Exam 12: The Open Economy Revisited: the Mundell-Fleming Model and the Exchange-Rate Regime

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.

How can the Fed keep the economy from falling into a recession if the budget deficit is reduced? Use the IS-LM model to illustrate graphically the impact of both the fiscal policy reducing the deficit and the monetary policy, which prevents output from falling. 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.

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.

Compare the impact of a tax cut on consumption, investment, output, and interest rates in the classical model of Chapter 3 versus the IS-LM model.

An economic change that does not shift the aggregate demand curve is a change in:

If taxes are raised, but the Fed prevents income from falling by raising the money supply, then:

A change in income in the IS-LM model resulting from a change in the price level is represented by a aggregate demand curve, while a change in income in the IS-LM model for a given price level is represented by a aggregate demand curve.

Suppose that people finally realize that they must save a larger proportion of their income in order to retire and that they simultaneously begin to use new technology that allows them to reduce their holdings of real cash balances as a proportion of their income. Use the IS-LM model to illustrate graphically the impact of these two changes in household behavior 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:

Assume that the economy is initially in short-run equilibrium at a level of output above the natural rate. Use the IS-LM model to illustrate graphically how the levels of income and interest rates change as the economy returns to the natural rate of output in the long run.

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.

A movement along an aggregate demand curve corresponds to a change in income in the IS-LM model , while a shift in an aggregate demand curve corresponds to a change in income in the IS-LM model .

The Great Depression in the United States:

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:

A tax cut shifts the to the right, and the aggregate demand curve .

If inflation is bad, why isn't deflation good? Use the IS-LM model to explain how deflation could result in a contraction in output.

Assume that an economy is described by the IS curve Y = 3,600 + 3G - 2T - 150r and the LM curve Y = 2 M/P + 100r [or r = 0.01Y - 0.02(M/P)]. The investment function for this economy is 1,000 - 50r. The consumption function is C = 200 + (2/3)(Y - T). Long-run equilibrium output for this economy is 4,000. The price level is 1.0. a. Assume that government spending is fixed at 1,200. The government wants to achieve a level of investment equal to 900 and also achieve Y = 4,000. What level of r is needed for I = 900? What levels of T and M must be set to achieve the two goals? What will be the levels of private saving, public saving, and national saving? (Hint: Check C + I + G = Y.) b. Now assume that the government wants to cut taxes to 1,000. With G set at 1,200, what will the interest rate be at Y = 4,000? What must be the value of M? What will I be? What will be the levels of private, public, and national saving? (Hint: Check C + I + G = Y.) c. Which set of policies may be referred to as tight fiscal, loose money? Which set of policies may be referred to as loose fiscal, tight money? Which "policy mix" most encourages investment?

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; and (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.

The Pigou effect:

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