as discussed

118.

Assume the following model of the economy, with the price level fixed at 1.0: C = 0.8(Y – T) T = 1,000 I = 800 – 20r G = 1,000 Y = C + I + G Ms/P = Md/P = 0.4Y – 40r Ms = 1,200 a. Write a numerical formula for the IS curve, showing Y as a function of r alone. (Hint: Substitute out C, I, G, and T.) b. Write a numerical formula for the LM curve, showing Y as a function of r alone. (Hint: Substitute out M/P.) c. What are the short-run equilibrium values of Y, r, Y – T, C, I, private saving, public saving, and national saving? Check by ensuring that C + I + G = Y and national saving equals I. d. Assume that G increases by 200. By how much will Y increase in short-run equilibrium? What is the government-purchases multiplier (the change in Y divided by the change in G)? e. Assume that G is back at its original level of 1,000, but Ms (the money supply) increases by 200. By how much will Y increase in short-run equilibrium? What is the multiplier for money supply (the change in Y divided by the change in Ms)?

ANSWER:

118.

a. Y = 5,000 – 100r. b. Y = 3,000 + 100r. c. In the short-run equilibrium, Y = 4,000; r = 10; Y – T = 3,000; C = 2,400; I = 600; private saving is 600; public saving is 0; and national saving is 600. d. Y increases by 500. The government spending multiplier is 2.5. e. Y increases by 250. The multiplier for money supply is 1.25.

119.

Assume that an economy is characterized by the following equations: C = 100 + (2/3)(Y – T) T = 600 G = 500 I = 800 – (50/3)r Ms/P = Md/P = 0.5Y – 50r a. Write the numerical IS curve for the economy, expressing Y as a numerical function of G, T, and r. b. Write the numerical LM curve for this economy, expressing r as a function of Y and M/P. c. Solve for the equilibrium values of Y and r, assuming P = 1.0 and M = 1,200. How do they change when P = 2.0? Check by computing C, I, and G. d. Write the numerical aggregate demand curve for this economy, expressing Y as a function of G, T, and M/P.

ANSWER:

a.	Y = 2,700 + 3G – 2T – 50r.
b.	r = 0.01Y – 0.02(M/P).
c.	For P = 1.0, Y = 2,800 and r = 4; C = 1,566.67 and I = 733.33 For P = 2.0, Y = 2,400 and r = 12; C = 1,300 and I = 600.
d.	Y = 1,800 + 2G – (4/3)T + (2/3)M/P.
120.	Assume that an economy is described by the IS curve Y = 3,600 + 3G – 2T – 150r and the LM curve Y = 2 M/P + 100r [or r = 0.01Y – 0.02(M/P)]. The investment function for this economy is 1,000 – 50r. The consumption function is C = 200 + (2/3)(Y – T). Long-run equilibrium output for this economy is 4,000. The price level is 1.0. a. Assume that government spending is fixed at 1,200. The government wants to achieve a level of investment equal to 900 and also achieve Y = 4,000. What level of r is needed for I = 900? What levels of T and M must be set to achieve the two goals? What will be the levels of private saving, public saving, and national saving? (Hint: Check C + I + G = Y.) b. Now assume that the government wants to cut taxes to 1,000. With G set at 1,200, what will the interest rate be at Y = 4,000? What must be the value of M? What will I be? What will be the levels of private, public, and national saving? (Hint: Check C + I + G = Y.) c. Which set of policies may be referred to as tight fiscal, loose money? Which set of policies may be referred to as loose fiscal, tight money? Which “policy mix” most encourages investment?

ANSWER:

a.	r = 2; T = 1,450; M = 1,900. Private saving = 650; public saving = 250; national saving = 900.
b.	r = 8; M = 1,600; I = 600; private saving = 800; public saving = –200; national saving = 600.
c.	The policy under part a is tight fiscal, loose money. The policy under part b is loose fiscal, tight money. The policy under part a most encourages investment.

121.

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; and v. the terminal equilibrium values.

ANSWER

122.

Suppose Congress passes legislation that reduces taxes. Use the IS–LM model to illustrate graphically the impact of the tax reduction 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; and v. the terminal equilibrium values.

ANSWER

123.

How can the Fed keep the economy from falling into a recession if the budget deficit is reduced? Use the IS–LM model to illustrate graphically the impact of both the fiscal policy reducing the deficit and the monetary policy, which prevents output from falling. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curves shift; and v. the terminal equilibrium values.

ANSWER

124.

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; and v. the terminal equilibrium values.

