Chapter 10

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Name Testbank Chapter 10: Aggregate Demand I

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Multiple Choice 0 points
Question
John Maynard Keynes wrote that responsibility for low income and high unemployment in economic
downturns should be placed on:
Answer low levels of capital.
an untrained labor force.
inadequate technology.
low aggregate demand.
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Question
According to classical theory, national income depends on ______, while Keynes proposed that
______ determined the level of national income.
Answer aggregate demand; aggregate supply
aggregate supply; aggregate demand
monetary policy; fiscal policy
fiscal policy; monetary policy
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Question
The IS-LM model takes ______ as exogenous.
Answer the price level and national income
the price level
national income
the interest rate
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Question
The variable that links the market for goods and services and the market for real money balances in
the IS-LM model is the:
Answer consumption function.
interest rate.
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price level.
nominal money supply.
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Question
In the IS-LM model, which two variables are influenced by the interest rate?
Answer supply of nominal money balances and demand for real balances
demand for real balances and government purchases
supply of nominal money balances and investment spending
demand for real money balances and investment spending
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Question
Two interpretations of the IS–LM model are that the model explains:
Answer the determination of income in the short run when prices are fixed, or what shifts the
aggregate demand curve.
the short-run quantity theory of income, or the short-run Fisher effect.
the determination of investment and saving, or what shifts the liquidity preference
schedule.
changes in government spending and taxes or the determination of the supply of real
money balances.
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Question
The IS curve plots the relationship between the interest rate and ______ that arises in the market for
______.
Answer national income; goods and services
the price level; goods and services
national income; money
the price level; money
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Question
For the purposes of the Keynesian cross, planned expenditure consists of:
Answer planned investment.
planned government spending.
planned investment and government spending.
planned investment, government spending, and consumption expenditures.
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Question
In the Keynesian-cross model, actual expenditures equal:
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Answer GDP.
the money supply.
the supply of real balances.
unplanned inventory investment.
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Question
In the Keynesian-cross model, actual expenditures differ from planned expenditures by the amount of:
Answer liquidity preference.
the government-purchases multiplier.
unplanned inventory investment.
real money balances.
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Question
Planned expenditure is a function of:
Answer planned investment.
planned government spending and taxes.
planned investment, government spending, and taxes.
national income and planned investment, government spending, and taxes.
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Question
When planned expenditure is drawn on a graph as a function of income, the slope of the line is:
Answer zero.
between zero and one.
one.
greater than one.
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Question
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:
Answer right with a slope less than one.
right with a slope greater than one.
left with a slope less than one.
left with a slope greater than one.
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Question
The equilibrium condition in the Keynesian-cross analysis in a closed economy is:
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Answer income equals consumption plus investment plus government spending.

planned expenditure equals consumption plus planned investment plus government
spending.
actual expenditure equals planned expenditure.
actual saving equals actual investment.
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Question
With planned expenditure and the equilibrium condition Y = PE drawn on a graph with income along
the horizontal axis, if income exceeds expenditure, then income is to the ______ of equilibrium income
and there is unplanned inventory ______.
Answer right; decumulation
right; accumulation
left; decumulation
left; accumulation
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Question
According to the analysis underlying the Keynesian cross, when planned expenditure exceeds
income:
Answer income falls.
planned expenditure falls.
unplanned inventory investment is negative.
prices rise.
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Question
When firms experience unplanned inventory accumulation, they typically:
Answer build new plants.
lay off workers and reduce production.
hire more workers and increase production.
call for more government spending.
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Question
The Keynesian cross shows:
Answer determination of equilibrium income and the interest rate in the short run.
determination of equilibrium income and the interest rate in the long run.
equality of planned expenditure and income in the short run.
equality of planned expenditure and income in the long run.
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Question
Exhibit: Keynesian Cross
Reference: Ref 10-1
(Exhibit: Keynesian Cross) In this graph, the equilibrium levels of income and expenditure are:
Answer Y1 and PE1.
Y2 and PE2.
Y3 and PE3.
Y3 and PE4.
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Question
Reference: Ref 10-1
(Exhibit: Keynesian Cross) In this graph, if firms are producing at level Y , then inventories will ______
1
inducing firms to ______ production.
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Answer rise; increase

