Exam 2 part 5

Question 1

Monetary expansion (Increase in M)…

Answer 1

lowers r and shifts LM downward.

Question 2

The LM curve has a direct relationship between the

Answer 2

interest rate and output

Question 3

an increase in Y increases real money demand which increases

Answer 3

the interest rate

Question 4

An increase in income results in an

Answer 4

increase in money demand

Question 5

When income (Y) is high…

Answer 5

expenditure is high, and people engage in more transactions that require the use of money.

Question 6

Demand (M/P)^d

Answer 6

Demand curve STILL slopes downward and is affected by the interest rate (𝑟).
The interest rate is the opportunity cost of holding assets as money (instead of bonds or interest-bearing bank deposits).

Question 7

Supply (M/P)^s

Answer 7

We assume a fixed money supply (𝑀̅) chosen by the central bank, and a fixed price level (𝑃̅; sticky in short-run).
Therefore, with 𝑀 and 𝑃 both exogenous, the short-run supply curve is vertical.

Question 8

Liquidity Preference Theory:

Answer 8

Liquidity preference is a model of the interest rate in which the interest rate adjusts to equilibrate the supply and demand of real money balances.

Question 9

The Liquidity-Money (LM) Curve

Answer 9

Equilibrium in the market for money balances.

Plots the interest rate and the level of income.

Developed from the Theory of Liquidity Preferences.

Question 10

How does an increase in 𝑟 affect 𝑌?

Answer 10

An increase in the interest rate (𝑟) decreases investment (𝐼).

A decrease in investment (𝐼) shifts down planned expenditure (𝐶+𝐼+𝐺).

Therefore, an increase in the interest rate decreases income/output (𝑌).

In other words, the IS curve has an inverse relationship between the interest rate and output.

Question 11

Suppose we see a reduction in taxes by ∆𝑇.

Answer 11

A decrease in taxes also increases planned expenditure, which increases equilibrium income.

Question 12

Suppose we see an increase in government spending by ∆𝐺.

Answer 12

An increase in government spending increases planned expenditure, which increases equilibrium income

Question 13

If 𝑌<𝐶+𝐼+𝐺, unplanned drop in inventory leads to

Answer 13

rise in income until 𝑌=𝐶+𝐼+𝐺

Question 14

If 𝑌>𝐶+𝐼+𝐺 unplanned inventory accumulation leads to

Answer 14

a fall in income until 𝑌=𝐶+𝐼+𝐺

Question 15

Keynesian Cross equilibrium occurs when

Answer 15

Planned expenditure equals actual expenditure

Question 16

Unplanned inventory investment

Answer 16

Difference in planned expenditure and actual expenditure

Question 17

Actual Expenditure

Answer 17

is the amount they actually spend (GD𝑃=𝑌).

Question 18

Planned Expenditure

Answer 18

is the amount that households, firms, and government would like to spend

Question 19

Keynesian Cross

Answer 19

is a model of income determination developed from Keynes’ General Theory, and shows how spending affects aggregate income.

Total income is determined by spending plans: more people spend -> more output firms produce -> more workers firms hire (i.e., lower unemployment).

Based in Keynes’ central premise that business cycles are due to a fall in aggregate demand due to insufficient spending.

Question 20

The Investment-Savings (IS) Curve

Answer 20

Equilibrium in the market for goods and services.

Plots the interest rate and the level of income.

Developed with the Keynesian Cross.