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Solutions to Problems
Chapter 29
1a. A decrease in government expenditures leads to a decrease in aggregate demand, which in turn sets up a process in which
real GDP starts to decrease and the price level starts to fall.
The decrease in government expenditures has a multiplier effect on aggregate demand. Aggregate demand decreases and
shifts the AD curve in figure 1(a) leftward by $50b from AD0 to AD0/. Real GDP begins to decrease and the price level starts
to fall towards the new equilibrium a//.
1b. Real GDP decreases and the interest rate falls.
In the first round, real GDP begins to decrease and the price level begins to fall. In the second round, as real GDP decreases
the demand for money decreases from MD0 to MD1 in figure 1(b). As the price level falls, the quantity of real money
increases from MS0 to MS1 in figure 1(b). As a result, the interest rate falls from 5% to 4%. The fall in the interest rate limits
the decrease in real GDP.
1c. As the interest rate falls, interest-sensitive expenditure increases from $100b to $112b in figure 1(c).
1d. The increase in interest-sensitive expenditure increases aggregate demand and the aggregate demand curve starts to shift
rightward from AD0/ to AD1 in figure 1(a). This second-round increase in aggregate demand is less than the initial decrease.
With an increase in investment and other interest sensitive expenditure of $12b the AD curve in figure 1(a) will move to the
right by $24b to AD1.
1e. In the long run the equilibrium will be at potential real GDP.
Comparing the final equilibrium with the initial equilibrium, the decrease in government expenditures on goods and services
has lead to a decrease in real GDP, a fall in the price level, and a fall in the interest rate. The new equilibrium real GDP is
$580b and the price level of 97.5. Unless this is potential real GDP this is a short-run equilibrium, long-run equilibrium is at
potential real GDP.
Note: Apart from the initial decrease in aggregate demand to $550b the rest of the figures for GDP and price level have no
exactness. Their values will depend on the relative interest rate elasticities of money demand and interest sensitive
expenditure.
Price level (GDP deflator)
Fiscal Policy – Problem 1
SAS
100
•a
95
a
/
•a
//
•b
•
AD0/ AD1 AD0
550
580 600
Real GDP ($billions)
Figure 1(a)
Interest rate
Interest rate
Fiscal Policy – Problem 1
MS0 MS1
5
•a
5
•b
4
a
•
•b
4
MD0
IE
MD1
400
100
410
Real money ($billions)
Figure 1(b)
112
Interest sensitive expenditure ($billions)
Figure 1(c)
3a. A decrease in the money supply raises the interest rate.
.
A decrease in the money supply with a constant price level decreases the real money supply and shifts the real money supply
curve in figure 3(a) leftward. The interest rate rises from 5% to 6%.
3b. The increase in the interest rate decreases planned investment.
The higher interest rate decreases interest-sensitive expenditure by $25 billion, from $100b to $75b in figure 3(b).
3c. Aggregate planned expenditure falls by twice the decrease in interest-sensitive expenditure when the multiplier is two.
The decrease in interest-sensitive expenditure decreases aggregate demand and shifts the AD curve leftward by $50b, from
AD0 to AD0/ in figure 3(c). The decrease in interest-sensitive expenditure has a multiplier effect of two on aggregate
demand.
3d. Real GDP decreases and the interest rate falls.
In the second round, the decreasing real GDP decreases the demand for money. The money demand curve in figure 3(a)
shifts leftward from MD0 to MD1 and the interest rate begins to fall from 6%. The falling price level increases the supply of
real money and the real money supply curve shifts rightward from MS 0/ to MS1. The interest rate falls further to 5.3%. As
the interest rate falls, interest-sensitive expenditure increases from $75b to $90b in figure 3(b). The increase in interestsensitive expenditure increases aggregate demand and the aggregate demand curve starts to shift back to the right from AD 0/
to AD1. But aggregate demand increases by less than the initial decrease in aggregate demand.
3e. At the new equilibrium, the fall in aggregate demand is less than initially.
In the first round, real GDP begins to decrease and the price level begins to fall. In the second round, as real GDP decreases
the demand for money decreases. As the price level falls, the quantity of real money increases. As a result, the interest rate
falls. The fall in the interest rate limits the decrease in interest-sensitive expenditure and limits the decrease in real GDP.
6.0
•a
Interest rate
Interest rate
Monetary Policy – Problem 3
MS0/ MS1
MS0
/
•b
5.3
5.0
•a
6.0
•b
5.3
a
•
/
5.0
a
•
IE
MD0
MD1
75
400
350
Real money ($billions)
Figure 3(a)
90 100
Interest sensitive expenditure ($billions)
Figure 3(b)
Price level (GDP deflator)
Monetary Policy – Problem 3
SAS
100
97
•a
/
•a
•b
//
•a
AD
AD0/ AD1 0
550
585 600
Figure 3(c)
5a. A given change in the quantity of real money supplied has a larger effect on real GDP in economy B, the economy with the
less elastic demand for money.
Economy A has the more elastic (interest rate sensitive) demand for money function.
