Econ 320 Lecture 12 Practice Problems

In 1936, _____ published The General Theory of Employment, Interest, and Money, a book that transformed macroeconomics. Milton Friedman Gunnar Myrdal John Maynard Keynes Elinor Ostrom

John Maynard Keynes

Suppose that the Federal Reserve tightens the money supply in order to control inflation. In the short run, this policy MOST likely will cause interest rates to _____ and shift the LM curve to the left. remain unmoved decrease fluctuate wildly increase

increase

Suppose that the marginal propensity to consume is 0.75, and both government purchases and taxes increase by $100. In this case, income will: increase by $100. increase by $400. decrease by $400. remain unchanged.

increase by $100.

Suppose that the marginal propensity to consume is 0.8, and both government purchases and taxes increase by $100. In this case, income will: decrease by $400. remain unchanged. decrease by $100. increase by $100.

increase by $100.

Suppose that the marginal propensity to consume is 0.8, and government purchases increase by $100. In this case, income will: decrease by $80. decrease by $400. increase by $500. increase by $400.

increase by $500.

Suppose that the demand for real money balances is (M / P)d = 5Y − 20r. If the supply of real balances is 400, and the gross domestic product is 100, then the equilibrium interest rate is: 2.5. 5. 7.5. 10.

5

The slope of the IS curve depends on the: sensitivity of the demand for real money balances to the interest rate. level of the investment rate divided by NX. level of government expenditures. sensitivity of investment to the interest rate.

sensitivity of investment to the interest rate.

All else equal, an increase in government purchases by 100 will: shift the IS curve to the right by exactly 100. not shift the IS curve. shift the IS curve to the left by exactly 100. shift the IS curve to the right by 100 / (1 − MPC).

shift the IS curve to the right by 100 / (1 − MPC).

Suppose that the Federal Reserve increases the money supply. This action will: make the LM curve flatter. shift the LM curve downward (or rightward). not affect the LM curve. make the LM curve steeper.

shift the LM curve downward (or rightward).

Suppose that the Federal Reserve decreases the money supply. This action will: not affect the LM curve. make the LM curve flatter. shift the LM curve upward (or leftward). make the LM curve steeper.

shift the LM curve upward (or leftward).

If the Federal Reserve increases the supply of real money balances, the LM curve will: become steeper. shift to the right. shift to the left. become flatter.

shift to the right.

If the government purchases increase, then the planned expenditure line: shifts upward. shifts downward. is indeterminate. remains the same.

shifts upward.

The LM curve, in the usual case: is vertical. is horizontal. slopes down to the right. slopes up to the right.

slopes up to the right.

Aggregate Demand — Quick Quiz Problem Please complete the following statement. According to the theory of liquidity preference, the central bank can increase the demand/supply of money and raise/lower the interest rate.

supply / lower

If the interest rate is above the equilibrium value, the: demand for real balances exceeds the supply. supply of real balances exceeds the demand. market for real balances clears. demand for real balances increases.

supply of real balances exceeds the demand.

The IS curve shifts when any of the following economic variables change EXCEPT: the interest rate. government spending. taxes. the marginal propensity to consume.

the interest rate.

In deriving the IS curve, all of these are assumed to be constant EXCEPT: the marginal propensity to consume. the multiplier. government taxes and expenditures. the real interest rate.

the real interest rate.

A decrease in the nominal money supply, other things being equal, will shift the LM curve: upward and to the right. downward and to the right. downward and to the left. upward and to the left.

upward and to the left.

If the marginal propensity to consume is 0.7, the government-purchases multiplier is: 0.3. 0.7. 1.4. 3.3.

3.3.

If the marginal propensity to consume is 0.75, then the government-purchases multiplier is: 0.25. 0.75. 4. 4.75.