rise; decrease
fall; increase
fall; decrease
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Question
Reference: Ref 10-1
(Exhibit: Keynesian Cross) In this graph, if firms are producing at level Y , then inventories will ______
3
inducing firms to ______ production.
Answer rise; increase
rise; decrease
fall; increase
fall; decrease
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Question
The government-purchases multiplier indicates how much ______ change(s) in response to a $1
change in government purchases.
Answer the budget deficit
consumption
income
real balances
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Question
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
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______.
Answer $1 billion; more than $1 billion
$0.75 billion; more than $0.75 billion
$0.75 billion; $0.75 billion
$1 billion; $1 billion
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Question
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:
Answer one unit.
∆G.
∆G divided by the quantity one minus the marginal propensity to consume.
∆G multiplied by the quantity one plus the marginal propensity to consume.
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Question
In the Keynesian-cross model, if government purchases increase by 100, then planned expenditures
______ for any given level of income.
Answer increase by 100
increase by more than 100
decrease by 100
increase, but by less than 100
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Question
In the Keynesian-cross model, if government purchases increase by 250, then the equilibrium level of
income:
Answer increases by 250.
increases by more than 250.
decreases by 250.
increases, but by less than 250.
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Question
In the Keynesian-cross model, fiscal policy has a multiplied effect on income because fiscal policy:
Answer increases the amount of money in the economy.
changes income, which changes consumption, which further changes income.
is government spending and, therefore, more powerful than private spending.
changes the interest rate.
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Question
According to the Keynesian-cross analysis, if MPC stands for marginal propensity to consume, then a
rise in taxes of ∆T will:
Answer decrease equilibrium income by ∆T.
decrease equilibrium income by ∆T/(1 – MPC).
decrease equilibrium income by (∆T)(MPC)/(1 – MPC).
not affect equilibrium income at all.
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Question
In the Keynesian-cross model, if taxes are reduced by 100, then planned expenditures ______ for any
given level of income.
Answer increase by 100
increase by more than 100
decrease by 100
increase, but by less than 100
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Question
In the Keynesian-cross model, if taxes are reduced by 250, then the equilibrium level of income:
Answer increases by 250.
increases by more than 250.
decreases by 250.
increases, but by less than 250.
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Question
The tax multiplier indicates how much ______ change(s) in response to a $1 change in taxes.
Answer the budget deficit
consumption
income
real balances
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Question
In the Keynesian-cross model with a given MPC, the government-expenditure multiplier ______ the
tax multiplier.
Answer is larger than
equals
is smaller than
is the inverse of the
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Question
In the Keynesian-cross model, if the MPC equals 0.75, then a $1 billion decrease in taxes increases
planned expenditures by ______ and increases the equilibrium level of income by ______.
Answer $1 billion; more than $1 billion
$0.75 billion; more than $0.75 billion
$0.75 billion; $0.75 billion
$1 billion; $1 billion
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Question
After the Kennedy tax cut in 1964, real GDP:
Answer fell and unemployment rose.
rose and unemployment fell.
and unemployment both rose.
and unemployment both fell.
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Question
Both Keynesians and supply-siders believe a tax cut will lead to growth:
Answer and both agree it works through incentive effects.
but Keynesians believe it works through incentive effects whereas supply-siders believe it
works through aggregate demand.
but Keynesians believe it works through aggregate demand whereas supply-siders
believe it works through incentive effects.
and both agree it works through aggregate demand.
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Question
Tax cuts stimulate ______ by improving worker's incentive and expand ______ by raising households'
disposable income.
Answer velocity; demand for loanable funds
demand for loanable funds; velocity
aggregate demand; aggregate supply
aggregate supply; aggregate demand
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Question
In the Keynesian-cross model, the equilibrium level of income is determined by:
Answer the factors of production.
the money supply.
planned spending.
liquidity preference.
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Question
In the Keynesian-cross model, what adjusts to move the economy to equilibrium following a change in
exogenous planned spending?
Answer planned spending
the interest rate
production
the price level
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Question
The Keynesian-cross analysis assumes planned investment:
Answer is fixed and so does the IS analysis.
depends on the interest rate and so does the IS analysis.
is fixed, whereas the IS analysis assumes it depends on the interest rate.
depends on expenditure and so does the IS analysis.
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Question
The simple investment function shows that investment ______ as ______ increases.
Answer decreases; the interest rate
increases; the interest rate
decreases; government spending
increases; government spending
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Question
An increase in the interest rate:
Answer reduces planned investment, because the interest rate is the cost of borrowing to finance
investment projects.
increases planned investment, because people who make money from interest have
more money to invest.
has no effect on investment.
may be caused by a drop in investment demand.
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Question
An explanation for the slope of the IS curve is that as the interest rate increases, the quantity of