ANSWER

125.

Suppose that people finally realize that they must save a larger proportion of their income in order to retire and that they simultaneously begin to use new technology that allows them to reduce their holdings of real cash balances as a proportion of their income. Use the IS–LM model to illustrate graphically the impact of these two changes in household behavior 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; and v. the terminal equilibrium values.

ANSWER

The interest rate decreases, but the impact on output is ambiguous, depending on whether the IS or LM curve shifts more.

126.	Use the IS–LM model to illustrate graphically the impact of the Pigou effect on the equilibrium level of income and interest rate during the Great Depression, when prices were falling.

ANSWER

Income increases because the falling prices increase money balances, thus making consumers feel wealthier. The increase in wealth causes consumers to consume more, thereby shifting the IS curve to the right. Income also increases because the decrease in prices increases real money balances, which shifts the LM curve to the right. The impact on interest rates is indeterminate.

127.

Assume that initially everyone expects the price level to stay the same. Now the Federal Reserve announces that it will increase the rate of money growth in one year. People now expect inflation. Use the IS–LM model to illustrate graphically the impact of expected inflation on the level of output and on the real and nominal interest rates.

ANSWER

The increase in expected inflation increases output and the nominal interest rate, and lowers the real interest rate.

128.	Assume that the economy is initially in short-run equilibrium at a level of output above the natural rate. Use the IS–LM model to illustrate graphically how the levels of income and interest rates change as the economy returns to the natural rate of output in the long run.

ANSWER

Prices increase, reducing real money balances, resulting in lower output and a higher interest rate.

129.

Two identical countries, Alpha and Beta, can be described by the IS–LM model in the short run. The governments of both countries cut taxes by the same amount. The Central Bank of Alpha follows a policy of holding a constant money supply. The Central Bank of Beta follows a policy of holding a constant interest rate. Compare the impact of the tax cut on income and interest rates in the two countries.

ANSWER:

The interest rate will increase in Alpha, but remain constant in Beta. The increase in output will be larger in Beta because the Central Bank of Beta will increase the money supply to keep the interest rate constant in the face of the tax cut. Thus, there will be no crowding out of investment in Beta, but there will be crowding out in Alpha because of the higher interest rate.

130.

Policymakers are contemplating undertaking either an increase in government spending or an increase in the money supply. Either policy is forecast to have the same impact on income in the short run. Use the IS–LM model to compare the impact on consumption and investment of the two policy alternatives.

ANSWER

The increase in government spending will increase interest rates, but the increase in the money supply will lower interest rates. The amount of consumption will rise under either policy. There will be less investment if the policy of increasing government spending is chosen because some investment will be crowded out to accommodate the higher level of government spending. There will be more investment if the monetary supply expansion is chosen, because interest rates will be lower.

131.	A decrease in government spending reduces output more in the Keynesian-cross model than in the IS–LM model. Explain why this is true.

ANSWER

In the Keynesian-cross model, both the price level and interest rate are held constant. A decrease in government spending reduces output by 1/(1 – MPC) times the change in government spending. In the IS–LM model, the decrease in government spending reduces income as in the Keynesian-cross model, but the reduction in income also reduces the demand for money, which in turn reduces the interest rate for a given money supply. The lower interest rate stimulates the off-setting investment spending.

132.	Compare the impact of a tax cut on consumption, investment, output, and interest rates in the classical model of Chapter 3 versus the IS–LM model.

ANSWER

Output increases in the IS–LM model, but it is fixed at the natural level in the classical model because it is determined by the factors of production and technology. In both models, consumption increases because the tax cut increases disposable income. The interest rate increases in both models. In the classical model, the tax cut reduces saving, which increases the interest rate and reduces the equilibrium quantity of investment. In a closed classical economy, since income is fixed, the increase in consumption exactly offsets the decrease in investment. In the IS–LM model, the increase in income increases money demand, which results in a higher interest rate to bring money demand into equilibrium with the constant money supply. The higher interest rate partially crowds out investment in the IS–LM model (for the usual interest sensitivities of investment and money demand).

133.

a. An economy is initially at the natural level of output. There is an increase in government spending. Use the IS–LM model to illustrate both the short-run and long-run impact of this policy change. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium, iv. the short-run equilibrium, and v. the terminal equilibrium. b. Explain in words the short-run and long-run impact of the change in government spending on output and interest rates.

