Middle East Technical University

Department of Economics
ECON 202 Section 2
Instructor: Dr. Pnar Derin-Gre
TA: zgen ztrk

Fall, 2016

PROBLEM SET #2
Due Date: Friday, October 28, 2016 at the beginning of the recitation our (at 9:00, strictly). No late problem sets will be
accepted.
MULTIPLE CHOICE ANSWERS WILL BE HANDED IN USING THE OPTICAL FORMS. PLEASE FILL IN YOUR
OPTICAL FORMS WITH FULL CREDENTIALS (i.e. NAME and ID). OTHERWISE YOU WILL NOT GET ANY
POINTS FROM MULTIPLE CHOICE PART.
EMPTY OPTICAL FORMS WILL BE HANDED IN CLASS ON WEDNESDAY, or YOU CAN OBTAIN FROM
ZGENS OFFICE (A211).
Note: Please keep your answers short! In most cases two or three sentences will be more than enough. If your answers
are too long or contain obviously irrelevant information you may incur a penalty, i.e. brevity in your responses is
strongly recommended.
If you would like, you may work in small groups of 2-3 people to discuss the problem sets. However, you must write
up answers individually. If you decide to work in a group, please list the names of the group members on your
problem set.
A note on academic integrity: As the syllabus clearly states, work that you hand in should be your own work: A
student shall not submit work [] that is not the result of the students own effort.
Please show your work for full credit on analytical questions, i.e., show the formulas, calculations (if appropriate). Do
not report only the final answers for the essay questions.

PART I - MULTIPLE CHOICE.

Choose the one alternative that best completes the statement or answers the question.

1) Suppose the economy is currently operating on both the LM curve and the IS curve. Which of the following is
true for this economy?
A) financial markets are in equilibrium.
B) production equals demand.
C) the quantity supplied of bonds equals the quantity demanded of bonds.
D) the money supply equals money demand.
E) all of the above.

2) In late 2007 and early 2008, the U.S. Federal Reserve pursued expansionary monetary policy. Which of the
following will occur as a result of this monetary policy action?
A) the LM curve shifts down.
B) the LM curve shifts up.
C) the IS curve shifts leftward as the interest rate increases.
D) the IS curve shifts rightward as the interest rate falls.
E) none of the above.

3) Suppose fiscal policy makers implement a policy to reduce the size of a budget deficit. Based on the IS-LM
model, we know with certainty that the following will occur as a result of this fiscal policy action.
A) investment spending may increase, decrease, or not change.
B) investment spending will decrease.
C) there will be no change in investment spending.
D) investment spending will increase.
E) none of the above.

4) Suppose investment spending is NOT very sensitive to the interest rate. Given this information, we
know that:
A) the LM curve should be relatively steep.
B) neither the IS nor the LM curve will be affected.
C) the IS curve should be relatively flat.
D) the IS curve should be relatively steep.
E) the LM curve should be relatively flat.

5) A reasonable dynamic assumption for the IS-LM model is that

A) the economy is always on the LM curve, but moves only slowly to the IS curve.
B) the economy is always on both the IS and LM curves.
C) adjustment to the new IS-LM equilibrium is instantaneous after an LM shift, but not after an IS shift.
D) the economy is always on the IS curve, but moves only slowly to the LM curve.
E) the money market is quick to adjust, but the bond market adjusts more slowly.

6) An increase in the money supply will cause an increase in which of the following variables?
A) investment.
B) output.
C) consumption.
D) all of the above.
E) none of the above.

7) Based on our understanding of the IS-LM model that takes into account dynamics, we know that a reduction in
government spending will cause:
A) an immediate reduction in i and no initial change in Y
B) a gradual reduction in i and an immediate reduction in Y
C) an immediate drop in Y and immediate increase in i
D) a gradual reduction in i and gradual reduction in Y

8) Suppose the demand for money is NOT very sensitive to the interest rate. Given this information, we know
that:
A) the IS curve should be relatively flat.

B) the LM curve should be relatively steep.

C) neither the IS nor the LM curve will be affected.
D) the LM curve should be relatively flat.
E) the IS curve should be relatively steep.

9) Suppose there is a simultaneous Fed sale of bonds and increase in consumer confidence. We know with
certainty that these two simultaneous events will cause:
A) an increase in output (Y)
B) an increase in the interest rate (i)
C) a reduction in i
D) a reduction in Y

10) An increase in the reserve deposit ratio, , will most likely have which of the following effects?
A) a downward shift in the LM curve
B) a rightward shift in the IS curve
C) a leftward shift in the IS curve
D) an upward shift in the LM curve

11) A reduction in the aggregate price level, P, will most likely have which of the following effects?
A) a leftward shift in the IS curve
B) an upward shift in the LM curve
C) a downward shift in the LM curve
D) a rightward shift in the IS curve

12) Based on our understanding of the IS-LM model that takes into account dynamics, we know that a reduction in
the money supply will cause:
A) an immediate drop in Y and immediate increase in i
B) a gradual increase in i and gradual reduction in Y
C) an immediate increase in i and no initial change in Y
D) none of the above

ESSAY TYPE QUESTIONS. Answer the questions in the space provided.

