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

Question 1

In the IS-LM model, changes in taxes initially affect planned expenditures through:

A)consumption.
B)investment.
C)government spending.
D)the interest rate.

Answer 1

consumption.

Question 2

In the IS-LM model when taxation increases, in short-run equilibrium, in the usual case, the interest rate and output .

A)rises; falls
B)rises; rises
C)falls; rises
D)falls; falls

Answer 2

falls; falls

Question 3

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:

A)directly.
B)by lowering the interest rate so that investment spending increases.
C)by raising the interest rate so that investment spending increases.
D)by increasing government spending on goods and services.

Answer 3

by lowering the interest rate so that investment spending increases.

Question 4

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:

A)prices.
B)investment.
C)the money supply.
D)taxes.

Question 5

In the IS-LM model, the impact of an increase in government purchases in the goods market has ramifications in the money market, because the increase in income causes a(n) in money .

A)increase; supply
B)increase; demand
C)decrease; supply
D)decrease; demand

Question 6

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

A)rises; falls
B)rises; rises
C)falls; rises
D)falls; falls

Question 7

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

A)the price level and the inflation rate.
B)the interest rate and the price level.
C)investment and the money supply.
D)the interest rate and the level of output.

Question 8

Using the IS-LM analysis, if the LM curve is not horizontal, the multiplier for an increase in government spending is for an increase in government purchases using the Keynesian-cross analysis. .

A)larger than the multiplier
B)the same as the multiplier
C)smaller than the multiplier
D)sometimes larger and sometimes smaller than the multiplier

Question 9

The monetary transmission mechanism works through the effects of changes in the money supply on:

A)the budget deficit.
B)investment.
C)government expenditures.
D)taxation.

Question 10

In the IS-LM model, a decrease in government purchases leads to a(n) in planned expenditures, a(n) in total income, a(n) in money demand, and a(n) in the equilibrium interest rate.

A)decrease; decrease; decrease; decrease
B)increase; increase; increase; increase
C)decrease; decrease; increase; increase
D)increase; increase; decrease; decrease

Question 11

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.

A)less than
B)greater than
C)equal to
D)sometimes less and sometimes greater than

Question 12

In the IS-LM model when the Federal Reserve decreases the money supply, people bonds and the interest rate , leading to a(n) in investment and income.

A)buy; rises; increase
B)sell; falls; decrease
C)sell; rises; decrease
D)buy; rises; decrease

Question 13

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)investment is not affected by the interest rate whereas in the IS-LM model fiscal expansion raises the interest rate and crowds out investment.
B)investment is not affected by the interest rate whereas in the IS-LM model fiscal expansion lowers the interest rate and crowds out investment.
C)investment is autonomous whereas in the IS-LM model fiscal expansion encourages higher investment, which raises the interest rate.
D)the price level is fixed whereas in the IS-LM model it is allowed to vary.

Question 14

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 .

A)rises; falls
B)rises; rises
C)falls; rises
D)falls; falls

Question 15

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

A)slopes up to the right.
B)slopes down to the right.
C)is horizontal.
D)is vertical.

Question 16

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

A)always less than in the Keynesian-cross model.
B)less than in the Keynesian-cross model unless the LM curve is vertical.
C)less than in the Keynesian-cross model unless the LM curve is horizontal.
D)less than in the Keynesian-cross model unless the IS curve is vertical.

Question 17

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

A)rises; falls
B)rises; rises
C)falls; rises
D)falls; falls

Question 18

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:

A)100.
B)200.
C)300.
D)400.

Question 19

In the IS-LM model when government spending rises, in short-run equilibrium, in the usual case, the interest rate and output .

A)rises; falls
B)rises; rises
C)falls; rises
D)falls; falls

Question 20

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

A)LM; left
B)LM; right
C)IS; left
D)IS; right

Question 21

A change in income in the IS-LM model for a fixed price represents a

A)shift in the aggregate demand curve. represents a movement along the aggregate demand curve.
B)has the same effect on the aggregate demand curve as a change in income in the IS-LM model resulting from a change in the price level.
C)does not represent a change in the aggregate demand curve.
D)and the interest rate in both the short and long runs.

Question 22

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:

A)zero.
B)$25 billion.
C)$75 billion.
D)$100 billion.