4

In the Keynesian-cross model, if the MPC equals 0.75, then a $3 billion decrease in taxes increases planned expenditures by _____ and increases the equilibrium level of income by _____. $3 billion; $9 billion $2.25 billion; $9 billion $2.25 billion; $2.25 billion $3 billion; $3 billion

$2.25 billion; $9 billion Answer: D. $2.25 billion; $9 billion -- Explanation: Here, MPC = 0.75 Thus, Multiplier = (1 / 1 - MPC) = 1/0.25 = 4 The tax decrease is lump-sum in nature. Thus, $3 billion less in taxes means $2.25 billion more in expenditures. - as new consumption = 0.75 × $3 billion = $2.25 billion Of the $2.25 billion spent, the multiplier allows it to increase the impact in the economy. Overall change in income: = 4 × $2.25 billion = $9 billion

Aggregate Demand — Quick Quiz Problem According to the Keynesian cross model, if the marginal propensity to consume is 2/3, a tax cut of $120 billion increases equilibrium income by _____ billion. $160 $180 $360 $240

$240

Aggregate Demand — Quick Quiz Problem According to the Keynesian cross model, if the marginal propensity to consume is 2/3, an increase in government purchases of $120 billion increases equilibrium income by _____ billion. $360 $240 $180 $160

$360

In the liquidity preference theory: - both the price level and the supply of money are determined exogenously. - neither the price level nor the supply of money is determined exogenously. - the price level is determined exogenously, but the supply of money is not. - the supply of money is determined exogenously, but the price level is not.

- both the price level and the supply of money are determined exogenously. In the Keynesian model, the price level is fixed in the short run.

Suppose that both government purchases and taxes increase by the same amount. The multiplier for this "balanced budget" increase in government purchases is: 1 / (1 − MPC). MPC^2 / (1 − MPC). 1. −MPC / (1 − MPC).

1 The government-purchases multiplier is equal to 1 / (1 − MPC), and the tax multiplier is equal to −MPC / (1 − MPC).

Assume that the money demand function is (M / P)d = 2,200 - 200r, where r is the interest rate in percent. If the price level is fixed at P=2, and the Fed wants to fix the interest rate at 7 percent, it should set the money supply at: 2,000. 1,800. 1,600. 1,400.

1,600.

Suppose that the demand for real money balances is (M / P)d = 5Y − 20r. If the supply of real balances is 300, and the gross domestic product is 100, then the equilibrium interest rate is: 2.5. 5. 7.5. 10.

10

According to the Keynesian-cross analysis, if the marginal propensity to consume is 0.6 and government expenditures and autonomous taxes are both increased by 100, equilibrium income will rise by: 0. 100. 150. 250.

100

Suppose that the demand for real money balances is (M / P)d = 5Y − 20r. If the supply of real balances is 400, and the gross domestic product is 90, then the equilibrium interest rate is: 2.5. 5. 7.5. 10.

2.5.

Suppose that the investment curve is I = 100 − 5r, and the marginal propensity to consume is 0.75. If the interest rate falls from 4 percent to 3 percent, then the rise in Y required to maintain equilibrium in the goods market is: 5. 20. 80. 85.

20

Suppose that the investment curve is I = 500 − 50r and that the marginal propensity to consume is 0.8. If the interest rate falls from 5 percent to 3 percent, then the rise in Y required to maintain equilibrium in the goods market is: 80. 100. 125. 500.

500. At r = 5 percent, I = 500 − (50 × 5) = 250; at r = 3 percent, I = 500 − (50 × 3) = 350, so ΔI = 350 − 250 = 100. The multiplier is equal to 1 / (1 − MPC), so if MPC = 0.8, then the multiplier is 5.

Suppose that the demand for real money balances is (M / P)d = 5Y − 20r. If the point (Y = 100, r = 5) is on the LM curve, and Y = 110, then the value of r that produces money market equilibrium is: 2.5. 5. 7.5. 10.

7.5 With Y = 100 and r = 5, (M / P)d = (5 × 100) − (20 × 5) = 400; because this point is on the LM curve, this is also the supply of real balances; therefore, if Y = 110, then to achieve equilibrium, r must satisfy 400 = (5 × 110) − 20r.

Suppose that the demand for real money balances is (M / P)d = 5Y − 20r. If the supply of real balances is 300, and the gross domestic product is 90, then the equilibrium interest rate is: 2.5. 5. 7.5. 10.

7.5.

Using the Keynesian-cross analysis, assume that the consumption function is given by C = 200 + 0.7 (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: 70. 120. 170. 220.

70.