ANSWER:

a. b. The economy is initially at output Yn and interest rate r1. As a result of the increase in government spending in the short run, output increases to Y1 and the interest rate increases to r2 as the IS curve shifts from IS1 to IS2. In the long run, the price level increases, shifting the LM curve from LM1 to LM2. Output returns to Yn and the interest rate eventually increases to r3 in the long run.

134.	An increase in money supply shifts the LM curve to the right, but an increase in money demand shifts the LM curve to the left. Explain why there is a difference.

ANSWER:

When the money supply increases (for a fixed money demand and price level), the demand for money is less than the money at the existing interest rate, so households use the extra money to buy bonds, which drives up the price of bonds and reduces the interest rate. The same level of income is associated with a lower interest rate, which shifts the LM curve downward to the right. When money demand increases (for a fixed money supply and price level), money demand exceeds the unchanged money supply, so people start to sell bonds, which drives down the price of bonds and increases the interest rate. The same level of income is now associated with a higher interest rate, which shifts the LM curve upward to the left.

135.

Assume the economy is initially in a short-run equilibrium at a level of output below the natural rate. a. Use the IS–LM model to graphically illustrate: (1) how the economy will adjust in the long-run if the no policy action is taken; and (2) the long-run equilibrium if fiscal policy is used to return the economy to the natural rate of output. b. Explain how investment, the interest rate, and the price level differ in the new long-run equilibrium in the two cases.

ANSWER

a. The economy starts in equilibrium at A. (1) With no policy change the price level will eventually fall, shifting LM1 to LM2. The new long-run equilibrium will be at B. (2) If fiscal policy is used to restore the natural rate, IS1 will shift to IS2 and the new equilibrium will be a C. b. If no policy is used to restore full employment, the interest rate and the price level fall. Since the long-run interest rate will be lower, investment will be larger. If fiscal policy is used, the IS curve will shift to the right. The price level will not change, but the long-run interest rate will increase. This will reduce the amount of private investment at the new equilibrium, C.

136.	If inflation is bad, why isn't deflation good? Use the IS–LM model to explain how deflation could result in a contraction in output.

ANSWER:

An unexpected deflation will reduce output by transferring wealth from debtors to creditors. If creditors have a lower propensity to spend than debtors, then the reduction in spending by debtors will be more than the increase in spending by creditors. This reduction in consumption will shift the IS curve to the left, resulting in a lower equilibrium level of output. If there is an expected deflation, this increases the real interest at every level of nominal interest rate and reduces investment spending. The decrease in investment spending shifts the IS curve to the left and results in a lower equilibrium level of income.

137.	The LM curve can shift to the right if there is an increase in the supply of money or 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 of the aggregate demand curve? Explain.

ANSWER:

The aggregate demand curve shows the relationship between income and the price level, holding other factors constant, including the money supply. An increase in the money supply which shifts the LM curve to the right also shifts the aggregate demand curve to the right because the money supply is not constant since it is along any given aggregate demand curve. A reduction in the price level that shifts the LM curve to the right is a movement down the demand curve, because the money supply is held constant along the aggregate demand curve, and the aggregate demand curve shows how income changes as the price level changes.

138.

Use the IS–LM model to predict the short-run impact on the interest rate and output if the Fed pushes interest rates down at the same time that both consumption and investment fall due to a financial crisis. Illustrate your answer graphically. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium; and iv. the direction the curves shift. Explain your answer in words.

ANSWER:

Starting from A with interest rate r1 and income Y1, the reduction in interest rates by the Fed moves the LM curve to the right. The fall in consumption and investment spending moves the IS curve to the left. At the new equilibrium the interest rate will be lower, but the impact on output will depend on the relative magnitudes of the shifts. If the IS curve shifts relatively more than the LM curve, output will be lower. If the LM curve shifts relatively more than the IS curve, output will increase.

139.	How does a change in fiscal policy bring changes in the IS curve in a short-run equilibrium?

ANSWER:

When the government increases its purchases of goods and services, the economy’s planned expenditure, i.e. the government’s expenditure, rises. The increase in planned expenditure stimulates the production of goods and services, which causes total income (Y) and interest rate (r) to rise. Similarly, changes in taxes affect the economy much the same as changes in government purchases do, except that taxes affect expenditure through consumption. The tax cut raises both income and interest rate.

140.	A change in money supply shifts the LM curve downward. Explain why.

ANSWER:

An increase in money supply (M) leads to an increase in real money balances (M/P) because the price level is fixed in the short run. An increase in real money balances leads to a lower interest rate. Therefore, the LM curve shifts downward as the increase in money supply lowers the interest rate and raises the level of income.

