Exam 2 part 4

Question 1

Suppose a fiscal expansion…

Answer 1

An increase in government spending, or a decrease in taxes, shifts the IS curve to the right by increasing output for any given price level.

This also indicates a rightward shift in AD.

Question 2

Suppose a monetary expansion…

Answer 2

For any given 𝑃, an increase in the money supply (𝑀) increases real money balances (𝑀/𝑃).

An increase in 𝑀/𝑃 decreases 𝑟 for any given 𝑃. This shifts the LM curve rightward.

This results in an increase in output (𝑌) for any given price.

This indicates a rightward shift in aggregate demand.

Question 3

A decrease in real money balances corresponds with an

Answer 3

increase in interest rates (𝑟) by a leftward shift of the LM curve (recall the theory of liquidity preferences).

Thus, an increase in 𝑃 corresponds with a decrease in 𝑌.

Question 4

Changes in IS and LM could also affect other variables such as:

Answer 4

Consumption increases with higher income and decreases with lower income.

Investment decreases with a higher interest rate and increases with a lower interest rate.

Unemployment decreases with a higher income and increases with lower income (recall Okun’s Law)

Question 5

LM shocks are

Answer 5

exogenous changes in the demand for money.

Question 6

IS shocks are

Answer 6

exogenous changes in the demand of goods and services.

Question 7

Suppose the Fed holds income (𝑌) constant:

The leftward shift in the IS curve is responded to by

Answer 7

The leftward shift in the IS curve is responded to by the Fed with an expansion of the money supply (i.e., a rightward shift of LM)

We see 𝑌 remain constant, but a significant decrease in 𝑟.

Question 8

Suppose the Fed holds the interest rate (𝑟) constant:

The leftward shift in the IS curve is responded to by

Answer 8

The leftward shift in the IS curve is responded to by a leftward shift in the LM curve (i.e., the Fed contracts the money supply).

We see 𝑟 remain constant, but 𝑌 significantly decreases.

Question 9

Suppose the Fed holds the money supply (𝑀) constant:

An increase in taxes shifts the IS curve

Answer 9

An increase in taxes shifts the IS curve leftward.

We see a decrease in 𝑌 and a decrease in 𝑟.

Question 10

The Fed engages in open-market operations (the buying and selling of bonds) until

Answer 10

the money supply changes and the LM curve shifts such that the interest rate target is next.

Question 11

The federal funds rate

Answer 11

is the interest rate banks charge one another on overnight loans.

Question 12

An increase in the money supply leads to a

Answer 12

decrease in the interest rate, which stimulates investment and, thus, expands demand for goods and services.

Question 13

The monetary transmission mechanism

Answer 13

the process by which changes in the money supply (𝑀) affects the amount that households and firms wish to spend on goods and services.

Question 14

Suppose taxes decrease by ∆𝑇.

Answer 14

An decrease in taxation by ∆𝑇 increases output by ∆𝑇∗𝑀𝑃𝐶/(1−𝑀𝑃𝐶).

This occurs through a rightward shift of the IS curve.

This results in an increase in output and an increase in the interest rate.

Question 15

Suppose government spending increases by ∆𝐺. What happens?

Answer 15

An increase in gov’t spending by ∆𝐺 increases output by ∆𝐺/(1−𝑀𝑃𝐶).

This occurs through a rightward shift of the IS curve.

This results in an increase in output and an increase in the interest rate

Question 16

The intersection of IS and LM is the one combination of 𝑟 and 𝑌 that equilibrates both the

Answer 16

goods market (IS) and the money market (LM).

Question 17

Exogenous and Endogenous variables in the IS and LM curves

Answer 17

Exogenous variables include 𝑇, 𝐺, 𝑀, and 𝑃.
Endogenous variables include 𝑟 and 𝑌