investment ______, and this shifts the expenditure function ______, thereby decreasing income.
Answer increases; downward
increases; upward
decreases; upward
decreases; downward
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Question
In the Keynesian-cross model, a decrease in the interest rate ______ planned investment spending
and ______ the equilibrium level of income.
Answer increases; increases
increases; decreases
decreases; decreases
decreases; increases
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Question
When drawn on a graph with income along the horizontal axis and the interest rate along the vertical
axis, the IS curve generally:
Answer is vertical.
is horizontal.
slopes upward and to the right.
slopes downward and to the right.
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Question
Along any given IS curve:
Answer tax rates are fixed, but government spending varies.
government spending is fixed, but tax rates vary.
both government spending and tax rates vary.
both government spending and tax rates are fixed.
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Question
The IS curve shifts when any of the following economic variables change except:
Answer the interest rate.
government spending.
tax rates.
the marginal propensity to consume.
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Question
An increase in government spending generally shifts the IS curve, drawn with income along the
horizontal axis and the interest rate along the vertical axis:
Answer downward and to the left.
upward and to the right.
upward and to the left.
downward and to the right.
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Question
An increase in taxes shifts the IS curve, drawn with income along the horizontal axis and the interest
rate along the vertical axis:
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Question
Based on the Keynesian model, one reason to support spending increases over tax cuts as measures
to increase output is that:
Answer government spending increases the MPC more than tax cuts.
the government-spending multiplier is larger than the tax multiplier.
government-spending increases do not lead to unplanned changes in inventories, but tax
cuts do.
increases in government spending increase planned spending, but tax cuts reduce
planned spending.
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Question
Gary Becker's criticism of government spending on infrastructure as part of President Obama's
stimulus plan was that:
Answer spending on infrastructure would not increase production in the economy.
there is a conflict between where spending on infrastructure would benefit employment
and where infrastructure is most needed.
government spending on infrastructure is less effective in increasing production than an
equal amount of private spending on infrastructure.
government spending on infrastructure only increases demand, but tax cuts increase
demand and supply.
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Question
One argument in favor of tax cuts over spending on infrastructure to increase production is that:
Answer tax cuts increase the MPC by a larger amount than spending on infrastructure.
tax cuts increase planned spending, but spending on infrastructure offsets private
spending.
the tax multiplier is larger than the government spending multiplier.
it takes longer to implement spending on infrastructure than to implement tax cuts.
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Question
Changes in fiscal policy shift the:
Answer LM curve.
money demand curve.
money supply curve.
IS curve.
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Question
Along an IS curve all of the following are always true except:
Answer planned expenditures equal actual expenditures.
planned expenditures equal income.
the demand for real balances equals the supply of real balances.
there are no unplanned changes in inventories.
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Question
An IS curve shows combinations of:
Answer taxes and government spending.
nominal money balances and price levels.
interest rates and income that bring equilibrium in the market for real balances.
interest rates and income that bring equilibrium in the market for goods and services.
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Question
The IS curve shows combinations of ______ that are consistent with equilibrium in the market for
goods and services.
Answer inflation and unemployment
the price level and real output
the interest rate and the level of income
the interest rate and real money balances
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Question
The IS curve generally determines:
Answer income.
the interest rate.
both income and the interest rate.
neither income nor the interest rate.
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Question
When the LM curve is drawn, the quantity that is held fixed is:
Answer the nominal money supply.
the real money supply.
government spending.
the tax rate.
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Question
According to the theory of liquidity preference, the supply of real money balances:
Answer decreases as the interest rate increases.
increases as the interest rate increases.
increases as income increases.
is fixed.
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According to the theory of liquidity preference, the supply of nominal money balances:
Answer is chosen by the central bank.
depends on the interest rate.
varies with the price level.
changes as the level of income changes.
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Question
The theory of liquidity preference implies that:
Answer as the interest rate rises, the demand for real balances will fall.
as the interest rate rises, the demand for real balances will rise.
the interest rate will have no effect on the demand for real balances.
as the interest rate rises, income will rise.
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Question
If the interest rate is above the equilibrium value, the:
Answer demand for real balances exceeds the supply.
supply of real balances exceeds the demand.
market for real balances clears.
demand for real balances increases.
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Question
According to the theory of liquidity preference, if the supply of real money balances exceeds the
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demand for real money balances, individuals will:

Answer sell interest-earning assets in order to obtain non-interest-bearing money.
purchase interest-earning assets in order to reduce holdings of non-interest-bearing
money.
purchase more goods and services.
be content with their portfolios.
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Question
According to the theory of liquidity preference, if the demand for real money balances exceeds the
supply of real money balances, individuals will:
Answer sell interest-earning assets in order to obtain non-interest-bearing money.
purchase interest-earning assets in order to reduce holdings of non-interest-bearing
money.?
purchase fewer goods and services.
be content with their portfolios.
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Question
Exhibit: Market for Real Money Balances
Reference: Ref 10-2
(Exhibit: Market for Real Money Balances) Based on the graph, the equilibrium levels of interest rates
and real money balances are:
Answer r1 and M1/P1
r2 and M2/P2
r3 and M2/P2
r3 and M3/P3
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Question
Reference: Ref 10-2
(Exhibit: Market for Real Money Balances) Based on the graph, if the interest rate is r , then people
1
will ______ bonds and the interest rate will ______.
Answer sell; rise
sell; fall
buy; rise
buy; fall
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Question
Reference: Ref 10-2
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(Exhibit: Market for Real Money Balances) Based on the graph, if the interest rate is r , then people
3
will ______ bonds and the interest rate will ______.
Answer sell; rise
sell; fall
buy; rise
buy; fall
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Question
The theory of liquidity preference implies that, other things being equal, an increase in the real money
supply will:
Answer lower the interest rate.
raise the interest rate.
have no effect on the interest rate.
first lower and then raise the interest rate.
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Question
When Paul Volcker tightened the money supply:
Answer the inflation rate immediately fell.
nominal interest rates fell in the short run.
nominal interest rates fell in the long run.
real balances rose in the short run.
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Question
According to the theory of liquidity preference, tightening the money supply will ______ nominal
interest rates in the short run, and according to the Fisher effect, tightening the money supply will
______ nominal interest rates in the long run.
Answer increase; increase
increase; decrease
decrease; decrease
decrease; increase
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Question
Reducing the money supply ______ nominal interest rates in the short run, and ______ nominal
interest rates in the long run.
Answer produces no change in; raises
raises; produces no change in
raises; lowers
lowers; raises
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Question
In the liquidity preference model, what adjusts to move the money market to equilibrium following a
change in the money supply?
Answer planned spending
the interest rate
production
the price level
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Question
The theory of liquidity preference implies that the quantity of real money balances demanded is:
Answer negatively related to both the interest rate and income.
positively related to both the interest rate and income.
positively related to the interest rate and negatively related to income.
negatively related to the interest rate and positively related to income.
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Question
With the real money supply held constant, the theory of liquidity preference implies that a higher
income level will be consistent with:
Answer no change in the interest rate.
a lower interest rate.
a higher interest rate.
first a lower and then a higher interest rate.
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Question
According to the theory of liquidity preference, holding the supply of real money balances constant, an
increase in income will ______ the demand for real money balances and will ______ the interest rate.
Answer increase; increase
increase; decrease
decrease; decrease
decrease; increase
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Question
The LM curve, in the usual case:
Answer is vertical.
is horizontal.
slopes down to the right.
slopes up to the right.
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Question
An explanation for the slope of the LM curve is that as:
Answer the interest rate increases, income becomes higher.
the interest rate increases, income becomes lower.
income rises, money demand rises, and a higher interest rate is required.
income rises, money demand rises, and a lower interest rate is required.
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Question
An LM curve shows combinations of:
Answer taxes and government spending.
nominal money balances and price levels.
interest rates and income, which bring equilibrium in the market for real money balances.
interest rates and income, which bring equilibrium in the market for goods and services.
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Question
A decrease in the real money supply, other things being equal, will shift the LM curve:
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Question
A decrease in the nominal money supply, other things being equal, will shift the LM curve:
Answer upward and to the right.
downward and to the left.
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Question
A decrease in the price level, holding nominal money supply constant, will shift the LM curve:
Answer upward and to the right.
downward and to the left.
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Question
An increase in income raises money ______ and ______ the equilibrium interest rate.
Answer demand; raises
demand; lowers
supply; raises
supply; lowers
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Question
At a given interest rate, an increase in the nominal money supply ______ the level of income that is
consistent with equilibrium in the market for real balances.
Answer raises
lowers
does not change
may either raise or lower
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Question
Changes in monetary policy shift the:
Answer LM curve.
planned spending curve.
money demand curve.
IS curve.
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Question