Consider a decrease in the money supply of $100 billion in figure 5(a). Because the demand for money is more interest rate
sensitive in economy A, the interest rate needs to rise by less to restore equilibrium in the money market than it does in
economy B.
The impact of monetary policy on real GDP is through its effect on interest rate sensitive components of aggregate demand.
Because the interest rate rises by less in economy A, other things remaining the same, investment falls by less so there is a
similar impact on aggregate demand. Economy B in figure 5(a) shows the largest fall in aggregate demand.
5b. The increase in government expenditure has a larger impact on real GDP in economy A, the economy with the more elastic
demand for money.
The effect of a change in government expenditure on goods and services occurs through its direct impact on aggregate
demand. But this is party offset by the induced change in interest rates affecting interest rate sensitive components of
aggregate demand as real GDP changes.
As government expenditure increases, the AD curve shifts to the right, increasing real GDP and the price level in the short
run, at given interest rates. But as real GDP increases, so does the demand for money. And as the price level increases the
quantity of real money decreases; see figure 5(b).
The interest rate rises by more in economy B than it does in economy A. Thus, there is a larger induced fall in planned
investment in economy B than in economy A. If interest sensitive spending falls by $5 billion in economy A, then it will fall
by $20 billion in economy B; see figure 5(b). The increase in government expenditure has a larger impact in economy A
than in economy B..
5c. The crowding-out effect is weaker in economy A.
Crowding out refers to the offsetting effects on interest sensitive expenditure of an induced increase in interest rates
following an increase in government purchases.
Crowding out occurs more the greater the induced increase in interest rate from increased government spending. This
induced change in the interest rate is larger the more inelastic is the demand for money; see figure 5(b).
Thus, the crowding-out effect is weaker in economy A.
.
MS0
MS1
/
9
•b
6
•
Interest rate
Interest rate
Effectiveness of Monetary Policy – Problem 5
a/
•b
/
9
•a
6
•a
5
/
•
5
a
IE
MDB MDA
100
400
300
Real money ($billions)
115
120
Interest sensitive expenditure ($billions)
Figure 5(a)
MS/ MS
MDB MDB/
•b
5.8
/
Interest rate
Interest rate
Effectiveness of Fiscal Policy – Problem 5
5.8
•b
/
MDA MDA/
5.2
5.0
a/
•
•a
5.2
•a
/
•
5.0
a
IE
390 400
Real money ($billions)
Figure 5(b)
100
115
120
Interest sensitive expenditure ($billions)
Interest rate
Interest rate
Effectiveness of Fiscal Policy – Problem 6
MS1 MS0
6.5
6.0
b
•
6.5
•a
•a
/
• b/
•a
6.0
IEA
MD
IEB
115
320 300
Real money ($billions)
105 100
Interest sensitive expenditure ($billions)
Figure 6(b)
7a. An increase in government expenditures and a decrease in taxes are expansionary fiscal policies. Aggregate demand
increases in the first round. Real GDP and the price level begin to increase. In the second round, the increasing real GDP
increases the demand for money and the interest rate rises. The rising price level decreases the supply of real money and
increases the interest rate further. Interest-sensitive expenditure decreases and limits the increase in real GDP. The decrease
in interest-sensitive expenditure includes a decrease in investment and net exports.
An increase in the money supply lowers the interest rate, increases interest-sensitive expenditure and increases aggregate
demand in the first round. Real GDP and the price level begin to increase. In the second round, increasing real GDP
increases the demand for money and the interest rate rises. The rising price level decreases the supply of real money and the
interest rate rises further. The decrease in interest-sensitive expenditure limits the increase in real GDP. The resulting
increase in interest-sensitive expenditure includes an increase in investment and net exports.
7b. The expansionary fiscal policies raise the interest rate and the interest-sensitive expenditure component of aggregate demand
decrease. The exchange rate rises, exports decrease, imports increase, and net exports decrease.
An increase in the money supply lowers the interest rate and the interest-sensitive expenditure component of aggregate
demand increase. The exchange rate falls, exports increase, imports decrease, and net exports increase.
7c. All policies increase real GDP and raise the price level.
7d. The best policy is to decrease interest rates.
Increasing the money supply results in a lower interest rate and lowers the exchange rate. The lower interest rate increases
investment and lowers the exchange rate increasing net exports.
9a. A combination of an increase in the money supply and a decrease in government expenditures.
9b. An increase in the money supply lowers the interest rate and increases interest-sensitive expenditure including investment.
The aggregate demand curve shifts rightward. A decrease in government expenditures decreases aggregate demand and
shifts the aggregate demand curve leftward. Real GDP decreases, the interest rate decreases, and interest-sensitive
expenditure, including investment, increases. If the decrease in government expenditures is of the correct magnitude, the
leftward shift of the aggregate demand curve will offset the rightward shift created by the increase in the money supply. The
price level will remain the same.
9c. The lower interest rate will increase investment and consumption expenditure and the lower exchange rate will increase
exports.
9d. In the short run, real GDP and the price level do not change. The aggregate demand curve remains the same—only the
composition of aggregate demand changes.
In the long run, the increase in investment will encourage economic growth. Real GDP growth will increase and the price
level will remain the same.