Chapter 5

Question 1

Equilibrium in the Goods Market

Answer 1

The demand for goods is an increasing function of output.

Equilibrium requires that the demand for goods be equal to output.

Question 2

The Goods Market and the IS Relation

Answer 2

1. ZZ is upward-sloping because, for a given value of the interest rate, an increase in output leads to an increase in the demand for goods through its effects on consumption and investment.
2. ZZ is a curve rather than a line because we have not assumed that the consumption and investment relations in equations are linear.
3. ZZ is flatter than the 45-degree line because we have assumed that an increase in output leads to a less than one-for-one increase in demand.
4. The intersection of ZZ and the 45-degree line (point A) is the equilibrium level of output

Question 3

The Derivation of the IS Curve

Answer 3

(a) An increase in the interest rate decreases the demand for goods at any level of output, leading to a decrease in the equilibrium level of output.

(b) Equilibrium in the goods market implies that an increase in the interest rate leads to a decrease in output.
The IS curve is therefore downward sloping.

Question 4

Shifts of the IS Curve

Answer 4

1. An increase in taxes shifts the IS curve to the left.
2. Downward-sloping IS curve: Equilibrium in the goods market implies that an increase in the interest rate leads to a decrease in output.
3. Shifting the IS curve: Changes in factors that decrease (increase) the demand for goods given the interest rate shift the IS curve to the left (right).

Question 5

The LM Curve

Answer 5

The central bank chooses the interest rate (and adjusts the money supply so as to achieve it).

Question 6

Financial Markets and the LM Relation

Answer 6

1. The IS and LM relations together determine output.
2. Any point on the downward sloping IS curve corresponds to equilibrium in the goods market.
3. Any point on the horizontal LM curve corresponds to equilibrium in financial markets.
4. Only at their intersection (point A) are both equilibrium relations satisfied.

Question 7

The IS–LM Model

Answer 7

1. Equilibrium in the goods market implies that an increase in the interest rate leads to a decrease in output.
2. This is represented by the IS curve.
3. Equilibrium in financial markets is represented by the horizontal LM curve. Only at point A, which is on both curves, are both goods and financial markets in equilibrium.

Question 8

Fiscal Policy

Answer 8

Decrease in G–T ⇔ fiscal contraction ⇔ fiscal consolidation

Increase in G–T ⇔ fiscal expansion

Question 9

Steps for analyzing the effects of changes in policy or exogenous variables

Answer 9

1. Does it shift the IS curve and/or the LM curve?
2. What does this do to equilibrium output and the equilibrium interest rate?
3. Describe the effects in words

Question 10

The Effects of an Increase in Taxes

Answer 10

An increase in taxes shifts the IS curve to the left.

This leads to a decrease in the equilibrium level of output

Question 11

Monetary Policy

Answer 11

Decrease in i ⇔ increase in M ⇔ monetary expansion

Increase in i ⇔ decrease in M ⇔ monetary contraction ⇔ monetary tightening

Question 12

The Effects of a Decrease in the Interest Rate

Answer 12

A monetary expansion shifts the LM curve down, and leads to higher output

Question 13

Using a Policy Mix

Answer 13

1. Monetary-fiscal policy mix is the combination of monetary and fiscal policies.
2. Suppose that the economy is in a recession and output is too low.
3. Both fiscal and monetary policies can be used to increase output.

Question 14

The Effects of a Combined Fiscal and Monetary Expansion

Answer 14

The fiscal expansion shifts the IS curve to the right.

A monetary expansion shifts the LM curve down.

Both lead to higher output

Question 15

The South African Growth Rate

Answer 15

1. After the longest expansion phases (which lasted 99 months), the South African economy experienced an economic recession starting in the fourth quarter of 2008.
2. The recession was triggered by the fall falling of house prices in the United States, known as the subprime mortgage crisis

Question 16

The Repurchase rate in South Africa

Answer 16

The recession was met by strong macroeconomic policy response.

The South African Reserve Bank cut the repurchase rate, from 11.5% in April 2008 to 7% by the end of 2009

Question 17

National Government Revenues and Expenditure (percentage of GDP)

Answer 17

The sharp decline in revenues was due to the decline in output and income and the decline in income tax rates (as part of the expansionary fiscal policy)

Question 18

Deficit Reduction

Answer 18

1. Given private saving (S), a lower government deficit (higher T − G) means higher I.
2. However, a fiscal contraction lowers output and so S goes down by more than T − G increases, so I decreases.

Question 19

The South African recession of 2008

Answer 19

1. The decrease in demand for goods led to a sharp decrease in the IS curve.
2. The monetary expansion shifted the LM curve down.
3. The decrease in the tax rates and increase in government spending both led to a shift of the IS curve to the right

Question 20

How Does the IS-LM Model Fit the Facts?

Answer 20

1. Consumers are likely to take time to adjust their consumption following a change in disposable income.
2. Firms are likely to take time to adjust investment spending following a change in their sales.
3. Firms are likely to take time to adjust investment spending following a change in the interest rate.
4. Firms are likely to take time to adjust production following a change in their sales

Question 21

The Empirical Effects of an Increase in the Federal Funds Rate

Answer 21

In the short run, an increase in the federal funds rate leads to a decrease in output and to an increase in unemployment, but it has little effect on the price level.