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

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 M^s/P = M^d/P = 0.4Y - 40r M^s = 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 M^s)?

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.

A decrease in government spending reduces output more in the Keynesian-cross model than in the IS-LM model. Explain why this is true.

An increase in money supply shifts the LM curve to the right, but an increase in money demand shifts the LM curve to the left. Explain why there is a difference.

The monetary transmission mechanism in the IS-LM model is a process whereby an increase in the money supply increases the demand for goods and services:

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 M^s/P = M^d/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. d. 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. e. Write the numerical aggregate demand curve for this economy, expressing Y as a function of G, T, and M/P.

Suppose Congress passes legislation that reduces taxes. Use the IS-LM model to illustrate graphically the impact of the tax reduction 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.

All of the following events are consistent with the spending hypothesis as contributing to the Great Depression except:

Policymakers are contemplating undertaking either an increase in government spending or an increase in the money supply. Either policy is forecast to have the same impact on income in the short run. Use the IS-LM model to compare the impact on consumption and investment of the two policy alternatives.

The increase in income in response to a fiscal expansion in the IS-LM is:

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:

The money hypothesis suggests that the Great Depression was caused by a:

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

The LM curve can shift to the right if there is an increase in the supply of money or a fall in the price level. In which case is this movement along the aggregate demand curve, and in which case is this a shift of the aggregate demand curve? Explain.