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

Question 1

In the Keynesian-cross model, fiscal policy has a multiplied effect on income because fiscal policy:

A)increases the amount of money in the economy.
B)changes income, which changes consumption, which further changes income.
C)is government spending and, therefore, more powerful than private
D)spending. changes the interest rate.

Answer 1

B

Question 2

When planned expenditure is drawn on a graph as a function of income, the slope of the line is:

A)zero.
B)between zero and one.
C)one.
D)greater than one.

Answer 2

B

Question 3

In the Keynesian-cross model, actual expenditures differ from planned expenditures by the amount of:

A)liquidity preference.
B)the government-purchases multiplier.
C)unplanned inventory investment.
D)real money balances.

Answer 3

C

Question 4

Both Keynesians and supply-siders believe a tax cut will lead to growth:

A)and both agree it works through incentive effects.
B)but Keynesians believe it works through incentive effects whereas supply-siders believe it works through aggregate demand.
C)but Keynesians believe it works through aggregate demand whereas supply-siders believe it works through incentive effects.
D)and both agree it works through aggregate demand.

Question 5

In the Keynesian-cross model, if taxes are reduced by 250, then the equilibrium level of income:

A)increases by 250.
B)increases by more than 250.
C)decreases by 250.
D)increases, but by less than 250.

Question 6

The Keynesian-cross analysis assumes planned investment:

A)is fixed and so does the IS analysis.
B)depends on the interest rate and so does the IS analysis.
C)is fixed, whereas the IS analysis assumes it depends on the interest
D)rate. depends on expenditure and so does the IS analysis.

Question 7

According to the analysis underlying the Keynesian cross, when planned expenditure exceeds income:

A)income falls.
B)planned expenditure falls.
C)unplanned inventory investment is negative.
D)prices rise.

Question 8

In the Keynesian-cross model, the equilibrium level of income is determined by:

A)the factors of production.
B)the money supply.
C)planned spending.
D)liquidity preference.

Question 9

In the IS-LM model, which two variables are influenced by the interest rate?

A)supply of nominal money balances and demand for real balances
B)demand for real money balances and government purchases
C)supply of nominal money balances and investment spending
D)demand for real money balances and investment spending

Question 10

Two interpretations of the IS-LM model are that the model explains:

A)the determination of income in the short run when prices are fixed, or what shifts the aggregate demand curve.
B)the short-run quantity theory of income, or the short-run Fisher effect.
C)the determination of investment and saving, or what shifts the liquidity preference schedule.
D)changes in government spending and taxes, or the determination of the supply of real money balances.

Question 11

In the Keynesian-cross model, if the MPC equals 0.75, then a $1 billion increase in government spending increases planned expenditures by and increases the equilibrium level of income by .

A)$1 billion; more than $1 billion
B)$0.75 billion; more than $0.75 billion
C)$0.75 billion; $0.75 billion
D)$1 billion; $1 billion

Question 12

When firms experience unplanned inventory accumulation, they typically:

A)build new plants.
B)lay off workers and reduce production.
C)hire more workers and increase production.
D)call for more government spending.

Question 13

In the Keynesian-cross model, if government purchases increase by 250, then the equilibrium level of income:

A)increases by 250.
B)increases by more than 250.
C)decreases by 250.
D)increases, but by less than 250.

Question 14

Planned expenditure is a function of:

A)planned investment.
B)planned government spending and taxes.
C)planned investment, government spending, and taxes.
D)national income and planned investment, government spending, and taxes.

Question 15

The equilibrium condition in the Keynesian-cross analysis in a closed economy is:

A)income equals consumption plus investment plus government spending.
B)planned expenditure equals consumption plus planned investment plus government spending.
C)actual expenditure equals planned expenditure.
D)actual saving equals actual investment.

Question 16

For the purposes of the Keynesian cross, planned expenditure consists of:

A)planned investment.
B)planned government spending.
C)planned investment and government spending.
D)planned investment, government spending, and consumption expenditures.

Question 17

According to the Keynesian-cross analysis, when there is a shift upward in the government-purchases schedule by an amount ∆G and the planned expenditure schedule by an equal amount, then equilibrium income rises by: one unit.

A)∆G.
B)∆G divided by the quantity one minus the marginal propensity to consume.
C)∆G multiplied by the quantity one plus the marginal propensity to consume.

Question 18

In the Keynesian-cross model, if taxes are reduced by 100, then planned expenditures for any given level of income.

