PROBLEM SET 5
Problems for Chapter 5
1.
For each part below, start with and IS-LM diagram drawn like that below.
i
LM
A
i1
IS
Y1
Y
Suggest a mix of monetary and fiscal policy that will achieve the following objectives.
Justify your answers by using the diagram and explain your reasoning.
a.
b.
2.
Increase Y while keeping I constant at i1.
Decrease the government budget deficit while keeping Y constant
at Y1.
Use the graph below to answer the following questions. Suppose the
economy is initially at point A in the graph. Assume that government
spending increases.
i
LM
A
i1
IS
Y1
a.
b.
Y
What effect will this increase in government spending (G) have on
the IS curve?
Suppose that the Fed wants to maintain the interest rate at the
initial level (i1). What type of monetary policy must the Fed
pursue to maintain the interest rate at its initial level? Illustrate the
effects of the higher government spending and the Fed response in
the diagram above. In your graph, label the new equilibrium.
3.
Briefly discuss what effect each of the following separate events will have on
the IS curve, LM curve, equilibrium output, and the equilibrium interest rate.
Show the impact in a graph of the IS-LM model.
a.
An increase in consumer confidence.
b.
A reduction in consumer confidence.
c.
An increase in the use of credit cards (HINT: Consider the impact on
money demand).
d.
A decrease in the nominal money supply.
e.
An increase in the nominal money supply.
f.
An increase in the price level.
g.
A decrease in the price level.
4.
Use the graphs below to answer the following questions.
Interest rate (i)
Interest rate (i)
M/P
A
A
i0
i0
(M/P)d (Y0)
Md , M s
a.
b.
c.
d.
Y0
Y
Initially let I = i0 and Y = Y0. Suppose Y falls to Y1. Illustrate
what happens to money demand as a result of this drop in Y. At
the interest rate, what type of situation exists? Briefly explain.
What must happen to the interest rate as a result of the drop in Y?
Briefly explain. Label the new equilibrium A’ after you mark it in
the graph on the right side above.
Repeat the analysis in a and b assuming that Y falls even further to
Y2. Label this point A” and plot it in the graph on the right side
above.
What does the plot of points in the right-hand graph above
represent? Explain.
TEXTBOOK, p. 105- 106: #1, 7 (a and b)
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SELECTED ANSWERS
1.
a.
Expansionary fiscal policy (increase government spending and/or decrease
taxes), other things constant, will increase the interest rate. To bring the interest rate back
down to i1, the Fed can implement an expansionary monetary policy.
i
LM
Expansionary fiscal
policy shifts IS right.
A
B
Expansionary monetary
policy shifts LM right.
i1
IS
Y1
Y2
Y
b.
Decreasing the deficit requires contractionary fiscal policy, which, other
things constant, decreases Y. To keep Y at Y1, given the contractionary fiscal policy,
requires expansionary monetary policy. (This is the Clinton-Greenspan policy mix
described on p. 98 of the text).
i
LM
Expansionary monetary policy shifts LM right.
A
i1
B
Contractionary fiscal policy shifts IS
left.
i2
IS
Y1
Y
a.
The IS curve shifts to the right.
b.
To keep i at the initial level, the Fed must increase the money supply as
money demand increases. This will shift the LM curve right. The final equilibrium is at
point B, as depicted on the next page.
2.
3
i
LM
A
B
i1
IS
Y1
Y2
Y
3.
EQUILIBRIUM Y
(+ increase;
- decrease)
+
+
+
+
CURVE THAT SHIFTS
IS right
IS left
LM right
LM left
LM right
LM left
LM right
a.
b.
c.
d.
e.
f.
g.
EQUILIBRIUM i
(+ increase;
- decrease)
+
+
+
-
4.
a.
The drop in Y will cause a drop in transactions and, therefore, a drop in
money demand. Money demand falls to Md’. At the initial interest rate, there is now an
excess supply of money. Individuals hold more money than they would like.
b.
For the money market to be in equilibrium, i must fall to restore
equilibrium. The new equilibrium is given by point A’. See the graph below.
Interest rate (i)
Interest rate (i)
M/P
A
A
i0
i0
A’
i1
i2
A’
A”
A”
d
(M/P) (Y0)
(M/P)d (Y1)
Md , M s
c.
d.
Y2 Y1
Y0
Y
See the graph.
The combinations of i and Y which maintain equilibrium in the money
market form the LM curve.
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TEXTBOOK: #1:
a.
True.
b.
True.
c.
False.
d.
False. The balanced budget multiplier is positive (it equals 1), so the IS
curve shifts right. (This is a bit “advanced.”)
e.
False.
f.
Uncertain. An increase in G leads to an increase in Y (which tends to
increase investment), but an increase in the interest rate (which tends to
reduce investment).
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