Chapter 11 - Aggregate Demand (Building IS-LM Model)

Question 1

Government Purchases Multiplier

Answer 1

Change in Y/Change in G. The increase in income resulting from a $1 increase in G.

Government Purchases Multiplier = 1/(1-MPC)

Question 2

Tax Multiplier

Answer 2

Change in Y/Change in T. The change in income resulting from a $1 increase in T.

Tax Multiplier = -MPC/(1-MPC)

Question 3

IS curve

Answer 3

Graph of all combinations of r and Y that result in goods market equilibrium (actual expenditure = planned expenditure -> Y = PE)

Question 4

Equation for IS curve

Answer 4

Y = C(Y-T) + I(r) + G
Y, T, G are fixed

Question 5

Why is the IS curve negatively sloped?

Answer 5

A fall in interest rate motivates firms to increase investment spending, which increases planned expenditure (PE). Output (Y) must increase to restore equilibrium (since all points on IS curve represent equilibrium in goods market)

Question 6

What factors shift the IS curve?

Answer 6

Use of fiscal policy (changes in government spending and taxes)

Question 7

Theory of Liquidity Preference

Answer 7

Real interest rate is determined by money supply and money demand.

Question 8

Why is the supply of real money balances fixed?

Answer 8

Money supply (M) is determined by the Central Bank, and price level (P) is exogenous (fixed since prices are sticky).

Question 9

How does the Central Bank influence the interest rate?

Answer 9

The Central Bank sets the money supply to increase/decrease interest rate as they see fit.

Question 10

LM curve

Answer 10

Graph of all combinations of r and Y that equate the supply and demand for real money balances.
M/P = L(r, Y)

Question 11

Why is the LM curve upward sloping?

Answer 11

An increase in income (Y) raises money demand. Since supply of real balances is fixed, there is excess demand in the money market at the initial interest rate. Interest rate must increase to restore equilibrium in the money market.

Question 12

What factors shift the LM curve?

Answer 12

Changes in the money supply (M)

Question 13

What is the short-run equilibrium in the IS-LM model?

Answer 13

The combination of r and Y that simultaneously satisfies the equilibrium conditions in the goods and money markets.

Question 14

True or False: At short-run equilibrium in the IS-LM model, output always equals the natural level of output.

Answer 14

False. In the short run, it is possible for equilibrium to be above or below the natural level of output while also satisfying the equilibrium condition of the IS-LM model.