Chapter 12 Macro

If MPC=0.75 (and there are no income taxes) when G increases by 100, then the IS curve for any given interest rate shifts to the right by:

400 answer explanation: use the multiplier = 1 / ( 1 - 0.75) = 4 to conclude

The LM curve can shift to the right if there is an increase in the supply of money for a fall in the price level. In which case is this movement along the aggregate demand curve, and in which case is this a shift in the aggregate demand curve? explain.

The aggregate demand curve shows the relationship between quantity of output demand, Y, and the price level, P (holding other factors constant). An increase in money supply means one of the other factors held constant is now changed. Hence, we must have a new demand curve, i.e., it is a shift of the original demand curve. A change in the price is just a movement along the demand curve (see also the derivation of the aggregate demand curve from the IS-LM diagram in your class notes).

In the IS-LM model when M rises but P remains constant, in the new short-run equilibrium, the interest rate ________ and output ________.

falls; rises answer explanation: Same as question 5 above

In the IS-LM model when M/P rises, in the new equilibrium, the interest rate _________ and output ________.

falls; rises answer explanation: Use diagram (the LM curve shifts to the right/down) to find the new equilibrium point

An increase in investment demand for any given level of income and interest rates - due for example, to more optimistic "animal spirits" - will, within the IS-LM (equilibrium) framework, __________ output and ___________ interest rates.

increase; raise answer explanation: Because there is an increase in investment in every level of interest rate, this is mathematically identical to an increase in G in the goods market equilibrium equation (since in the total demand expression: C + I + G, I and G appear in the same way). Hence, the IS curve would shift right and from the diagram, the new equilibrium has a higher interest rate and higher output

In the IS-LM model, an increase in government spending increases the equilibrium interest rate and crowds out:

investment

The aggregate demand curve generally slopes downward and to the right because, for any given money supply M a higher price level P causes a __________ real money supply M/P, which _________ the interest rate and ___________ spending.

lower; raises; reduces answer explanation: Follow the argument in the derivation of the aggregate demand curve from the IS-LM model. In the IS-LM model, use the money market equation to deduce that the LM curve has shifted to the left/up when price increases

In the IS-LM model, when government spending rises, the equilibrium interest rate ________ and output __________.

rises; falls answer explanation: Use the diagram with both IS and LM curves (the IS curve shifts to the right) to see the new equilibrium point

In the IS-LM model, when the Federal Reserve decreases the money supply, the Fed _________ bonds and the interest rate _________, leading to a(n) _________ in investment and income.

sells; rises; decrease

If MPC=0.75 (and there are no income taxes but only lump-sum taxes) when T decreases by 100, then the IS curve for any given interest rate shifts to the right by:

300 answer explanation: use the tax multiplier = 0.75 / ( 1 - 0.75 ) = 3 to conclude

The interaction of the IS curve and the LM curve together determine:

the interest rate and the level of output.

If the LM curve is vertical and government spending rises by G, in the IS-LM analysis, then equilibrium income rises by:

zero answer explanation: Use diagram with a vertical LM curve while shifting the IS curve to the right

Use the IS-LM model to illustrate graphically the impact on output and interest rates of a one-time increase in the price level due to a large increase in oil prices. Be sure to label: i. the axes: ii. The curves: iii. the initial equilibrium values: iv. The direction the curves shift: v. The terminal/new equilibrium values.

A one-time increase in oil prices would increase, P in our model. Now use argument in question 7 above (basically M/P falls which shifts the LM curve up/left) to deduce that in the new equilibrium, interest rate must rise and output falls

Suppose congress wishes to reduce the budget deficit by reducing government spending. Use the IS-LM model to illustrate graphically the impact of the reduction in government spending on output and interest rates. Be sure to label: i. the axes: ii. The curves: iii. the initial equilibrium values: iv. The direction the curves shift: v. The terminal/new equilibrium values.

We did the increase in G in class. Now reverse the argument there to conclude that the IS curve must shift to the left if G decreases. Hence in the new equilibrium, both output and interest rate are lower (from the diagram)

If consumption is given by C=200+0.75(Y-T) and investment is given by I=200-25r, then the formula for the IS curve is:

Y=1,600-3T-100r+4G answer explanation: Since Y = C + I + G, plug in all the given expressions into C and I in the equation. Now isolate Y on one side to get choice B. Alternatively, we know because MPC = 0.75, the government expenditure (or investment) multiplier is 4 and the tax multiplier is negative 3. The constant terms '200' in the consumption function and '200' in the investment function add up to '400', which is like an additional amount of government expenditure (since total demand is (C + I + G) and the three variables appear in the same way in the expression). Since the total constant term is '400'. With the multiplier, it becomes 1600. The investment multiplier is also 4, hence the effect of 'r' is 4*25*r = 100*r. The term '4*G' is because of the multiplier value of 4. Similar argument for the term '- 3*T'

