178.200 06-4

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178.200 Intermediate MacroeconomicsTutorial (4)

IS – LM Model I

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True or False Questions

(1) According to Keynesian cross, the difference between actual and planned expenditure is the marginal propensity to consume MPC.

Answer: F.Hint: The difference between actual and

planned expenditure is unplanned inventory investment. (See P259&P262)

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(continued)

Y>E

Y<E

Y=E

E

YE Y

E

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(2) An decrease in government purchases shifts IS curve to the right by ΔG/(1-MPC).

Answer: F.

Hint: An decrease in government purchases shifts IS curve to the left by ΔG/(1-MPC).

(See P269)

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(3) Either IS curve or LM curve can determine the level of income Y and the interest rate r.

Answer: F.

Hint: The level of income Y and the interest rate r determined when IS curve and LM curve intersected. (See P277)

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(4) The supply curve for real money balances is vertical because the central bank controls the supply of money through open-market operations.

Answer: T.Hint: The supply curve for real money

balances is vertical because the supply does not depend on the interest rate. (See P272)

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(5) More accurately, the nominal interest rate determines money demand and the real interest rate determines investment.

Answer: T.

Hint: (See P272).

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(6) The government – purchases multiplier

implies that the bigger the MPC is, the higher the equilibrium income level would be.

Answer: T.Hint: (See P263).

MPCG

Y

1

1

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Multiple-Choice Questions

(1) In the Keynesian cross model, the 45-degree line indicates that:

a. GDP rises whenever consumption rises.b. actual expenditure is always equal to income.c. the equilibrium level of income increases

whenever actual income increases.d. all of the above.Answer: b.Hint: (See P261).

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(2) If income exceeds planned expenditure, firms will cut back production because unplanned inventory accumulation will be:

a. positive.b. negative.c. zero.d. indeterminate.Answer: a.Hint: (See P262).

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(3) If the consumption function is C = 100 + 0.8 (Y – T), the government-purchases

multiplier is:a. 0.8.b. 1.25.c. 4.d. 5.Answer: d.Hint: (ΔY/ΔG = 1/ (1-0.8) = 10/2 = 5)

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(4) If the consumption function is C = 100 + 0.8 (Y – T) and taxes decrease by $1,

the equilibrium level of income will:a. decrease by $5.b. decrease by $4.c. increase by $5.d. increase by $4.Answer: d.Hint: (ΔY = (-MPC*ΔT)/(1-MPC) = -0.8*(-1)/0.2)

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(5) According to the quantity equation MV = PY. If velocity is constant, the:

a. LM curve will slope upward.

b. LM curve will slope downward.

c. LM curve will be horizontal.

d. LM curve will be vertical.

Answer: d.

Hint: (See PP275-276).

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(6) A normal LM curve can be derived from the quantity equation if it is assumed that:

a. a higher interest rate reduces money demand and raises velocity.

b. a higher interest rate reduces both money demand and velocity.

c. velocity is constant.d. the price level is constant.Answer: a.Hint: (See P276)

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Multiple-Choice Questions(2005 Exam Question)

(7) If investment, taxes, and government purchases are held constant, the planned expenditure curve:

a. slopes upward and its slope is equal to the MPC.b. slopes downward and its slope is equal to the

MPC.c. is a 45-degree line.d. is a vertical line.Answer: a.Hint: (See P260).

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(8) At the equilibrium level of income:a. unintended inventory accumulation is equal to

zero.b. planned expenditure is equal to actual

expenditure.c. there is no tendency for GDP to change.d. all of the above.Answer: d.Hint: (See P261).

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(9) The FALSE statement below is:a. a decrease in the interest rate increases planned

investment.b. a decrease in the interest rate shifts the planned

expenditure curve upward.c. a decrease in the interest rate shifts the IS curve to the

right.d. as the interest rate falls, planned expenditure is equal to

actual expenditure at a higher level of income.Answer: c.Hint: (See 277)

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(10) An increase of $1 in government purchases will:

a. shifts the planned expenditure curve upward by $1.

b. shifts the IS curve to the right by $1/(1-MPC).

c. not shift the LM curve.

d. all of the above.