A)increase by 100
B)increase by more than 100
C)decrease by 100
D)increase, but by less than 100

Question 19

In the Keynesian-cross model, if government purchases increase by 100, then planned expenditures for any given level of income.

A)increase by 100.
B)increase by more than
C)100. decrease by 100.
D)increase, but by less than 100.

Question 20

When drawn on a graph with Y along the horizontal axis and PE along the vertical axis, the line showing planned expenditure rises to the:

A)right with a slope less than one.
B)right with a slope greater than one.
C)left with a slope less than one.
D)left with a slope greater than one.

Question 21

The simple investment function shows that investment as increases.

A)decreases; the interest rate
B)increases; the interest rate
C)decreases; government spending
D)increases; government spending

Question 22

The theory of liquidity preference implies that:

A)as the interest rate rises, the demand for real balances will fall.
B)as the interest rate rises, the demand for real balances will rise.
C)the interest rate will have no effect on the demand for real
D)balances. as the interest rate rises, income will rise.

Question 23

Suppose Congress decides to reduce the budget deficit by cutting government spending. Use the Keynesian-cross model to illustrate graphically the impact of a reduction in government purchases on the equilibrium level of income. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curve shifts; and v. the terminal equilibrium values.
b. Explain in words what happens to equilibrium income as a result of the cut in government spending and the time horizon appropriate for this analysis.

Question 24

When drawn on a graph with income along the horizontal axis and the interest rate along the vertical axis, the IS curve generally:

A)is vertical.
B)is horizontal.
C)slopes upward and to the right.
D)slopes downward and to the right.

Question 25

Use the Keynesian-cross model to illustrate graphically the impact of an increase in the interest rate on the equilibrium level of income. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curve shifts; and v. the terminal equilibrium values.
b. Explain in words what happens to equilibrium income as a result of the increase in the interest rate.

Question 26

Graphically illustrate the impact of an open-market purchase by the Federal Reserve on the equilibrium interest rate using the theory of liquidity preference and the market for real money balances. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curve shifts; and v. the terminal equilibrium values.
b. Explain in words what happens to the equilibrium interest rate as a result of the open-market purchase.
c.

Question 27

Based on the Keynesian model, one reason to support government spending increases over tax cuts as measures to increase output is that:

A)government spending increases the MPC more than tax cuts.
B)the government-spending multiplier is larger than the tax multiplier.
C)government-spending increases do not lead to unplanned changes in inventories, but tax cuts do.
D)increases in government spending increase planned spending, but tax cuts reduce planned spending.

Question 28

Assume that the consumption function is given by C = 200 + 0.5(Y - T) and the investment function is I = 1,000 - 200r, where r is measured in percent, G equals 300, and T equals 200.
a. What is the numerical formula for the IS curve? (Hint: Substitute for C, I, and G in the equation Y = C + I
+ G and then write an equation for Y as a function of r or r as a function of Y.) Express the equation two ways.
b. What is the slope of the IS curve? (Hint: The slope of the IS curve is the coefficient of Y when the IS
curve is written expressing r as a function of Y.)
c. If r is one percent, what is I? What is Y? If r is 3 percent, what is I? What is Y? If r is 5 percent, what is I? What is Y?
d. If G increases, does the IS curve shift upward and to the right or downward and to the left?

Question 29

Along an IS curve all of the following are always true except:

A)planned expenditures equal actual expenditures.
B)planned expenditures equal income.
C)the demand for real balances equals the supply of real balances.
D)there are no unplanned changes in inventories.

Question 30

According to the theory of liquidity preference, if the demand for real money balances exceeds the supply of real money balances, individuals will:

A)sell interest-earning assets in order to obtain non-interest-bearing money.
B)purchase interest-earning assets in order to reduce holdings of non-interest-bearing money.
C)purchase fewer goods and services.
D)be content with their portfolios.

Question 31

As an economy moves into a recession, income falls. Illustrate graphically the impact of a decrease in income on the equilibrium interest rate using the theory of liquidity preference and the market for real money balances. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curve shifts; and v. the terminal equilibrium values.
b. Explain in words what happens to the equilibrium interest rate as a result of the fall in income.

Question 32

Suppose Congress passes legislation that significantly reduces taxes. Use the Keynesian-cross model to illustrate graphically the impact of a reduction in taxes on the equilibrium level of income. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curve shifts; and v. the terminal equilibrium values.
b. Explain in words what happens to equilibrium income as a result of the tax cut and the time horizon appropriate for this analysis.

