Exam 11: Aggregate Demand II: Applying the Is-Lm Model

In the IS-LM model, a decrease in the interest rate would be the result of a(n):

Assume the economy is initially in a short-run equilibrium at a level of output below the natural rate. a. Use the IS-LM model to graphically illustrate: 1. how the economy will adjust in the long run if the no policy action is taken. 2. the long-run equilibrium if fiscal policy is used to return the economy to the natural rate of output. b. Explain how investment, the interest rate, and the price level differ in the new long-run equilibrium in the two cases.

In the IS-LM model when M rises but P remains constant, in short-run equilibrium, in the usual case, the interest rate and output .

Suppose Congress wishes to reduce the budget deficit by reducing government spending. Use the IS-LM model to illustrate graphically the impact of the reduction in government spending on output and interest rates. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curves shift; and v. the terminal equilibrium values.

According to the macroeconometric model developed by Data Resources Incorporated, if taxes are increased by $100 billion but the money supply is held constant, then GDP will fall by about:

In the IS-LM analysis, the increase in income resulting from a tax cut is usually the increase in income resulting from an equal rise in government spending.

An economy is initially at the natural level of output. There is an increase in government spending. Use the IS-LM model to illustrate both the short-run and long-run impact of this policy change. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium, iv. the short-run equilibrium, and v. the terminal equilibrium. b. Explain in words the short-run and long-run impact of the change in government spending on output and interest rates.

One policy response to the U.S. economic slowdown of 2001 was to increase money growth. This policy response can be represented in the IS-LM model by shifting the curve to the .

If the money supply increases, then in the IS-LM analysis the curve shifts to the .

When bond traders for the Federal Reserve seek to decrease interest rates, they bonds, which shifts the curve to the right.

In the IS-LM model under the usual conditions in a closed economy, an increase in government spending increases the interest rate and crowds out:

Assume the following model of the economy, with the price level fixed at 1.0: C = 0.8(Y - T) T = 1,000 I = 800 - 20r G = 1,000 Y = C + I + G Ms/P = Md/P = 0.4Y - 40r Ms = 1,200 a. Write a numerical formula for the IS curve, showing Y as a function of r alone. (Hint: Substitute out C, I, G, and T.) b. Write a numerical formula for the LM curve, showing Y as a function of r alone. (Hint: Substitute out M/P.) c. What are the short-run equilibrium values of Y, r, Y - T, C, I, private saving, public saving, and national saving? Check by ensuring that C + I + G = Y and national saving equals I. d. Assume that G increases by 200. By how much will Y increase in short-run equilibrium? What is the government-purchases multiplier (the change in Y divided by the change in G)? e. Assume that G is back at its original level of 1,000, but Ms (the money supply) increases by 200. By how much will Y increase in short-run equilibrium? What is the multiplier for money supply (the change in Y divided by the change in Ms)?

The interaction of the IS curve and the LM curve together determine:

If the demand for real money balances does not depend on the interest rate, then the LM curve:

Assume that initially everyone expects the price level to stay the same. Now the Federal Reserve announces that it will increase the rate of money growth in one year. People now expect inflation. Use the IS-LM model to illustrate graphically the impact of expected inflation on the level of output and on the real and nominal interest rates.

According to the IS-LM model, if Congress raises taxes but the Fed wants to hold income constant, then the Fed must the money supply.

Assume that an economy is characterized by the following equations: C = 100 + (2/3)(Y - T) T = 600 G = 500 I = 800 - (50/3)r Ms/P = Md/P = 0.5Y - 50r a. Write the numerical IS curve for the economy, expressing Y as a numerical function of G, T, and r. b. Write the numerical LM curve for this economy, expressing r as a function of Y and M/P. c. Solve for the equilibrium values of Y and r, assuming P = 1.0 and M = 1,200. How do they change when P = 2.0? Check by computing C, I, and G. d. Write the numerical aggregate demand curve for this economy, expressing Y as a function of G, T, and M/P.

The reason that the income response to a fiscal expansion is generally less in the IS-LM model than it is in the Keynesian-cross model is that the Keynesian-cross model assumes that:

If MPC = 0.75 (and there are no income taxes but only lump-sum taxes) when T decreases by 100, then the IS curve for any given interest rate shifts to the right by:

Use the IS-LM model to illustrate graphically the impact on output and interest rates of a one-time increase in the price level due to a large increase in oil prices. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curves shift; and v. the terminal equilibrium values.