nor other shocks have occurred during the considered time interval. The economy starts in point E as shown in the following graph, figure 6.