Chapter 12 - Aggregate Demand (Applying IS-LM Model)

Question 1

Why does the Bank of Canada target interest rates instead of the money supply?

Answer 1

Interest rates are easier to measure than the money supply (often don’t have exact money supply). More importantly, targeting the interest rate stabilizes income better than targeting the money supply.

Question 2

When the IS curve shifts due to a change in government spending, how much does Y increase/decrease?

Answer 2

Y changes by: (Government Spending Multiplier)*(change in G)

Question 3

When the IS curve shifts due to a change in taxes, how much does Y increase/decrease?

Answer 3

Y changes by: (Tax Multiplier)*(change in T)

Question 4

IS Shocks

Answer 4

Exogenous changes in the demand for goods and services

Question 5

LM Shocks

Answer 5

Exogenous changes in the demand for money

Question 6

Why does the AD curve have a negative slope?

Answer 6

An increase in the price level decreases real money balances. Thus, LM shifts left giving a new combination of r and Y (smaller Y) that clear both the goods and money markets.

Question 7

How can the Central Bank change aggregate demand?

Answer 7

Increase AD: Increase M, increase G, decrease T (shift LM or IS right)

Decrease AD: Decrease M, decrease G, increase T (shift LM or IS left)