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178.

200 Intermediate Macroeconomics


Tutorial (5)
IS – LM Model II

1
True or False Questions

• The increase in income in response to a


fiscal expansion is smaller in the IS-LM
model than it is in the Keynesian cross. (I
is assumed to be fixed).
Answer: T.
Hint: (See P283).

2
True or False Questions

(2) The output effect for a change in the


money supply is large when investment is
sensitive to the rate of interest.
Answer: T.
Hint: (See P309).

3
True or False Questions

(3) An increase in the transaction demand for


money ratio decreases the output effect of a
change in the money supply.
Answer: T.
Hint: (See P289).

4
True or False Questions

(4) An increase in government spending


always crowds-out investment.
Answer: F.
Hint: Thinking about whether investment is
interest-sensitive or not.

5
True or False Questions

(5) A liquidity trap arises when portfolio


holders have an infinite demand for bond
because they do not want to hold money.
Answer: F.
Hint: The liquidity trap occurs as portfolio
holders having an infinite demand for
money therefore there is no liquidity effect
and no change in output. (See P303)

6
True or False Questions

(6) Both shocks to the IS curve and the LM


curve are endogenous changes in the
demand for goods and services and for
money respectively.
Answer: F.
Hint: (See PP288-289).

7
Multiple-Choice Questions
(2005 Exam Question)
(1) If real income rose and the interest rate fell
following an increase in government purchases,
the:
b. IS curve must be vertical.
c. LM curve must be vertical.
d. central bank must have increased the money
supply at the same time.
e. central bank must have decreased the money
supply at the same time.
Answer: c.
Hint: (See next slide) 8
Multiple-Choice Questions
LM1
r
(1) LM2
(2)
r2

r1 IS2

IS1

Y1 Y2 Y3 Y

9
Multiple-Choice Questions
(2005 Exam Question)

(2) If the central bank decreases the money supply at


the same time as taxes increase, the:
b. interest rate will definitely rise.
c. interest rate will definitely fall.
d. equilibrium level of income will definitely rise.
e. equilibrium level of income will definitely fall.
Answer: d.
Hint: (See P286)
10
Multiple-Choice Questions
(2005 Exam Question)

(3) The IS curve will shift to the right if:


b. consumer confidence in the economy improves.
c. firms become more optimistic about the
economy and decide to invest more at each
interest rate.
d. the government increases transfer payments.
e. all of the above.
Answer: d.
Hint: (See PP282-283).
11
Multiple-Choice Questions
(2005 Exam Question)

(4) If people suddenly wish to hold more money at


each interest rate:
b. the money demand curve will shift to the right.
c. the LM curve will shift upward to the left.
d. real income will fall.
e. all of the above.
Answer: d.
Hint: (See P289).
12
Multiple-Choice Questions
(2005 Exam Question)
(5) Which of the following statements explains why the
aggregate demand curve is downward-sloping?
b. A lower price level increase real balances.
Consequently, the LM curve shifts downward and the
level of income increases.
c. A lower price level forces the central bank to increase
the money supply. Consequently, the LM curve shifts
down and the level of income increases.
d. A lower price level induces the government to reduce
taxes. Consequently, the IS curve shifts to the right and
the level of income increases.
e. All of the above.
Answer: a.
Hint: (See P284) 13
Multiple-Choice Questions

(6) As we move along a stationary aggregate demand


curve, one factor that is held constant is:
b. real income.
c. the aggregate price level.
d. the (nominal) money supply.
e. real money balances.
Answer: c.
Hint: (See PP242-243).
14
Multiple-Choice Questions
(2005 Exam Question)
(7) The FALSE statement below is:
b. the classical assumption that output reaches its natural
rate is best used to describe the long run.
c. in the short run, output may deviate from its natural rate.
d. in the IS-LM model, the price level is assumed to be
sticky in the short sun.
e. in the IS-LM model, aggregate demand is never equal to
the natural rate of output even in the long run.
Answer: d.
Hint: (See P294).

15
Multiple-Choice Questions
(2005 Exam Question)
(8) If income is initially less than the natural rate of
output, the price level:
b. will gradually fall, shifting the LM curve
downward.
c. will gradually rise, shifting the LM curve
upward.
d. will fall, shifting the IS curve to the right.
e. is stuck at this level even in the long run.
Answer: a.
Hint: (See P294)
16
Multiple-Choice Questions

(9) According to adherents of the money hypothesis,


the Great Depression was caused by a:
b. sharp decline in the money supply.
c. decline in business confidence.
d. decline in consumer confidence.
e. sharp decline in real money balances.
Answer: a.
Hint: (See P298).
17
Multiple-Choice Questions