Aggregate Demand I — Work It Out Question 1 In the Keynesian cross model, assume that the consumption function is given by C=$155+0.7(Y−T)C=$155+0.7(Y−T) Planned investment is $100; government purchases and taxes are both $150. d. What level of government purchases is needed to achieve an income of $1120? Assume taxes remain at $150. G = $ e. What level of taxes is needed to achieve an income of $1120? Assume government purchases remain at $150. T = $

G = $186 T = $98.57

In the Keynesian-cross model, actual expenditures equal: GDP. the money supply. the supply of real balances. unplanned inventory investment.

GDP

On Macro Island, a closed economy described by the Keynesian cross, consumers spend two-thirds of their disposable income. Investment, government purchases, and taxes are each equal to $300. a. What is equilibrium income? Y = $ b. What is the value of the government-purchases multiplier (GPM)? GPM = c. What is the value of the tax multiplier (TM)? TM = d. If the government wants to change equilibrium income to $1,500, by how much must it change government purchases? (Use a negative sign to indicate a decrease, if warranted.) $ e. If the government wants to change equilibrium income to $1,500, by how much must it change taxes? (Use a negative sign to indicate a decrease, if warranted.) $

Y = $1200 GPM = 3 TM = -2 change government purchases = $100 change in taxes = -$150

A country with a higher marginal propensity to consume will have _____ a country with a lower marginal propensity to consume. a negative IS curve compared to the same IS curve as a flatter IS curve than a steeper IS curve than

a flatter IS curve than Consider what effect a larger ΔY for a given has on Δr -Δr / ΔY, the slope of the IS curve. A higher marginal propensity to consume implies a larger multiplier, and so the rise in Y that is required to maintain goods market equilibrium, following a rise in I induced by a fall in r, is larger.

Aggregate Demand — End of Chapter Problem Consider the impact of an increase in thriftiness in the Keynesian cross model. Suppose the consumption function is: 𝐶=𝐶⎯⎯⎯⎯+𝑐(𝑌−𝑇) where Y is income, T is taxes. and 𝐶 is a parameter called autonomous consumption that represents exogenous influences on consumption. Also, c is the marginal propensity to consume. Use this information to answer the following four questions. a. Consider the graph of the Keynsian cross below. The consumption curve has the intercept 𝐶 and the slope c. What happens to equilibrium income when the society becomes more thrifty, as represented by a decline in 𝐶? First, adjust the planned expenditure (PE) curve. Second, move point A to indicate the new equilibrium level of income and expenditure. Assume that the marginal propensity to consume c is unchanged. b. What happens to equilibrium saving? Equilibrium saving remains unchanged. c. The paradox of thrift, as illustrated here, is that although thriftiness increases, saving does not change. d. This paradox not arise in the classical model of Chapter 3 because equilibrium income in the classical model is determined only by capital, labor and, technology.

a. If society becomes more thrifty—meaning that for any given level of income, people save more and consume less—the planned-expenditure function shifts downward. Thus, equilibrium income falls. b. The planned expenditure function can be written 𝑃𝐸=𝐶+𝑐(𝑌−𝑇)+𝐼+𝐺 where desired investment 𝐼 is fixed. Since, according to the national accounts identity, saving equals investment, or S = I, equilibrium saving does not change. Overall saving (𝑆 + sY, where 𝑆 is "autonomous" saving) is thus the same in both equilibria. Although an increase in thriftiness increases saving, 𝑆, at any given level of income, income falls as a result of the fall in consumption. Thus, the component of saving that is a function of income, sY, falls, and the changes in saving from these two sources offset each other c. The paradox of thrift is that, although thriftiness increases, saving is unaffected. Increased thriftiness leads only to a fall in income. d. In the classical model, the paradox of thrift does not arise. In that model, output is fixed by the factors of production and the production technology, and the interest rate adjusts to equilibrate saving and investment. An increase in thriftiness decreases consumption and increases saving for any level of output. At the new equilibrium, the interest rate is lower, and investment and saving are higher.

