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Study Questions on Chapter 11 ( IS-LM Model)
1. According to the IS–LM model, what happens to the interest rate, income, consumption, and
investment under the following circumstances?
a. The central bank increases the money supply.
b. The government increases government purchases.
c. The government increases taxes.
d. The government increases government purchases and taxes by equal amounts.
2. Use the IS–LM model to predict the effects of each of the following shocks on income, the
interest rate, consumption, and investment. In each case, explain what the Fed should do to keep
income at its initial level.
a. After the invention of a new high-speed computer chip, many firms decide to upgrade their
computer systems.
b. A wave of credit-card fraud increases the frequency with which people make transactions
in cash.
c. A best-seller titled Retire Rich convinces the public to increase the percentage of their income
devoted to saving.
3. Consider the economy of Hicksonia where
C = 200 + 0.75 (Y - T)
I = 200 – 25 r
G = 100 and T = 100
Real money demand (M/P) = Y – 100 r
Nominal money supply M = 1,000 and the price level P = 2.
a. Find the equilibrium interest rate r and the equilibrium level of income Y.
b. Suppose that government purchases are raised from 100 to 150. What is the new equilibrium?
c. Suppose instead that the money supply is raised from 1,000 to 1,200. What is the new
equilibrium?
d. With the initial values for monetary and fiscal policy, suppose that the price level rises from 2
to 4. What are the new equilibrium interest rate and level of income?
e. Derive and graph an equation for the aggregate demand curve.
4. Policy Mix
a. Suppose that the government wants to raise investment but keep output constant. In the
IS–LM model, what mix of monetary and fiscal policy will achieve this goal?
b. In the early 1980s, the U.S. government cut taxes and ran a budget deficit while the Fed
pursued a tight monetary policy. What effect should this policy mix have?
5. Short Run vs Long Run
Use the IS–LM diagram to describe the short run and long-run effects of the following changes
on income, the interest rate, the price level, consumption, investment, and real money balances.
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a. An increase in the money supply.
b. An increase in government purchases
6. Fixing Money Supply vs Fixing Interest Rate
The Fed is considering two alternative monetary policies:
A. holding the money supply constant and letting the interest rate adjust, or
B. adjusting the money supply to hold the interest rate constant.
In the IS–LM model, which policy will better stabilize output under the following conditions?
a. All shocks to the economy arise from exogenous changes in the demand for goods and ervices.
b. All shocks to the economy arise from exogenous changes in the demand for money.
7. Modified Money Demand
Suppose that the demand for real money balances depends on disposable income.That is, the
money demand function is M/P = L(r, Y −T ).
Using the IS–LM model, discuss whether this change in the money demand function alters the
following:
a. The analysis of changes in government purchases.
b. The analysis of changes in taxes.
8. Policy Effectiveness and Aggregate Demand
How does the sensitivity of investment to the interest rate affect the slope of the aggregate
demand curve?
9. Policy Effectiveness
a. Use a diagram to explain what makes the fiscal policy more effective. What is the economic
intuition behind this.
b. Use a diagram to explain how α (multiplier) and b (the interest sensitivity of investment) affect
the effectiveness of monetary policy. What is the economic intuition behind these.
10. Numeric with Income Taxation
The following equations describe a closed economy:
C = 75 + 0.75 (Y + TR – TA)
I = 750 – 50 r
TR = 100
TA= t * Y
L = 0.2 Y – 50 r
P=3
G = 700
NX = 0
t = 0.20
M = 1200
a. What is the equation that describes the IS curve?
(2 pts)
b. What is the equation that describes the LM curve?
(2 pts)
c. What are the equilibrium levels of income and interest rate? Show these on a diagram (4 pts)
d. If price level P decreases to 2, what will be the new equilibrium?
( 4 pts)
e. Using parts c and d, sketch a Aggregate Demand curve.
( 4 pts)
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11. Numeric with Income Taxation
The following equations describe a closed economy:
C = 0.8 ( 1- t )Y
I = 900 – 50 r
L= 0.25 Y - 62.5 r
NX = 0
t = 0.25
G = 800
M /P = 500
a. What is the equation that describes the IS curve?
b. What is the equation that describes the LM curve?
c. What are the equilibrium levels of income and interest rate? Show these on a diagram
d. If government spending increases by 100 units, what will be the new equilibrium?
e. Is there a crowding-out effect? If no, why not? If yes, what is the size of crowding out
12. Numeric with a modified money demand:
Consumption:
C = 2000 + 0.75(Y – T)
Tax
T = 200
Investment
I = 1200 – 50 r
Government Spending G = 1800
Net Exports
NX = 0
Real Money Supply M/P = 2000
Real Money Demand M/P = 0.25(Y- T) – 50 r
a. Derive the IS curve
b. Derive the LM curve
c. Compute the equilibrium levels of interest rate and the income, and show the
equilibrium on a diagram.
Assume a decrease in business confidence causes investment to go down by 100.
d. Calculate the new equilibrium, and show the impact on the diagram above.
e. Suppose that the Central bank has the responsibility to keep the income
constant at the level as calculated in part c. What must be the monetary policy
and by how much, if the central bank is to fulfill its responsibility.
f. Refer to original problem and ignore the part related to decrease in
business confidence. Instead, now assume that government increases taxes
by 100. Calculate the new equilibrium and show the impact on the diagram.
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13. Shock to Money Demand and Stabilization
Consider an economy which is characterized by the following:
Consumption:
C = 2000 + 0.75 (Y – T)
Tax
T = 0.2Y
Investment
I = 1000 – 40 r
Government Spending G = 800
Net Exports
NX = 0
Real Money Supply M/P = 4000
Real Money Demand M/P = 0.4Y – 40 r +1000
a. Derive the IS curve
b. Derive the LM curve
c. Compute the equilibrium levels of interest rate and the income.
d. Assume that the “increase in expected future prices” causes the demand for money
increase by 500. Calculate the new equilibrium, and show the impact on a new
diagram.
e.Suppose that the equilibrium, computed in part c, is the natural (potential) level of GDP.
What type of fiscal policy the government can use to restore the GDP back to its
potential level, and by how much? Note: Ignore tax policies.
f. Suppose the government and the central bank take no action to return the economy back
to its potential gdp. Explain what kind of changes will take place in the long-run.
g. Assume that this economy experiences frequent “expected future prices” shocks, as
described in part d. Also assume that the central bank of this economy has 2 options on
its monetary policy: (A) fixing the money supply or (B) fixing the interest-rate. Which
option is better, A or B, if the central bank’s main concern is to stabilize the gdp
output? Explain by using diagrams.
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