Week 3 - Aggregate Demand

Question 1

What is the Keynesian multiplier?

Answer 1

Definition: The increase in Y that comes about from a £1 increase in G.
Formula: [1 / (1-MPC)]
Explanation: Initial increase in G increases Y but the spending amount. However, higher Y leads to higher C, which leads to higher Y etc etc.

Question 2

What is the tax multiplier?

Answer 2

The change in income resulting form a £1 increase in T.

Question 3

What are the properties of the tax multiplier?

Answer 3

• Negative: An increase in taxes always has a negative impact on Y
• Greater than 1: Changes in taxes has a multiplier effect on Y.
• Smaller than Keynesian multiplier: This is because consumers save a fraction of the initial tax cut. Therefore, the initial increase in spending is smaller, and the final effect is also smaller.

Question 4

What does the IS curve show?

Answer 4

All the combinations of r and Y such that the goods market clears. i.e. actual expenditure = planned expenditure.
Equation: Y = C(Y - T) + I( r ) + G

Question 5

How can we derive the IS curve?

Answer 5

Using the Keynesian cross diagram, we can show that a fall in r causes increased investment, and an increase in Y. Hence, there is a negative relationship between r and Y, as shown by the IS curve.

Question 6

How does fiscal policy affect the IS curve?

Answer 6

At any level of r, and increase in government spending leads to an increase in planned expenditure (E), causing an increase in Y. Thus, an increase in G will shift the IS curve to the right.

Question 7

Why, in Keynes’ liquidity preference theory, is the supply of money fixed, and the demand for money downward sloping?

Answer 7

Supply is assumed to be simply set by the central bank. Demand is downward sloping because as r increases, the opportunity cost of holding cash also increases. This is why there is a negative relationship between r and liquid money demand.

Question 8

How does the central bank raise / lower the interest rate?

Answer 8

It simply adjusts the supply of money. This can be seen on the liquidity preference diagram.

Question 9

How do we derive the LM curve?

Answer 9

Considering the money supply / demand diagram, if we increase income money demand increases and shifts right, causing a higher r. Therefore, there is a positive relationship between r and Y. This is why the LM curve is upward sloping.

Question 10

How does the LM curve shift?

Answer 10

In response to changes in the supply of money. A fall in the money supply causes a shift to the left. An increase leads to a shift to the right.

Question 11

How does an injection of government spending affect national income?

Answer 11

Shifts the IS curve to the right - magnitude = (1 / 1 - MPC) * [delta]G. However, final increase in Y is smaller. This is because as income rises, so does the demand for money. This causes the interest rate to rise, reducing investment, and diminishing the final increase in Y.

Question 12

How does a tax cut affect national income?

Answer 12

IS curve shifts to the right - magnitude = (-MPC / 1 - MPC). This is less than an equal increase in govt spending.

Question 13

How does a monetary expansion affect income?

Answer 13

Shifts LM to the right, causing r to fall, and this increases investment and consequently income.

Question 14

Why might this simple IS/LM model be considered unrealistic when it comes to assessing policy interactions?

Answer 14

• Treats G, M and T as exogenous variables. In reality, these variables may well be influenced by one another (ie. they’re endogenous)

Question 15

What are the three potential responses of the central bank to an increase in government spending?

Answer 15

• Hold M constant (ie. do nothing)
• Hold r constant
• Hold Y constant

Question 16

Explain the response “Do nothing”.

Answer 16

• IS shifts right. (LM unchanged)
• Y increases
• R also increases

Question 17

Explain the response “interest rate targeting”.

Answer 17

Central bank will change money supply to try and keep r constant.

• IS shifts right.
• CB respond by increasing money supply, shifting LM to the right too.
• Y increases, whilst r remains stable.

Question 18

Explain the response “output targeting”.

Answer 18

• IS shifts to the right
• CB reduces money supply, shifting the LM curve to the left.
• This vastly increases r, but keeps Y constant.

Question 19

What are IS and LM shocks? give examples.

Answer 19

IS shock: Exogenous change in the demand for goods and services. Eg. Stock market boom / bust.
LM shock: Exogenous shock to the money market. Eg. Rapid increase in ATM’s; wave of credit card fraud.

Question 20

Why does the CB target interest rates, not money supply?

Answer 20

• Much easier to measure, because money circulates so frequently.
• CB might feel there are more LM shocks than IS shocks. If this is the case, then targeting interest rates stabilises income more effectively than money supply.