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

Question 1

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.

Answer 1

C

Question 2

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

A)leftward shift in the IS curve.
B)rightward shift in the IS curve.
C)leftward shift in the LM curve.
D)rightward shift in the LM curve.

Answer 2

C

Question 3

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 .

A)resulting from a change in monetary policy; resulting from a change in fiscal policy.
B)resulting from a change in fiscal policy; resulting from a change in monetary policyC. at a given price level; resulting from a change in the price level.
D)resulting from a change in the price level; at a given price level

Answer 3

D

Question 4

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)?

Question 5

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.

A)movement along the; shift. in the
B)shift in the; movement.
C)along the vertical; horizontal.
D)horizontal; vertical.

Question 6

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.

Question 7

The Pigou effect:

A)suggests that as prices fall and real money balances rise, consumers should feel less wealthy and spend less.
B)suggests that as prices fall and real money balances rise, consumers should feel wealthier and spend more.
C)suggests that as prices fall and real money balances rise, consumers should feel less wealthy but spend more.
D)is generally accepted as adequate proof that the economy must be able to correct itself.

Question 8

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 9

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 10

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 11

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 12

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

A)IS; shifts to the right.
B)IS; does not shift.
C)LM: shifts to the right
D)LM; does not shift.

Question 13

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.

Question 14

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 15

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 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

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

A)the decline in investment spending on housing because of a decline in immigration in the 1930s.
B)the decline in consumption spending caused by the stock market crash of 1929.
C)fiscal policy to reduce the budget deficit by raising taxes in 1932.
D)the 25-percent reduction in the money supply between 1929 and 1933.

Question 18

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.

Question 19

The Great Depression in the United States:

A)probably was caused by a rightward shift in the LM curve because the price level fell more rapidly than the fall in the money supply from 1929 to 1933.
B)cannot be attributed to a fall in the money supply because the money supply did not fall.
C)probably cannot be considered to have started because of a leftward shift in the LM curve because real balances did not fall between 1929 and 1931.
D)probably was caused by a leftward shift in the LM curve because interest rates remained high between 1929 and 1933.

Question 20

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?

Question 21

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.

Question 22

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 23

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.

Question 24

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.

Question 25

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 26

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 27

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 28

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 29

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 30

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 31

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 32

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 33

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 34

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.