Aggregate Demand I — End of Chapter Problem Although our development of the Keynesian cross in this chapter assumes that taxes are a fixed amount, most countries levy some taxes that rise automatically with national income. (Examples in the United States include the income tax and the payroll tax.) Let's represent this type of tax system by writing tax revenue (T) as 𝑇=T¯+tY where 𝑇and t are parameters of the tax code. The parameter 𝑇 is a lump‐sum tax (or, if negative, a lump-sum transfer). The parameter t is the marginal tax rate: If income rises by $1, the value of new taxes collected is t × $1. Use this information to answer the next three questions. a. How does this type of tax system change the way consumption responds to changes in GDP? The effect of an increase in income on consumption is larger/smaller. b. In the Keynesian cross, how does this tax system alter the government-purchases multiplier? The government-purchases multiplier becomes larger/smaller. c. In the IS-LM model, how does this tax system alter the slope of the IS curve? A given reduction in the interest rate now has a larger/smaller impact on real output, making The IS curve flatter/steeper.

a. If taxes do not depend on income (i.e., all taxes are lump‐sum), then a $1 increase in income raises disposable income by $1. This means that a $1 increase in income raises both planned consumption expenditure (C) and total planned expenditure (PE) by the full value of the marginal propensity to consume (MPC). However, when taxes depend on income, a $1 increase in income raises disposable income by only (1 - t) dollars. Consumption increases by the product of the MPC and the change in disposable income, or (1 - t)MPC, which is less than the MPC. Because disposable income changes by less than total income, the effect on consumption is smaller. b. When government purchases (G) increase under a lump‐sum tax system, the impact on disposable income of a $1 increase in G can be calculated using the government-purchases multiplier (GPM): 𝐺𝑃𝑀=1/(1−𝑀𝑃𝐶) When taxes depend on income, although an increase in government purchases of ΔG increases total income by ΔG, disposable income increases by only (1 - t)ΔG . Consumption then increases by (1 - t)MPC × ΔG. As a result, the government-purchases multiplier is now 1/1-(1-𝑡)𝑀𝑃𝐶 , which is much smaller than 1/1−𝑀𝑃𝐶. For example, if the marginal propensity to consume is 0.75, and the tax rate t is 1/3, then the multiplier falls from 1/1−3/4, or 4, to 1/1−(1−1/3)(3/4), or 2. c. To determine how this tax system alters the slope of the IS curve, we can derive the IS curve for the case in which taxes depend on income. Begin with the national income accounts identity: 𝑌=𝐶+𝐼+𝐺 The consumption function is 𝐶=𝑎+𝑏(𝑌−𝑇−𝑡𝑌) where taxes are in part a function of income. The investment function is 𝐼=𝑐+𝑑𝑟I=c+dr Substitute the consumption and investment functions into the national income accounts identity: 𝑌=[𝑎+𝑏(𝑌−𝑇−𝑡𝑌)]+𝑐+𝐺 Solving for r: 𝑟=(𝑎−𝑏𝑇+𝑐+𝐺/𝑑)+𝑌[𝑏(1−𝑡)−1/𝑑] The slope of the IS curve is therefore Δ𝑟/Δ𝑌=𝑏(1−𝑡)−1/𝑑 Recall that t is less than 1. As t increases, the slope of the IS curve increases in absolute value and thus becomes steeper. Suppose, for example, that b is 0.80, t is 0.1, and d is 0.5. The slope of the IS curve is then -0.56. If the tax rate increases to 0.2, then the slope becomes -0.72. Intuitively, if the tax rate is higher, then any given reduction in the interest rate has a smaller effect on real output Y because the multiplier will be smaller.

Aggregate Demand — End of Chapter Problem In the graphs below, indicate the effects of the policy changes described, assuming a marginal propensity to consume (MPC) of 2323. In each case, first shift the planned expenditure curve to its correct position. Then move point A to the new equilibrium to indicate the new level of output (Y). Be sure to use the appropriate multiplier formula, depending on whether the change is a change in spending or a change in taxes. a. A $3 billion increase in government purchases (G). b. A $3 billion increase in taxes (T). c. A $3 billion increase in government purchases (G) and a $3 billion increase in taxes (T).