The LM curve shows combinations of ______ that are consistent with equilibrium in the market for real
money balances.
Answer inflation and unemployment
the price level and real output
the interest rate and the level of income
the interest rate and real money balances
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Question
For any given interest rate and price level, an increase in the money supply:
Answer lowers income.
raises income.
has no effect on income.
lowers velocity.
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Question
The LM curve generally determines:
Answer income.
the interest rate.
neither income nor the interest rate.
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Question
The IS and LM curves together generally determine:
Answer income only.
the interest rate only.
income, the interest rate, and the price level.
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Question
The interest rate determines ______ in the goods market and money ______ in the money market.
Answer government spending; demand
government spending; supply
investment spending; demand
investment spending; supply
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Question
The intersection of the IS and LM curves determines the values of:
Answer r, Y, and P, given G, T, and M.
r, Y, and M, given G, T, and P.
r and Y, given G, T, M, and P.
p and Y, given G, T, and M.
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Question
Equilibrium levels of income and interest rates are ______ related in the goods and services market,
and equilibrium levels of income and interest rates are ______ related in the market for real money
balances.
Answer positively; positively
positively; negatively
negatively; negatively
negatively; positively
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Question
The IS-LM model is generally used:
Answer only in the short run.
only in the long run.
both in the short run and the long run.
in determining the price level.
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Question
The IS curve provides combinations of interest rates and income that satisfy equilibrium in the market
for ______, and the LM curve provides combinations of interest rates and income that satisfy
equilibrium in the market for ______.
Answer saving and investment; planned spending
real-money balances; loanable funds
goods and services; real money balances
real-money balances; goods and services
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Question
According to the Keynesian-cross analysis, if the marginal propensity to consume is 0.6, and
government expenditures and autonomous taxes are both increased by 100, equilibrium income will
rise by:
Answer 0.
100.
150.
250.
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Question
In the Keynesian-cross analysis, if the consumption function is given by C = 100 + 0.6(Y – T), and
planned investment is 100, G is 100, and T is 100, then equilibrium Y is:
Answer 350.
400.
600.
750.
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Question
Using the Keynesian-cross analysis, assume that the consumption function is given by C = 100 +
0.6(Y – T). If planned investment is 100 and T is 100, then the level of G needed to make equilibrium
Y equal 1,000 is:
Answer 200.
240.
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250.
260.
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Question
In the Keynesian-cross analysis, assume that the analysis of taxes is changed so that taxes, T, are
made a function of income, as in T = T + tY, where T and t are parameters of the tax code and t is
positive but less than 1. As compared to a case where t is zero, the multiplier for government
purchases in this case will:
Answer not change.
be smaller.
be bigger.
be equal to 1.
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Question
Consider the impact of an increase in thriftiness in the Keynesian-cross analysis. Assume that the
marginal propensity to consume is unchanged, but the intercept of the consumption function is made
smaller so that at every income level saving is greater. This will:
Answer lower equilibrium income by the decrease in the intercept multiplied by the multiplier.
lower equilibrium income by the decrease in the intercept.
raise equilibrium income by the decrease in the intercept.
raise equilibrium income by the decrease in the intercept multiplied by the multiplier.
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Question
Consider the impact of an increase in thriftiness in the Keynesian-cross analysis. Assume that the
marginal propensity to consume is unchanged, but the intercept of the consumption function is made
smaller so that at every income level saving is greater. This will:
Answer increase saving by the decrease in the intercept.
lead to no change in saving.
decrease saving by the decrease in the intercept.
lead to an increase in investment.
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Question
d
Assume that the money demand function is (M/P) = 2,200 – 200r, where r is the interest rate in
percent. The money supply M is 2,000 and the price level P is 2. The equilibrium interest rate is
______ percent.
Answer 2
4
6
8
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Question
d
percent. The money supply M is 2,000 and the price level P is 2. If the price level is fixed and the
supply of money is raised to 2,800, then the equilibrium interest rate will:
Answer drop by 4 percent.
drop by 2 percent.
drop by 1 percent.
remain unchanged.
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Question
d
percent. The money supply M is 2,000 and the price level P is 2. If the price level is fixed and the Fed
wants to fix the interest rate at 7 percent, it should set the money supply at:
Answer 2,000.
1,800.
1,600.
1,400.
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Essay 0 points
Question
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?
Answer a. Planned spending is 1,600. Inventory decumulation is 100. Equilibrium Y should be higher
than 1,500.
b. Equilibrium Y is 1,800.
c. Consumption is 1,200, private saving is 300, public saving is 0, and national saving is
300.
d. Equilibrium Y decreases by 300. The multiplier is 3.
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Question
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
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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?
Answer a. Y = 2,800 – 400r or r = 7 – 0.0025Y.