Question 33

Along any given IS curve:

A)tax rates are fixed, but government spending
B)varies. government spending is fixed, but tax
C)rates vary. both government spending and tax rates vary.
D)both government spending and tax rates are fixed.

Question 34

An increase in taxes shifts the IS curve, drawn with income along the horizontal axis and the interest rate along the vertical axis:

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

Question 35

Assume that the equilibrium in the money market may be described as M/P = 0.5Y - 100r, and M/P equals 800.
a. Write the LM curve two ways, expressing Y as a function of r and r as a function of Y. (Hint: Write the
LM curve only relating Y and r; substitute out M/P.)
b. What is the slope of the LM curve?
c. If r is 1 percent, what is Y along the LM curve? If r is 3 percent, what is Y along the LM curve? If r is 5 percent, what is Y along the LM curve?
d. If M/P increases, does the LM curve shift upward and to the left or downward and to the right?
e. If M increases and P is constant, does the LM curve shift upward and to the left or downward and to the right?
f. If P increases and M is constant, does the LM curve shift upward and to the left or downward and to the right?

Question 36

Gary Becker's criticism of government spending on infrastructure as part of President Obama's stimulus plan was that:

A)spending on infrastructure would not increase production in the economy.
B)there is a conflict between where spending on infrastructure would benefit employment and where infrastructure is most needed.
C)government spending on infrastructure is less effective in increasing production than an equal amount of private spending on infrastructure.
D)government spending on infrastructure only increases demand, but tax cuts increase demand and supply.

Question 37

Consider a closed economy to which the Keynesian-cross analysis applies. Consumption is given by the equation C = 200 + 2/3(Y - T). Planned investment is 300, as are government spending and taxes.
a. If Y is 1,500, what is planned spending? What is inventory accumulation or decumulation? Should equilibrium Y be higher or lower than 1,500?
b. What is equilibrium Y? (Hint: Substitute the values of equations for planned consumption, investment, and government spending into the equation Y = C + I + G and then solve for Y.)
c. What are equilibrium consumption, private saving, public saving, and national saving?
d. How much does equilibrium income decrease when G is reduced to 200? What is the multiplier for government spending?

Question 38

An increase in the interest rate:

A)reduces planned investment, because the interest rate is the cost of borrowing to finance investment projects.
B)increases planned investment, because people who make money from interest have more money to invest.
C)has no effect on investment.
D)may be caused by a drop in investment demand.

Question 39

The IS curve shows combinations of that are consistent with equilibrium in the market for goods and services.

A)inflation and unemployment.
B)the price level and real output.
C)the interest rate and the level of income.
D)the interest rate and real money balances.

Question 40

According to the theory of liquidity preference, if the supply of real money balances exceeds the demand for real money balances, individuals will:

A)sell interest-earning assets in order to obtain non-interest-bearing money.
B)purchase interest-earning assets in order to reduce holdings of non-interest-bearing money.
C)purchase more goods and services.
D)be content with their portfolios.

Question 41

Compare the predicted impact of an increase in the money supply in the liquidity preference model versus the impact predicted by the quantity theory and the Fisher effect. Can you reconcile this difference?

Question 42

During a recession, consumers may want to save more to provide themselves with a reserve to cushion possible job losses. Use the Keynesian model to describe the impact of an exogenous decrease in consumption (a decrease in C) on the equilibrium level of income in the economy. Will aggregate national saving increase?

Question 43

Explain what force moves the market back to equilibrium if the market is initially in disequilibrium in:
a. the market for goods and services;
b. the market for real money balances.

Question 44

Explain why a decrease in planned investment, which is a change in the goods market, will upset the equilibrium in the money market.

Question 45

In explaining the 2003 bill to cut taxes, President Bush is quoted as saying, "When people have more money, they can spend it on goods and services."
a. In the IS-LM model, will a tax cut change the money supply in the economy? Does a change in the money supply shift the IS or the LM curve?
b. In the IS-LM model, does a tax cut shift the IS or the LM curve?
c. Based on your answers in a and b, how can you reconcile the president's statement with economics? Can you suggest how his statement could be modified to be consistent with the IS-LM model?

Question 46

The IS-LM model simultaneously determines equilibrium in two markets.
a. Which two markets?
b. What two variables adjust to bring equilibrium in the markets?

Question 47

Explain why an increase in the money supply, which is a change in the money market, will upset the equilibrium in the goods market.