a. The government-purchases multiplier (GPM) is: 𝐺𝑃𝑀=Δ𝑌Δ𝐺=1(1−𝑀𝑃𝐶) If MPC=2/3, then the GPM= +3.0. This means that a $3 billion increase in government purchases (ΔG) increases output by $9 billion, for a new equilibrium output (Point A) of $18 billion. b. The tax multiplier (TM) is: 𝑇𝑀=Δ𝑌Δ𝑇=−𝑀𝑃𝐶(1−𝑀𝑃𝐶) If MPC=2/3, then the TM= −2.0. This means that a $3 billion increase in taxes (ΔT)decreases output by $6 billion, for a new equilibrium output (Point A) of $3 billion. c. We can calculate the effect of an equal increase in government expenditure and taxes by adding the two multiplier effects observed in parts a and b: Δ𝑌=(𝐺𝑃𝑀×Δ𝐺)−(𝑇𝑀×Δ𝑇)=(1(1−𝑀𝑃𝐶)×Δ𝐺)−(−𝑀𝑃𝐶(1−𝑀𝑃𝐶)×Δ𝑇) =$9𝑏𝑖𝑙𝑙𝑖𝑜𝑛−$6𝑏𝑖𝑙𝑙𝑖𝑜𝑛=$3𝑏𝑖𝑙𝑙𝑖𝑜𝑛 Thus, the effect of a $3 billion increase in both government purchases and taxes will be a $3 billion increase in output, for a new equilibrium output (Point A) of $12 billion. An alternative way of obtaining the same result is to note that, since ΔG = ΔT, the above equation can be written as Δ𝑌=(1(1−𝑀𝑃𝐶)×Δ𝐺)−(−𝑀𝑃𝐶(1−𝑀𝑃𝐶)×Δ𝐺)=$9𝑏𝑖𝑙𝑙𝑖𝑜𝑛−$6𝑏𝑖𝑙𝑙𝑖𝑜𝑛=$3𝑏𝑖𝑙𝑙𝑖𝑜𝑛 Dividing both sides by ΔG, we have Δ𝑌Δ𝐺=1(1−𝑀𝑃𝐶)−−𝑀𝑃𝐶(1−𝑀𝑃𝐶)=3−2=1 Thus, an equal increase in government purchases and taxes increases Y by the amount that G increases. That is, the balanced-budget multiplier is equal to 1.

On Macro Island, the demand for money is determines by (𝑀𝑃)𝑑=200−20𝑟. The price level P is 3. a. A higher interest rate decreases/increases the quantity of money demanded. b. If the central bank wants to set the interest rate to 5 percent, it should set a money supply of $360/$320/$300/$350/$390/$330. c. If the central bank wants to set the interest rate to 4 percent, it should set a money supply of $330/$360/$300/$390/$320/$350. d. This example illustrates that to reduce the interest rate, the central bank must increase/decrease the money supply.

a. decreases b. $300 c. $360 d. increase

Aggregate Demand I — Work It Out Question 1 In the Keynesian cross model, assume that the consumption function is given by C=$155+0.7(Y−T) Planned investment is $100; government purchases and taxes are both $150. a. Place points A and B to graph planned expenditure as a function of income b. Calculate the equilibrium level of income.

a. upward sloping ( Y 1000, PE 300) b. Y = $1000

The IS and LM curves together generally determine: income only. the interest rate only. both income and the interest rate. income, the interest rate, and the price level.

both income and the interest rate.

Suppose that the Federal Reserve tightens the money supply in order to reduce inflation. In the long run, this policy MOST likely will cause nominal interest rates to: fluctuate wildly. remain the same. increase. decrease.

decrease

Suppose that the marginal propensity to consume is 0.8 and that taxes increase by $100. In this case, income will: decrease by $80. increase by $500. decrease by $400. increase by $400.

decrease by $400.

According to the Keynesian-cross analysis, if MPC stands for marginal propensity to consume, then a rise in taxes of ΔT will: decrease equilibrium income by ΔT. decrease equilibrium income by ΔT / (1 - MPC). decrease equilibrium income by ΔT (MPC) / (1 - MPC). not affect equilibrium income at all.

decrease equilibrium income by ΔT (MPC) / (1 - MPC).

