178.200 06-5

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178.200 Intermediate MacroeconomicsTutorial (5)

IS – LM Model II

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True or False Questions

(1) The increase in income in response to a fiscal expansion is smaller in the IS-LM model than it is in the Keynesian cross. (I is assumed to be fixed).

Answer: T.

Hint: (See P283).

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(2) The output effect for a change in the money supply is large when investment is sensitive to the rate of interest.

Answer: T.

Hint: (See P309).

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(3) An increase in the transaction demand for money ratio decreases the output effect of a change in the money supply.

Answer: T.

Hint: (See P289).

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(4) An increase in government spending always crowds-out investment.

Answer: F.

Hint: Thinking about whether investment is interest-sensitive or not.

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(5) A liquidity trap arises when portfolio holders have an infinite demand for bond because they do not want to hold money.

Answer: F.Hint: The liquidity trap occurs as portfolio

holders having an infinite demand for money therefore there is no liquidity effect and no change in output. (See P303)

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(6) Both shocks to the IS curve and the LM curve are endogenous changes in the demand for goods and services and for money respectively.

Answer: F.

Hint: (See PP288-289).

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Multiple-Choice Questions(2005 Exam Question)(1) If real income rose and the interest rate fell

following an increase in government purchases, the:

a. IS curve must be vertical.b. LM curve must be vertical.c. central bank must have increased the money

supply at the same time.d. central bank must have decreased the money

supply at the same time.Answer: c.Hint: (See next slide)

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Multiple-Choice Questions

r

r2

r1

Y1 Y2 Y3 Y

IS1

IS2

LM1

LM2(1)

(2)

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Multiple-Choice Questions(2005 Exam Question)

(2) If the central bank decreases the money supply at the same time as taxes increase, the:

a. interest rate will definitely rise.

b. interest rate will definitely fall.

c. equilibrium level of income will definitely rise.

d. equilibrium level of income will definitely fall.

Answer: d.

Hint: (See P286)

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(3) The IS curve will shift to the right if:a. consumer confidence in the economy improves.b. firms become more optimistic about the

economy and decide to invest more at each interest rate.

c. the government increases transfer payments.d. all of the above.Answer: d.Hint: (See PP282-283).

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(4) If people suddenly wish to hold more money at each interest rate:

a. the money demand curve will shift to the right.

b. the LM curve will shift upward to the left.

c. real income will fall.

d. all of the above.

Answer: d.

Hint: (See P289).

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Multiple-Choice Questions(2005 Exam Question)(5) Which of the following statements explains why the

aggregate demand curve is downward-sloping?a. A lower price level increase real balances.

Consequently, the LM curve shifts downward and the level of income increases.

b. A lower price level forces the central bank to increase the money supply. Consequently, the LM curve shifts down and the level of income increases.

c. A lower price level induces the government to reduce taxes. Consequently, the IS curve shifts to the right and the level of income increases.

d. All of the above.Answer: a.Hint: (See P284)

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(6) As we move along a stationary aggregate demand curve, one factor that is held constant is:

a. real income.

b. the aggregate price level.

c. the (nominal) money supply.

d. real money balances.

Answer: c.

Hint: (See PP242-243).

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(7) The FALSE statement below is:

a. the classical assumption that output reaches its natural rate is best used to describe the long run.

b. in the short run, output may deviate from its natural rate.

c. in the IS-LM model, the price level is assumed to be sticky in the short sun.

d. in the IS-LM model, aggregate demand is never equal to the natural rate of output even in the long run.

Answer: d.

Hint: (See P294).

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Multiple-Choice Questions(2005 Exam Question)(8) If income is initially less than the natural rate of

output, the price level:a. will gradually fall, shifting the LM curve

downward.b. will gradually rise, shifting the LM curve

upward.c. will fall, shifting the IS curve to the right.d. is stuck at this level even in the long run.Answer: a.Hint: (See P294)

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(9) According to adherents of the money hypothesis, the Great Depression was caused by a:

a. sharp decline in the money supply.

b. decline in business confidence.

c. decline in consumer confidence.

d. sharp decline in real money balances.

Answer: a.

Hint: (See P298).

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(10) According to adherents of the spending hypothesis, the Great Depression was caused by:

a. a reduction in business and consumer confidence.

b. A contractionary (leftward) shift in the IS curve.c. the stock market crash.d. all of the above.Answer: d.Hint: (See P296).

