Chapter 11 Macro Part 2

Assume that the money demand function, L(r, Y)=Y-200r, where t is the interest rate in percent. The money supply M is 2,000, Y=2,200 and the price level P is 2. If the price level is fixed and the Fed wants to fix the interest rate at 7 percent, it should set (change) the money supply at (to):

1,600 answer explanation: we have M / P = M / 2 = 2200 - 200*7 = 800. Solving for M, we have M = 1600

By considering only the goods market equilibrium equation in the IS-LM model, if the marginal propensity to consume is 0.6, and government expenditures and taxes are both increased by 100, equilibrium income will rise by:

100 answer explanation: the value of MPC is irrelevant. Recall the so-called balanced budget multiplier, and we have shown in class that its value is one: an increase in G by 1 will lead to an increase in Y by the multiplier, 1 / (1 - MPC). An increase in T by 1 will lead to a decrease in Y by the tax multiplier of MPC / ( 1 - MPC). The total effect = 1 / (1 - MPC) - MPC / (1 - MPC) = (1 - MPC) / ( 1 - MPC) = 1

In the goods market equilibrium equation in the IS-LM model, assume that the consumption (function) is given by C=100+0.6(Y-T). If (planned) investment is 100 and T is 100, then the level of G needed to make equilibrium Y equal 1,000 is:

260 answer explanation: , we see immediately that the multiplier is 1 / (1 - MPC ) = 10 / 4 = 5 / 2 in this case. The constant term, '100', in the consumption function is like an additional government expenditure since Y = C + I + G . Now, since I = 100, the effect on Y is 100* 5 / 2 = 250. T = 100, the effect on Y is (using the tax multiplier): -150. The combined effect so far is 250 - 150 = 100. Since the target Y is 1000, we need an additional increase of 900 in Y. Since the government expenditure multiplier is 5/2, and let the government expenditure be G, then we must have: G* 5/2 = 900. Solving the last equation for G, we have G = 360. But since there is a constant term '100' in the consumption function which is like a government expenditure (see remark above), the level of government expenditure needed is 360 - 100 = 260

Explain why an increase in the money supply, which is a change in the money market, will upset/change the original equilibrium in the goods market.

An increase in money supply will decrease the equilibrium interest rate in the money market at any given level of income. A lower interest rate will increase investment in the goods market, which will increase the equilibrium level of income in the goods market. Graphically, this is represented by a shift in the LM curve to the right (or downward) and a movement along the IS curve (when interest rate changes) to the new intersection point of the IS-LM curves.

Changes in monetary policy shift the:

LM curve

59a. Suppose Congress decides to reduce the budget deficit by cutting government spending. Use the I S-LM model to illustrate graphically the impact of a reduction in government purchases on the equilibrium level of income. Be sure to label: i. The axes: ii. the curves: iii. the initial equilibrium values: iv. the direction of the curve shifts: v. and the terminal equilibrium values.

Please draw the IS - LM diagram. A reduction in government expenditure will shifts the IS curve to the left. Comparing the new equilibrium to the original one, we see that, at the new equilibrium, the income, Y, is lower

Suppose firms are less optimistic about the future and decide to cut back on investment expenditure (regardless of the level of interest rate). Explain why such an exogenous decrease (a decrease that is not due to changes in interest rate) in investment, which is a change in the goods market, will upset the (original) equilibrium in the money market

Since 'I' and 'G' appear in the same way in the expression C + I + G, an 'exogenous' change/shock (autonomous change) in investment spending (not caused initially by changes in interest rate) is (mathematically) equivalent to a decrease in government spending. This will lead, because of the multiplier effect, to a reduction in Y according to the goods market equilibrium equation. A decrease in income/Y would decrease the demand for money (so supply is now higher than demand in the money market), to restore equilibrium in the money market (bring demand back up), it means a lower interest rate is required. Graphically, this is represented by a shift of the IS curve to the left and a lower interest rate at the new intersection/equilibrium point

Compare the predicted impact of an increase in the money supply in the IS-LM model versus the impact predicted by the quantity theory of money (with the classical model) in the Fisher affect. Can you reconcile the difference?

The IS-LM model predicts that an increase in money supply will decrease interest rate (as seen in the IS -LM diagram). The quantity theory predicts that an increase in money supply will increase price level or inflation, which, via the Fisher effect, will increase the nominal interest rate. The IS-LM model emphasizes the short-run effect when prices are fixed and Y is variable, while the quantity theory and Fisher effect are long-run effects when prices are flexible and Y is fixed (at full employment level). The results are different because of the different underlying assumptions.

59b. Explain in words what happens to equilibrium income as a result of the cut in government spending and the time horizon appropriate for this analysis.

The level Y of is lower because of the (government expenditure) multiplier effect (at the initial interest rate). But a lower Y would mean a lower demand for money which means a higher demand for bonds, which means higher bond prices or lower interest rate (yield of the bonds). A lower interest rate will stimulate investment and partially offset the multiplier effect. But the net change in Y is still negative as seen in the diagram in part a. This analysis is appropriate for the short run (and prices are fixed - so there is no change in real money balances (M/P) or further shift in the LM curve).

Two identical countries, Country A and Country B, can each be described by the goods market equilibrium equation in the IS-LM model. The MPC is 0.9 in each country. Country A decided to increase government spending by $2 billion, while country B decides to cut taxes by $2 billion. In which county will the new equilibrium level of income be greater?