An explanation for the slope of the IS curve is that as the interest rate increases, the quantity of investment _____, and this shifts the expenditure function _____, thereby decreasing income. increases; downward increases; upward decreases; upward decreases; downward

decreases; downward

At a point to the right of the IS curve, actual spending _____ planned spending. fluctuates compared to is the same as is less than exceeds

exceeds To reach the IS curve from a point to its right, r would have to decrease for a given value of Y; what effect does a fall in r have on planned spending?

Please complete the following statement. The LM curve slopes upward because lower/higher income increases money supply/demand and, in turn, the interest rate.

higher / demand Consider whether income (Y) determines the supply of money in the money market.

According to the theory of liquidity preference, decreasing the money supply will _____ nominal interest rates in the short run, and, according to the Fisher effect, decreasing the money supply will _____ nominal interest rates in the long run. increase; increase increase; decrease decrease; decrease decrease; increase

increase; decrease

The theory of liquidity preference in macroeconomics describes how: interest rates are determined in the short run. money demand is determined in the long run. interest rates are determined in the long run. the price level is determined in the short run.

interest rates are determined in the short run.

The theory of liquidity preference is a model of the determination of: employment in the long run. exchange rates in the long run. interest rates in the short run. income in the short run.

interest rates in the short run. The theory of liquidity preference is part of a model of the determination of income in Keynesian theory but is not itself such a model.

When firms experience unplanned inventory accumulation, they typically: build new plants. lay off workers and reduce production. hire more workers and increase production. call for more government spending.

lay off workers and reduce production.

The Data of Macroeconomics — Quick Quiz Problem Please complete the following statement. The IS curve slopes downward because a higher/lower interest rate reduces planned investment/money demand and thus income.

lower / planned investment The interest rate is the cost of borrowing money for investment projects. Would a lower interest rate reduce planned investment?

Aggregate Demand I — Work It Out Question 1 In the Keynesian cross model, assume that the consumption function is given by C=$155+0.7(Y−T)C=$155+0.7(Y−T) Planned investment is $100; government purchases and taxes are both $150. c. If government purchases increase to $165, what is the new equilibrium income? What is the multiplier for government purchases? new Y = $ multiplier:

new Y = $1050 multiplier:3.33

The IS-LM model is generally used: only in the short run. only in the long run. both in the short run and in the long run. in determining the price level.

only in the short run.

Exhibit: Keynesian Cross In this graph, if firms are producing at level Y3, then inventories will _____, inducing firms to _____ production. rise; increase rise; decrease fall; increase fall; decrease

rise; decrease

Exhibit: Market for Real Money Balances Based on the graph, if the interest rate is r3, then people will _____ bonds, and the interest rate will _____. sell; rise sell; fall buy; rise buy; fall

sell; rise

Along an IS curve all of these are always true EXCEPT: planned expenditures equal actual expenditures. planned expenditures equal income. the demand for real balances equals the supply of real balances. there are no unplanned changes in inventories.

the demand for real balances equals the supply of real balances.

According to the liquidity preference theory, a decrease in the gross domestic product, all else equal, causes: the equilibrium interest rate to fall. a change in the equilibrium interest rate that is not predictable. no change in the equilibrium interest rate. the equilibrium interest rate to rise.

the equilibrium interest rate to fall.

Aggregate Demand — Quick Quiz Problem At the intersection of the IS and LM curves, the economy has the right balance of inflation and unemployment. the economy is at full employment. the goods market and money market are both in equilibrium. the goods market disequilibrium offsets the money market disequilibrium.

the goods market and money market are both in equilibrium.

Based on the Keynesian model, one reason to support government spending increases over tax cuts as measures to increase output is that: government spending increases the MPC more than tax cuts. the government-spending multiplier is larger than the tax multiplier. government-spending increases do not lead to unplanned changes in inventories, but tax cuts do. increases in government spending increase planned spending, but tax cuts reduce planned spending.

the government-spending multiplier is larger than the tax multiplier.

Which variable is determined by the IS-LM model? taxes the interest rate the price level government expenditure

the interest rate

The LM curve shows combinations of _____ that are consistent with equilibrium in the market for real money balances. inflation and unemployment the price level and real output the interest rate and the level of income the interest rate and real money balances

the interest rate and the level of income