Answer: d.

Hint: (See P269)

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Multiple-Choice Questions(2005 Exam Question)(11) According to the loanable funds interpretation of

the IS curve:a. firms want to invest more as their income rises.b. banks want to lend more as the interest rate rises.c. an increase in income raises saving and lowers

the interest rate that equilibrates the supply of and demand for loanable funds.

d. all of the above.Answer: c.Hint: (See P270)

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(12) A decrease in taxes will shift the planned expenditure curve________ and the IS curve to the__________.

a. upward, left.b. upward, right.c. downward, left.d. downward, right.Answer: b.Hint: (See P269)

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Multiple-Choice Questions(2005 Exam Question)(13) The following statement about the LM curve is TRUE:a. the LM curve slopes upward and it is drawn for a given

level of income.b. the LM curve slopes downward and an increase in price

shifts it upward.c. the LM curve slopes upward and it is drawn for a given

supply of real money balances.d. along the LM curve, actual expenditure is equal to

planned expenditure.Answer: c.Hint: (See P275).

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(14) An increase in the money supply shifts the:

a. LM curve upward (to the left).

b. LM curve downward (to the right).

c. IS curve to the right.

d. IS curve to the left.

Answer: b.

Hint: (See P276).

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Multiple-Choice Questions(2005 Exam Question)(15) At the intersection of the IS and LM curves:a. actual expenditure is equal to planned

expenditure.b. real money supply is equal to real money demand.c. the levels of Y and r satisfy both the goods market

equilibrium condition and the money market equilibrium condition.

d. all of the above.Answer: d.Hint: (See PP277-278)

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Numerical Questions(1) (Question 5 on Page 280) Suppose that the money demand function is where r is the interest rate in percent. The money supply M is

1,000 and the price level P is 2.a. Graph the supply and demand for real money balance.b. What is the equilibrium interest rate?c. Assume that the price level is fixed. What happens to the

equilibrium interest rate if the supply of money is raised from 1,000 to 1,200?

d. If the Fed wishes to raise the interest rate to 7 percent, what money supply should it set?

rPM d 100000,1)/(

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Numerical Questions

Answer

a. M = 1000, P =2 ⇨

500)/( sPM

rPM d 1001000)/(

r (M/P)s

(M/P)d

M/P1000500

10

5

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Numerical Questions

Answerb.

1000 – 100r = 500

r = 5.

sd PMPM )/()/(

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Numerical Questions

Answer

c. M = 1200, P =2 ⇨

600 = 1000 – 100r 100r = 400 r = 4%.

600)/( sPM

rPM d 1001000)/(

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Numerical Questions

Answerd.

M / P = 1000 –100r

where P = 2, r = 7. Then

M / 2 = 1000 – 100•7

M = 600.

Nominal money supply reduced from 1000 to 600.

sd PMPM )/()/(

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Numerical Questions

r (M/P)s1

(M/P)s0

7

5

(M/P)d

10

300 500 1000 M/P

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Numerical Questions

(2) Suppose that the following equations describe an economy:

C = 170 + 0.6(Y – T)

T = 200

I = 100 – 4r

G = 350

735/)/(

675.0)/(

PMPM

rYLPMs

d

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Numerical Questions

a. Derive the equation for the IS curve.

Answer:

IS: Y = C(Y – T) + I(r) + G

Y = 170 + 0.6(Y – 200) + 100 – 4r +350

0.4Y = 500 – 4r

Y = 1250 – 10r.

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Numerical Questions

b. Derive the equation for the LM curve.

Answer:

LM:

735 = 0.75Y – 6r

Y = 980 + 8r

ds PMPM )/()/(

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Numerical Questions

c. Now express both the IS and LM equation in terms of r, and calculate their slopes.

Answer:

IS: r = 125 – (1/10)Y.

LM: r = -122.5 + (1/8)Y

Slope for IS is –0.1.

Slope for LM is 0.125.

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Numerical Questions

d. Use the equation from Parts a and b to calculate the equilibrium levels of output, the interest rate, planned investment, and consumption.

Answer:

Y = 1100, r = 15%.

I = 40, C = 710.

rY

rY

8980

101250

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