According to the IS-LM model, when the government increases taxes and government purchases by equal amounts:

income and the interest rate rise, whereas consumption and investment fall. answer explanation: This is the balanced budget multiplier idea that we discussed in class. Recall, when G and T both go up by 1, then Y would go up by 1 (using only the goods market equation). What this mean is that the IS curve shifts horizontally to the right by 1. With the LM curve, the new equilibrium point has a higher Y (but the increase is less than 1) and higher interest rate. But since T increases by 1 while Y increases by less than 1, there is a net decrease in disposable income. Hence consumption must fall. Since there is an increase in interest rate, investment must fall

According to the IS-LM model, if Congress cut taxes but the Fed want to hold the (equilibrium) interest rate constant then the Fed must _________ the money supply.

increase answer explanation: Cutting taxes would shift the IS curve to the right (since it raises output, Y, at each level of interest rate, r). This means at the new intersection point, the interest rate is higher. To restore the original interest rate, we can shift the LM curve to the right so the final intersection point has the same interest rate as the original equilibrium point. Shifting the LM to the right means choice C.

According to the IS-LM model, if Congress wants to raise taxes but the Fed want to hold income constant then the Fed must _________ the money supply.

increase answer explanation: Similar to question 10 above except here, we shift the LM to the right so the final equilibrium point has the same level of output as before

In the IS-LM model, a decrease in equilibrium output would be the result of a(n):

increase in money demand answer explanation: Use argument in question 13

In the IS-LM model, the impact of an increase in government purchases/expenditure in the goods market has ramifications in the money market, because the increase in income causes a(n) _________ in money _________.

increase; demand

If the demand for real money balances does not depend on the interest rate, then the LM curve:

is vertical answer explanation: Recall the money market equilibrium equation: M/P = L (r, Y). If the demand for money L( r, Y) is independent of r, then the demand for money is a function of Y alone, i.e., L ( Y ). There is then only one level/value of Y, say Y*, that makes the right hand side equal to M/P, i.e., we are 'solving' for the value of 'Y' in the equation M/P = L(Y). It is true for any value of r. Hence, the LM curve must be a vertical line at Y = Y*.

An increase in the demand for money, at any given income level and level of interest rates, will, within the IS-LM framework, _________ output and _________ interest rates.

lower, raise answer explanation: Pick any point on the original/initial LM curve. If there is an increase in the demand for money, it means the demand exceeds supply (M / P ). To bring down demand to restore equilibrium, interest rate has to go up. This means the new (equilibrium) point must be vertically upward/higher. The above argument can be applied to every point on the LM curve. Hence, the LM curve shifts to the left/up. Now draw in the IS curve and find the new equilibrium point to conclude

In the IS-LM model, a decrease in the equilibrium interest rate would be the result of a(n):

none of the above answer explanation: All the choices involve higher interest rate in the new equilibrium point

Those economists who believe that fiscal policy (eg. increase in government expenditure) is more potent than monetary policy argue that the:

responsiveness of investment to the interest rate is small. answer explanation: Fiscal policy such as an increase in G, would raise Y. But this would, in the money market equation, raise the demand for money. To restore equilibrium, the interest rate has to rise. In essence, an increase in G would make interest rate rise. This rise in interest rate would decrease investment and decrease Y which partially offsets the increase in Y at the beginning. Hence, if investment is not sensitive (means doesn't respond much) to the rise in interest rate, then the offset is smaller and fiscal policy is more effective. Another way to see the answer: if investment is not sensitive to changes in interest rate, it means the IS curve is 'steeper' or nearly vertical (why? Changes in interest rate causes small changes in Y in the curve). If the IS curve is steep (draw the IS-LM diagram), then any shifts in the IS curve would lead to a good increase in Y, i.e., fiscal policy is effective

A movement along an aggregate demand curve corresponds to a change in income in the IS-LM model ________, while a shift in aggregate demand curve corresponds to a change in income in the IS-ML model _________.

resulting from a change in the price level; at a given price level

In the IS-LM model when M remains constant but P rises, in the new short-run equilibrium, the interest rate ___________ and output __________.

rises; falls answer explanation: Use diagram to find the new equilibrium point. The opposite of question 6 above

In the IS-LM model, if the LM curve is not horizontal, the effect for an increase in government spending is ________ than that of the multiplier effect (1/(1-MPC)) for government expenditure.

smaller than the multiplier answer explanation: The (government expenditure) multiplier effect is the effect on Y when there is no change in interest rate (or holding interest rate constant and hence no change in investment in the equation). It represents the horizontal movement/shift of the IS curve when there is an increase in G. But with the LM curve, we know the new equilibrium point has a higher output than the original equilibrium but the increase in output is less than the horizontal shift of the IS curve (use IS-LM diagram or the argument we presented in class - higher income leads to higher demand for money which raises interest rate. An increase in interest rate reduces investment and hence dampens the increase in Y due to the multiplier effect).