(10) According to adherents of the spending


hypothesis, the Great Depression was caused by:
b. a reduction in business and consumer
confidence.
c. A contractionary (leftward) shift in the IS curve.
d. the stock market crash.
e. all of the above.
Answer: d.
Hint: (See P296).
18
Multiple-Choice Questions
(2005 Exam Question)
(11) According to the Pigou effect:
b. for a given supply of money, a lower price level shifts
the LM curve outward, which leads to a higher level of
income.
c. since consumers will buy more of a good as its price
falls, real output will rise during a depression.
d. as prices fall and real balances rise, consumers will feel
wealthier and spend more.
e. all of the above.
Answer: c.
Hint: (See P299).
19
Multiple-Choice Questions
(12) According to the debt-deflation theory, unexpected
deflation hurts debtors and benefits creditors.
Consequently, national income will fall if:
b. both groups have the same spending propensities.
c. debtors have a higher propensity to spend than creditors.
d. creditors have a higher propensity to spend than debtors.
e. the MPC for both groups is less than 1.
Answer: b.
Hint: (See P299).

20
Multiple-Choice Questions
(13) The following statement is FALSE:
b. money demand depends on the nominal interest rate.
c. investment demand depends on the real interest rate.
d. IS-LM analysis is unable to incorporate changes in
expected inflation.
e. an expected deflation causes the real interest rate to rise
at each level of the nominal interest rate, which leads to
a contractionary (leftward) shift of the IS curve.
Answer: c.
Hint: (See P300).

21
Multiple-Choice Questions
(14) If an economy is in a liquidity trap, then:
b. the interest rate is so low that fiscal policy
cannot stimulate the economy.
c. the interest rate is so low that monetary policy
cannot stimulate the economy.
d. the budget deficit is so high that fiscal policy
cannot stimulate the economy.
e. all of the above.
Answer: b.
Hint: (See P303).
22
Multiple-Choice Questions

(15) If investment becomes very sensitive to the


interest rate, the:
b. IS curve becomes steeper.
c. IS curve becomes flatter.
d. LM curve becomes steeper.
e. LM curve becomes flatter.
Answer: b.
Hint: (See P308).
23
Multiple-Choice Questions

(16) A smaller MPC leads to:


b. a steeper planned expenditure curve.
c. a smaller government-purchases multiplier.
d. a flatter IS curve.
e. all of the above.
Answer: b.
Hint: MPC (1-MPC) 1/(1-MPC)

24
Multiple-Choice Questions
(17) If money demand is not very sensitive to the
level of income:
b. the money demand curve does not shift very far
to the right as income rises.
c. only a small change in interest rate is necessary
to offset the increase in money demand caused
by a change in income.
d. the LM curve is relatively flat.
e. all of the above.
Answer: d.
Hint: (See P309). 25
Multiple-Choice Questions
(2005 Exam Question)
(18) If the quantity of money demanded is very
sensitive to the interest rate:
b. the money demand curve will be relatively flat.
c. a shift in money demand due to a change in
income leads to a small change in the
equilibrium interest rate.
d. the LM curve is relatively flat.
e. all of the above.
Answer: d.
Hint: (See P309).
26
Numerical Questions

(1) In a two-sector model, suppose


C = 60 + 0.8Y
I = 116 – 2r
L = 0.2Y – 5r
M = 120
a. Derive the equation for IS curve in terms of
r.
27
Numerical Questions

(continued)
Answer: Y = C + I
Y = 60 + 0.8Y + 116 – 2r
0.2Y = 176 – 2r
r = -0.1Y + 88

28
Numerical Questions

b. Derive the equation for LM curve in terms


of r.
Answer:
M=L
120 = 0.2Y – 5r
5r = 0.2Y – 120
r = 0.04Y - 24
29
Numerical Questions

c. Find the equilibrium value of Y and r via


simultaneous equilibrium for IS and LM.
r = -0.1Y + 88 (1)

r = 0.04Y – 24 (2)
Answer: (1) – (2) then
0 = -0.14Y + 112
therefore, Y = 800. Back to (1) or (2) and obtain
r = 8%.
30
Numerical Questions

(2) Assume that the equations for the IS


and LM curves are:
IS curve: r = 40 – 0.025Y and
LM curve: i = -50 + 0.05Y
a. Find the initial equilibrium value of Y, i,
and r since the expected inflation rate is
zero.
31
Numerical Questions

(continued)
Answer:
Recall r = i – π , solving two equations by
e

the method like Question 1:


Y = 1200, r = i = 10%.

32
Numerical Questions

b. Now suppose that we have deflation and


expected inflation falls to 7.5%. What are
the new equilibrium values of Y, i, and r.
Answer: r = 40 – 0.025Y (1)
i = -50 + 0.05Y (2)
r = i + 7.5 (3)
33
Numerical Questions

(continued)
Reconstruct three equations and then
i + 7.5 = 40 – 0.025Y (4)
i = -50 + 0.05Y (5)
(4) – (5) and obtain
7.5 = 90 – 0.075Y. Thus Y = 1100.
Bring Y back to (1), i = 5%.
Then r = i + 7.5 = 12.5%
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