Question 23

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 .

A)LM; right
B)LM; left
C)IS; right
D)IS; left

Question 24

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.

A)increase
B)decrease
C)first increase and then decrease
D)first decrease and then increase

Question 25

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

A)buy; IS
B)buy; LM
C)sell; IS
D)sell; LM

Question 26

An increase in investment demand for any given level of income and interest rates-due, for example, to more optimistic "animal spirits"-will, within the IS-LM framework, output and interest rates.

A)increase; lower
B)increase; raise
C)lower; lower
D)lower; raise

Question 27

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

A)increase
B)decrease
C)first increase and then decrease
D)first decrease and then increase

Question 28

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

A)both consumption and investment remain unchanged.
B)consumption rises but investment falls.
C)investment rises but consumption falls.
D)both consumption and investment fall.

Question 29

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

A)decrease in taxes.
B)increase in the money supply.
C)increase in money demand.
D)increase in government purchases.

Question 30

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)?

Question 31

An increase in taxes lowers income:

A)and the interest rate in the short run, but leaves both unchanged in the long run.
B)in the short run, but leaves it unchanged in the long run, while increasing consumption and lowering investment.
C)in the short run, but leaves it unchanged in the long run, while lowering consumption and increasing investment.
D)and the interest rate in both the short and long runs.

Question 32

If Congress passed a tax increase at the request of the president to reduce the budget deficit, but the Fed held the money supply constant, then the two policies together would generally lead to income and a interest rate.

A)lower; lower
B)lower; higher
C)no change in; lower
D)no change in; higher

Question 33

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

A)buy; IS
B)buy; LM
C)sell; IS
D)sell; LM

Question 34

An increase in consumer saving for any given level of income will shift the:

A)LM curve upward and to the left.
B)LM curve downward and to the right.
C)IS curve downward and to the left.
D)IS curve upward and to the right.

Question 35

The aggregate demand curve generally slopes downward and to the right because, for any given money supply M a higher price level P causes a real money supply M/P, which the interest rate and spending.

A)lower; raises; reduces
B)higher; lowers; increases
C)lower; lowers; increases
D)higher; raises; reduces

Question 36

According to the macroeconometric model developed by Data Resources Incorporated, the response of GDP four quarters after an increase in government spending, with the nominal interest rate held constant, will be the response of GDP to a similar change with the money supply held constant.

A)less than half as great as
B)approximately equal to
C)more than two times as great as
D)more than three times as great as

Question 37

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

A)increase in the money supply.
B)increase in government purchases.
C)decrease in taxes.
D)increase in money demand.

Question 38

An increase in the demand for money, at any given income level and level of interest rates, will, within the IS-LM framework, output and interest rates.

A)increase; lower
B)increase; raise
C)lower; lower.
D)lower; raise

Question 39

One policy response to the U.S. economic slowdown of 2001 were tax cuts. This policy response can be represented in the IS-LM model by shifting the curve to the .

A)LM; right
B)LM; left
C)IS; right
D)IS; left

Question 40

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

A)the money supply.
B)the investment function.
C)the price level.
D)taxes.

Question 41

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.

Question 42

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.

Question 43

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.

Question 44

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.

Question 45

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.

Question 46

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

Question 47

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.

Question 48

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 and M = 1,200.
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?

Question 49

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.

Question 50

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.

Question 51

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.

Question 52

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.

Question 53

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.

Question 54

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.

Question 55

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.

Question 56

Two identical countries, Alpha and Beta, can be described by the IS-LM model in the short run. The governments of both countries cut taxes by the same amount. The Central Bank of Alpha follows a policy of holding a constant money supply. The Central Bank of Beta follows a policy of holding a constant interest rate. Compare the impact of the tax cut on income and interest rates in the two countries.

Question 57

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, which 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.

Question 58

Use the IS-LM model to illustrate graphically the impact of the Pigou effect on the equilibrium level of income and interest rate during the Great Depression, when prices were falling.

Question 59

Use the IS-LM model to predict the short-run impact on the interest rate and output if the Fed pushes interest rates down at the same time that both consumption and investment fall due
to a financial crisis. Illustrate your Answer graphically. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium; and iv. the direction the curves shift. Explain your Answer in words.