We use only the goods market equation to answer the question. Income in country A will increase more. The multiplier for G is 1/ ( 1 - MPC ) = 10. The multiplier for T is only MPC / ( 1 - MPC ) = 9. Hence A has an increase in Y of 2*10 = 20 while the increase in B is only 0.9*20 = 18.

The IS-LM model simultaneously determines equilibrium in two markets:

a. which two markets? - Goods and money markets b. which two variables are determined in the equilibrium? - The interest rate, r, and real output, Y

Consider (only) the goods market equilibrium equation in the IS-LM model. Consumption is given by the equation C=200+2/3(Y-T). Planned investment is 300, as are government spending, G, and taxes, T.

a. write down the goods market equilibrium equation in its original form - Y = C + I + G = 200 + 2/3(Y - T) + I + G. b. what is equilibrium Y? (hint: use your answers in part a, and solve for Y) - Using the equation in part a, we have: Y = 200 + 2/3( Y - 300) + 300 + 300 = 800 + Y*2/3 - 200 = 600 + Y*2 / 3. Solving for Y, we have Y = 1800. c. what are equilibrium consumption, private saving, public saving, and national saving? - Consumption = 200 + 2/3( 1800 - 300 ) = 1200. Private saving = Y - C - T = 1800 - 1200 - 300 = 300. Public saving = T - G = 0. National or total saving = 300 d. how much does equilibrium income decrease when G is reduced to 200? What is the multiplier for government spending? - The multiplier is 1 / (1 - MPC) = 3. Hence if G is reduced to 200 from 300, it means G is decreased by 100. Hence the decrease in Y is 3*100 = 300

The IS and LM curve together generally determine:

both income and interest rate

In the good market equilibrium equation of the I S-LM model, fiscal policy (changes in G or T) has a multiplied effect on income because fiscal policy:

changes income, which changes consumption, which further changes income

Assume that the money demand function (or demand for real balances) is: 2,2-200r, where r is the interest rate in percent. The money supply M is 2,000 and the price level P is 2. If the price level is fixed and the supply of money is raised to 2,800, then the equilibrium interest rate will:

drop by 2 percent answer explanation: we first solve for the initial interest rate. We have: M/P = 2000/2 = 1000 = 2200 - 200 r. Solving, r = 6. Next, M/ P = 2800 / 2 = 1400 = 2200 - 200r. Solving, we have r = 4. Hence, interest rate drops from 6 to 4, which means it drops by 2

The IS curve provides combinations of interest rates and income that satisfy equilibrium in the market for _______, and the LM curve provides combinations of interest rates and income that satisfy equilibrium in the market for _______.

goods and services; real money balances

An explanation for the slope of the LM curve is that as:

income rises, money demand rises, and a higher interest rate is required

An LM curve shows combinations of:

interest rates and income, which bring equilibrium in the market for real money balances.

The interest rate determines ________ in the goods market and money _________ in the money market.

investment spending; demand

In the goods market equilibrium equation with a given MPC, the magnitude of the government-expenditure multiplier _______ the tax multiplier.

is larger than

Equilibrium levels of income and interest rates are _______ related in the goods and services market, and equilibrium levels of income and interest rates are _______ related in the market for real money balances.

negatively, positively

The LM curve generally determines:

neither income nor the interest rate answer explanation: since all the points (combinations of interest rate and income) on the LM curve are consistent with money market equilibrium

Assume that the money demand (function), L=(r, Y)=Y-100r, where r is the interest rate in percent. The money supply M is 2,000, Y=2,000 and the price level P is 2. With the above, at Y=2,000, the (equilibrium) interest rate for the money market equilibrium equation is _______ percent.

none of the above answer explanation: we have: M / P = 2000 / 2 = 1000 = Y - 100 r = 2000 - 100 r , which means, 1000 = 100 r . Solving, we have r = 10

The IS-LM model is generally used:

only in the short run

The intersection of the IS and LM curve determines the values of:

r and Y, given G, T, M, and P. answer explanation: it is nice to keep track of all the other variables that are held constant

At a given interest rate, an increase in the nominal money supply ______ the level of income that is consistent with equilibrium in the market for real balances.

raises answer explanation: the demand for money has to increase at the given interest rate. Since the demand for money also depends positively in income (Y), it means the level of income has to rise for the money market to remain in equilibrium

Using the money market equilibrium equation, for any given interest rate and price level, an increase in the money supply:

raises income

The LM curve, in the usual case:

slopes up to the right answer explanation: it slopes upward (from left to right) since higher income leads to higher interest rate (see answer in question 32 above).

In the money market equilibrium equation of the IS-LM model, if the interest rate is above the equilibrium value, the:

supply of real balances exceeds the demand

Along an IS curve all of the following are always true except:

the demand for real balances equals the supply of real balances. answer explanation: As this choice represents the LM curve. Note that the LM curve only intersects the IS curve at one point. Hence, only one point on the IS curve is consistent with money market equilibrium.

Based on the goods market equilibrium equation of the IS-LM model, one reason to support government spending increases over tax cus as measures to increase outputs is that:

the government-spending multiplier is larger than the tax multiplier

The LM curve shows combinations of ______ that are consistent with equilibrium in the market for real money balances.

the interest rate and the level of income

A decrease in the real money supply, other things being equal, will shift the LM curve:

upward and to the left

A increase in the price level, holding nominal money supply constant, will shift the LM curve:

upward and to the left answer explanation: this is similar to a decrease in real money supply

A decrease in the nominal money supply, other things being equal, will shift the LM curve:

upward and to the left answer explanation: this is similar to a decrease in real money supply, M/P