b. The slope of the IS curve is –0.0025.
c. If r is 1 percent, I is 800 and Y is 2,400. If r is 3 percent, I is 400 and Y is 1,600. If r is 5
percent, I is 0 and Y is 800.
d. IS shifts upward and to the right.
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Question
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?
Answer a. Y = 1,600 + 200r, or r = –8 + 0.005Y.

b. The slope of the LM curve is 0.005.
c. If r is 1 percent, Y is 1,800. If r is 3 percent, Y is 2,200. If r is 5 percent, Y is 2,600.
d. The LM curve shifts downward and to the right.
e. The LM curve shifts downward and to the right.
f. The LM curve shifts upward and to the left.
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a. 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.
Answer a.
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b. The equilibrium level of income falls. This analysis is appropriate in the short run when
prices and the interest rate are constant.
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a. 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.
Answer a.
b. The equilibrium level of income increases. This analysis is appropriate in the short run
when prices and the interest rate are constant.
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a. 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
26 of 31 6/1/2012 8:51 PM
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.
Answer a.
b. The equilibrium level of income falls.

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a. 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.
Answer a.
b. The equilibrium interest rate falls.

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Question
a. 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.
Answer a.
b. The equilibrium interest rate falls.

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Question
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?
Answer a. Tax cuts do not change the money supply, which is controlled by the central bank (Federal
Reserve). Changes in the money supply shift the LM curve.
b. Tax cuts shift the IS curve.
c. The president used the word “money” as it is popularly understood, but not according to its
macroeconomic meaning. Rephrasing the statement to say “when people have more
disposable income as a result of the tax cut, they can spend more on goods and services”
would make the statement consistent with the economic model.
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Compare how equilibrium is attained in the market for goods and services versus the market for real
money balances. (Hint: Explain what force moves the market back to equilibrium if the market is
initially in disequilibrium.)
Answer In the market for goods and services if planned spending exceeds actual spending, for
example, then inventories will become depleted, firms will increase production, hire more
workers, and increase income and output until equilibrium is achieved. In the market for real
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money balances if the supply of real money balances exceeds the demand, for example,
households will buy bonds, driving bond prices up and interest rates down. Interest rates will
continue to decline until households are eventually willing to hold the amount of real money
balances supplied.
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Question
Two identical countries, Country A and Country B, can each be described by a Keynesian-cross
model. The MPC is 0.9 in each country. Country A decides to increase spending by $2 billion, while
Country B decides to cut taxes by $2 billion. In which country will the new equilibrium level of income
be greater?
Answer Income in Country A will increase more. The government-spending multiplier in Country A
equals 10, so income in Country A will increase by $20 billion. The tax multiplier in Country B
equals 9, so income in Country B will only increase by $18 billion.
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a. The interest rate affects which variable in the market for goods and services versus the market for