141.	If the congress announces a rise in taxes, how will the Fed react to this rise, according to the IS-LM model?

ANSWER:

According to IS-LM model, there can be three possible conditions:

A. The Fed holds the money supply constant. The rise in tax reduces the income and interest rates and shifts the IS curve to the left.

B. The Fed wants to hold the interest rate constant by reducing the money supply. In this case, when the tax increase shifts the IS curve to the left, the Fed must decrease the money supply to keep the interest rate at its original level. This fall in the money supply shifts the LM curve upward. The interest rate does not fall, but income falls by a larger amount than if the Fed had held the money supply constant.

C. The Fed wants to prevent the tax increase from lowering income. It must, therefore, raise the money supply and shift the LM curve downward enough to offset the shift in the IS curve. In this case, the tax increase does not cause a recession, but it does cause a large fall in the interest rate.

142.	What are shocks? How do shocks respond to the IS and LM curves?

ANSWER:

Shocks are disturbances other than monetary and fiscal policies that cause shifts to the IS and LM curves. Shocks to the IS curve are exogenous changes in the demand for goods and services. The fall in investment reduces planned expenditure and shifts the IS curve to the left, reducing income and employment. A rise in the consumption function increases planned expenditure and shifts the IS curve to the right, which raises income.

Shocks to the LM curve are exogenous changes in money supply. An increase in the money demand shifts the LM curve upward, which tends to raise the interest rate and depress income.

143.	When an economy expands its monetary and fiscal policies, how is the aggregate demand curve affected?

ANSWER:

If monetary policy is expanded, for a given price level the increase in money supply further increases real money balances. This shifts the LM curve downward and raises income. Thus, the aggregate demand curve is shifted to the right by an increase in money supply. On the other hand, the fiscal expansion (like increase in government purchases and a decrease in taxes) for any given price, shifts the IS curve to the right and raises income. Therefore, the aggregate demand curve is shifted to the right.

144.	How do changes in price level affect the equilibrium in the IS-LM model in the short as well as long run?

ANSWER:

In the short run the price level is assumed to be fixed. Thus, in the short-run equilibrium, the income of the economy will be less than its natural level. In other words, at the existing price level, there is insufficient demand for goods and services to keep the economy producing to its potential. The long-run equilibrium depends on aggregate demand and aggregate supply. The point at which aggregate demand and aggregate supply intersect each other represents the point at which the quantity of goods and services demanded equals the natural level of output. This long run equilibrium is achieved by a shift in the LM curve. The fall in the price level raises real money balances and therefore shifts the LM curve to the right.

145.	What are the spending hypothesis and monetary hypothesis? Illustrate your answer with examples.

ANSWER:

Some economists suggest that the cause of the decline in income may have been a contractionary shift in the IS curve. This is called a spending hypothesis because it places primary blame for the depression on an exogenous fall in spending on goods and services. Ex. In the great depression of 1930, the decline in income coincided with falling interest rates marked by the shift in IS curve.

When the primary blame for depression is placed on the Federal Reserve for allowing the money supply to fall by a huge amount, which shifts the LM curve, the monetary hypothesis is in play. For example,. the supply of money fell by 25 percent from 1929 to 1933, during which time the unemployment rate rose from 3.2 percent to 25.2 percent.

146.	To stabilize falling prices in 1930, what did Pigou suggest?

ANSWER:

Pigou pointed out that real money balances are part of household’s wealth. As prices fall and real money balances rise, consumers should feel wealthier and spend more. This increase in consumer spending should cause an expansionary shift in the IS curve, also leading to higher income.

147.	What is debt-deflation theory? How should a country treat the condition if depression repeats itself?

ANSWER

The debt-deflation theory explains the effect of unexpected falls in the price level. If prices are destabilizing, then a contraction in the money supply can lead to a fall in income, even without a decrease in real money balances or a rise in nominal interest rates. If depression repeats itself the following steps are suggested:

A. The monetary policy mistakes of the previous depression are unlikely to be repeated,

B. The fiscal policy mistakes of the previous depression should also be prevented,

C. Currently, a few economists suggest a rigid adherence to a balanced budget in the face of massive unemployment,

D. Reduction in income reduces the income tax, which also stabilizes the economy.

148.	Under what condition does a liquidity trap occur?

ANSWER

According to the IS-LM model, expansionary monetary policy works by reducing interest rates and stimulating investment spending. However, if the interest rate has already fallen almost to zero, then perhaps monetary policy is no longer effective. This situation is called the liquidity trap.