1.

One of the main pathology of the monetary policy is the concept of Liquidity Trap. Usually, this trap occurs
when the central bank worry about a decrease in output and reacts by following an expansionary monetary
policy. At this situation, money demand curve becomes perfectly elastic in low interest rates and LM curve
becomes perfectly elastic at lower interest rate regime also. Liquidity Trap is demonstrated as in Figure 1 and
2.

Figure 1: Liquidity Trap in i-M Plane

Figure 2: Liquidity Trap in i-Y Plane

Explain why does monetary policy lose its ability to influence output in a liquidity trap?
2.

All units are millions of US dollars.

C = 200 + 0.25 Yd

I = 150 + 0.25Y 1000i

T = 200

G = 250

(M/P)s =1600

(M/P)d =2Y 8000i

a.
b.
c.
d.
e.
f.

Find the equation for aggregate demand (Z).

Derive the IS equation.
Derive the LM equation.
Solve for equilibrium real output, interest rate, C and I.
Graph the IS LM diagram of the above with correct labels.
Let nominal money supply increase to 1840. Find equilibrium Y, i, C and I. What happens to Y, i, C and
I when the Central Bank increases money supply through open market operations.
g. Let government expenditure increase to 400. Find equilibrium Y, i, C and I. What happens to
equilibrium Y, i, C and I when government expenditure increases.
h. There is a sudden drop in consumer confidence and c0 drops from 200 to 100. How can the government
counterbalance the drop in GDP using government spending as a policy instrument?

3.

Consider an economy described by the following set of equations

= $ + & *
= $ + & *
./
0

= $
= $
3 = $

All the parameters (b0, b1, b2, c0, c1, c2) in this model are strictly positive and b1+c1<1. Also, P=1 and it will NOT
change.
Note that money demand here depends on consumption, not output.
a. Find out the goods market equilibrium. Derive the IS curve.
b. Find out the financial market equilibrium and derive the LM curve. Draw both curves on the same
graph. Call the equilibrium output Y0 and the equilibrium interest rate i0.
c. Assume that now there is a sudden drop in business confidence, modeled by an increase in b2. The new
level is b2, with b2 > b2. show graphically how the IS LM curves move.
d. Now suppose that the government want to counter balance the drop in business confidence using
government spending as a policy instrument. Should it increase or decrease G0? Compute the level of
government spending that completely offsets the drop in business confidence.
e. Suppose that the U.S. Congress does not allow the government to use fiscal tools. The Central Bank
then decides to use monetary policy to restore the original equilibrium output Y0. Should it increase or
decrease M0? Draw the IS LM curves.
f. For each of the two previous questions, state how i and I move (compared to point 2). Which of the two
policies achieves a higher level of I? Which achieves a higher level of the interest rate, i?
4.

Suppose the goods market is described as follows:

C0 is the consumer confidence

C1 is the marginal propensity to consume

Y is the output or income

I is the investment, which is equal to K0 when the interest rate i = 0 and output Y = 0. If i is positive, I
decreases by a for each unit increase in i. If Y is positive, I increase by b for each unit increase in output.

G is government spending, exogenously given at G0.

There is no tax for this economy.

45
6
49
6

is the real money supply. Assume that P = 1, andM 8 = M$ .

= gY hi.

Assume c1 + b <1.
a.
b.
c.
d.
e.

Write down the equations for consumption, investment and aggregate demand in the economy.
Derive the equation for the IS curve.
Derive the equation for the LM curve.
Draw IS and LM curves on an i Y space with correct labels. Also label the intercepts.
Now you have a short run framework for policy studies.

f.

Assume that there is a decrease in business confidence in period 1 (K0 decreases to K1 < K0). Assume
that the government cares only about output, nothing else. If you were an economic advisor to the
government, would you suggest the government to revive the economy in period 2 (restore * back to
$ ) through fiscal expansion (an increase in G), monetary expansion (an increase in money supply) or
both? Show your results graphically.
g. If the government chooses monetary expansion, find an analytical expression for * = *
& * $ .
h. Suppose the government now cares about the composition of output as well as its level. Like before, it
wants to restore the output level to $ . Can the government be indifferent between fiscal and monetary
policy? Explain.