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Multiple-Choice Questions(2005 Exam Question)(11) According to the Pigou effect:

a. for a given supply of money, a lower price level shifts the LM curve outward, which leads to a higher level of income.

b. since consumers will buy more of a good as its price falls, real output will rise during a depression.

c. as prices fall and real balances rise, consumers will feel wealthier and spend more.


Answer: c.

Hint: (See P299).

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(12) According to the debt-deflation theory, unexpected deflation hurts debtors and benefits creditors. Consequently, national income will fall if:

a. both groups have the same spending propensities.

b. debtors have a higher propensity to spend than creditors.

c. creditors have a higher propensity to spend than debtors.

d. the MPC for both groups is less than 1.

Answer: b.

Hint: (See P299).

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(13) The following statement is FALSE:

a. money demand depends on the nominal interest rate.

b. investment demand depends on the real interest rate.

c. IS-LM analysis is unable to incorporate changes in expected inflation.

d. an expected deflation causes the real interest rate to rise at each level of the nominal interest rate, which leads to a contractionary (leftward) shift of the IS curve.

Answer: c.

Hint: (See P300).

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(14) If an economy is in a liquidity trap, then:a. the interest rate is so low that fiscal policy

cannot stimulate the economy.b. the interest rate is so low that monetary policy

cannot stimulate the economy.c. the budget deficit is so high that fiscal policy

cannot stimulate the economy.d. all of the above.Answer: b.Hint: (See P303).

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(15) If investment becomes very sensitive to the interest rate, the:

a. IS curve becomes steeper.

b. IS curve becomes flatter.

c. LM curve becomes steeper.

d. LM curve becomes flatter.

Answer: b.

Hint: (See P308).

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(16) A smaller MPC leads to:

a. a steeper planned expenditure curve.

b. a smaller government-purchases multiplier.

c. a flatter IS curve.


Answer: b.

Hint: MPC (1-MPC) 1/(1-MPC)

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(17) If money demand is not very sensitive to the level of income:

a. the money demand curve does not shift very far to the right as income rises.

b. only a small change in interest rate is necessary to offset the increase in money demand caused by a change in income.

c. the LM curve is relatively flat.d. all of the above.Answer: d.Hint: (See P309).

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(18) If the quantity of money demanded is very sensitive to the interest rate:

a. the money demand curve will be relatively flat.b. a shift in money demand due to a change in

income leads to a small change in the equilibrium interest rate.

c. the LM curve is relatively flat.d. all of the above.Answer: d.Hint: (See P309).

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Numerical Questions

(1) In a two-sector model, suppose

C = 60 + 0.8Y

I = 116 – 2r

L = 0.2Y – 5r

M = 120

a. Derive the equation for IS curve in terms of r.

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Numerical Questions

(continued)

Answer: Y = C + I

Y = 60 + 0.8Y + 116 – 2r

0.2Y = 176 – 2r

r = -0.1Y + 88

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Numerical Questions

b. Derive the equation for LM curve in terms of r.

Answer:

M = L

120 = 0.2Y – 5r

5r = 0.2Y – 120

r = 0.04Y - 24

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Numerical Questions

c. Find the equilibrium value of Y and r via simultaneous equilibrium for IS and LM.

Answer: (1) – (2) then 0 = -0.14Y + 112therefore, Y = 800. Back to (1) or (2) and obtain r = 8%.

r = -0.1Y + 88 (1)

r = 0.04Y – 24 (2)

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Numerical Questions

(2) Assume that the equations for the IS and LM curves are:

IS curve: r = 40 – 0.025Y and

LM curve: i = -50 + 0.05Y

a. Find the initial equilibrium value of Y, i, and r since the expected inflation rate is zero.

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Numerical Questions

(continued)

Answer:

Recall r = i – , solving two equations by the method like Question 1:

Y = 1200, r = i = 10%.

e

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Numerical Questions

b. Now suppose that we have deflation and expected inflation falls to 7.5%. What are the new equilibrium values of Y, i, and r.

Answer: r = 40 – 0.025Y (1)

i = -50 + 0.05Y (2)

r = i + 7.5 (3)

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Numerical Questions

(continued)

Reconstruct three equations and then

(4) – (5) and obtain

7.5 = 90 – 0.075Y. Thus Y = 1100.

Bring Y back to (1), i = 5%.

Then r = i + 7.5 = 12.5%

i + 7.5 = 40 – 0.025Y (4)

i = -50 + 0.05Y (5)

178.200 06-5

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