real money balances?
b. The level of income affects which variable in the market for goods and services versus the market
for real money balances?
Answer a. The interest rate affects investment in the market for goods and services, and the demand
for money in the market for real money balances.
b. The level of income affects consumption in the market for goods and services, and the
demand for money in the market for real money balances.
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Question
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?
Answer The liquidity preference model predicts that an increase in the money supply will decrease
interest rates. The quantity theory predicts that an increase in the money supply will increase
inflation, which, via the Fisher effect, will increase the nominal interest rate. The liquidity
preference model emphasizes the short-run effect when prices are fixed, while the quantity
theory and Fisher effect are long-run effects when prices are flexible.
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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?
Answer a. The IS-LM model simultaneously determines equilibrium in the goods market and the
money market.
b. The interest rate (r) and real output (Y) are the two variables that adjust to bring
equilibrium in both markets.
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Question
Explain why a decrease in planned investment, which is a change in the goods market, will upset the
equilibrium in the money market.
Answer A decrease in planned investment spending decreases planned spending, which will reduce
the equilibrium level of income in the goods market. A decrease in income decreases the
demand for real money balances in the money market, which will decrease the equilibrium
level of the interest rate in the money market. Graphically, this is represented by a shift in the
IS curve to the left and a movement down the LM curve.
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Explain why an increase in the money supply, which is a change in the money market, will upset the
equilibrium in the goods market.
Answer An increase in the money supply will decrease the equilibrium interest rate in the money
market. A lower interest rate will increase investment spending in the goods market, which
will increase the equilibrium level of income in the goods market. Graphically, this is
represented by a shift in the LM curve to the right and a movement down the IS curve.
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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?
Answer A decrease in exogenous consumption reduces planned spending, which reduces the
equilibrium level of income by a greater amount via the consumption spending multiplier, i.e.,
a decrease in consumption spending leads to a decrease in income, which leads to another
decrease in consumption spending, and so on. At the new lower equilibrium level of income,
both income and consumption spending will have decreased by the same amount, so that
national saving (Y – C – G) will be unchanged.
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a. Graphically illustrate how an increase in income affects the equilibrium levels of saving, investment,
and the interest rate in the loanable funds model. 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 levels of saving, investment, and the interest rates
as a result of the increase in income.
Answer a.
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b. The equilibrium levels of saving and investment increase. The interest rate falls.
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Chapter 10

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Chapter 10

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Name Testbank Chapter 10: Aggregate Demand I

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Reference: Ref 10-1

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Reference: Ref 10-1

Answer rise; increase

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Reference: Ref 10-1

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