Percent change from 4 quarters earlier
10
8
6
Average growth rate
4
2
Growth rates of real GDP, consumption
Real GDP growth rate
Consumption growth rate
0
-2
-4
1970 1975 1980 1985 1990 1995 2000 2005 2010

Growth rates of real GDP, consumption, investment
Percent change from 4 quarters earlier
40
30
Investment growth rate
20
Real GDP growth rate
10
0
-10
-20
Consumption growth rate
-30
1970 1975 1980 1985 1990 1995 2000 2005 2010

Unemployment
Percent of labor force
12
10
8
6
4
2
0
1970 1975 1980 1985 1990 1995 2000 2005 2010

Percentage
10 change in real GDP 8
1951
1984
6
1966
4
2
1987

Y
Y

3

2
 u
2003
1971
2008
0
-2
-4
-3
2001
1991 1982
-2 -1 0 1
Change in unemployment rate
2 3
1975
4

 GDP growth averages about 3 percent per year over the long run with large fluctuations in the short run.
 Consumption and investment fluctuate with GDP, but consumption tends to be less volatile and investment more volatile than GDP.
 Unemployment rises during recessions and falls during expansions.
 Okun’s Law : the negative relationship between
GDP and unemployment.

Index of Leading Economic Indicators
 Published monthly by the Conference Board.
 Aims to forecast changes in economic activity 6-9 months into the future.
 Used in planning by businesses and govt, despite not being a perfect predictor.

 Average workweek in manufacturing
 Initial weekly claims for unemployment insurance
 New orders for consumer goods and materials
 New orders, nondefense capital goods
 Vendor performance
 New building permits issued
 Index of stock prices
 M2
 Yield spread (10-year minus 3-month) on Treasuries
 Index of consumer expectations

120
110
100
90
80
70
60
50
40
Source:
30
Conference
1970 1975 1980 1985 1990 1995 2000 2005 2010
Board

 Long run
Prices are flexible, respond to changes in supply or demand.
 Short run
Many prices are “sticky” at a predetermined level.
The economy behaves much differently when prices are sticky.

 The paradigm most mainstream economists and policymakers use to think about economic fluctuations and policies to stabilize the economy
 Shows how the price level and aggregate output are determined
 Shows how the economy’s behavior is different in the short run and long run

 We use a simple theory of AD based on the quantity theory of money.
 Recall the quantity equation
M V = P Y
 For given values of M and V , this equation implies an inverse relationship between P and Y :
Y = (M V) / P

An increase in the price level causes a fall in real money balances ( M/P ), causing a decrease in the demand for goods & services.
P
AD
Y

P
An increase in the money supply shifts the
AD curve to the right.
AD
1
AD
2
Y

 Recall from Chapter 3:
In the long run, output is determined by factor supplies and technology
Y  F K L )
Y is the full-employment or natural level of output, at which the economy’s resources are fully employed.
“Full employment” means that unemployment equals its natural rate (not zero).

P LRAS
Y so does not depend on
LRAS vertical. is
P ,
Y

Y
, )

P LRAS
An increase in M
AD to the right. shifts
In the long run, this raises the price level…
P
2
P
1
…but leaves output the same.
Y
AD
1
AD
2
Y

The short-run aggregate supply curve
P
The SRAS curve is horizontal:
The price level is fixed at a predetermined level, and firms sell as much as buyers demand.
P
SRAS
Y

P
In the short run when prices are sticky,…
…an increase in aggregate demand…
…causes output to rise.
P
Y
1
Y
2
SRAS
AD
2
AD
1
Y

Over time, prices gradually become “unstuck.”
When they do, will they rise or fall?
In the short-run equilibrium, if
Y  Y
Y  Y
Y  Y then over time,
P will… rise fall remain constant
The adjustment of prices is what moves the economy to its long-run equilibrium.


M > 0
A = initial equilibrium
P LRAS
B = new shortrun eq’m after Fed increases M
C = long-run equilibrium
P
2
P
A
Y
C
B
Y
2
SRAS
AD
2
AD
1
Y

The effects of a negative demand shock
AD shifts left, depressing output and employment in the short run.
P LRAS
B A SRAS
Over time, prices fall and the economy moves down its demand curve toward fullemployment.
P
P
2
Y
2
Y
C
AD
2
AD
1
Y

 A supply shock alters production costs, affects the prices that firms charge (also called price shocks )
 Examples of adverse supply shocks:
– Bad weather reduces crop yields, pushing up food prices
– Workers unionize, negotiate wage increases
– New environmental regulations require firms to reduce emissions
 Favorable supply shocks lower costs and prices

CASE STUDY:
 Early 1970s: OPEC coordinates a reduction in the supply of oil
 Oil prices rose
11% in 1973
68% in 1974
16% in 1975

CASE STUDY:
The 1970s oil shocks
The oil price shock shifts SRAS up, causing output and employment to fall.
P LRAS
B
In absence of further price shocks, prices will fall over time and economy moves back toward full employment.
P
2
P
1
Y
2
Y
SRAS
2
AD
SRAS
1
Y

Predicted effects of the oil shock:
• inflation 
• output 
• unemployment 
…and then a gradual recovery.
CASE STUDY:
The 1970s oil shocks
70%
60%
50%
40%
30%
20%
10%
0%
1973 1974 1975 1976
Change in oil prices (left scale)
Inflation rate-CPI (right scale)
Unemployment rate (right scale)
12%
10%
8%
6%
1977
4%

Late 1970s:
As economy was recovering, oil prices shot up again, causing another huge supply shock!!!
CASE STUDY:
The 1970s oil shocks
60%
50%
40%
30%
20%
10%
0%
1977 1978 1979 1980
Change in oil prices (left scale)
Inflation rate-CPI (right scale)
Unemployment rate (right scale)
14%
12%
10%
8%
6%
1981
4%

1980s:
A favorable supply shock-a significant fall in oil prices.
As the model predicts, inflation and unemployment fell:
CASE STUDY:
The 1980s oil shocks
40%
30%
20%
10%
8%
10%
6%
0%
-10%
4%
-20%
-30%
2%
-40%
-50%
1982 1983 1984 1985 1986 1987
0%
Change in oil prices (left scale)
Inflation rate-CPI (right scale)
Unemployment rate (right scale)

 def: policy actions aimed at reducing the severity of short-run economic fluctuations.
 Example: Using monetary policy to combat the effects of adverse supply shocks…

The adverse supply shock moves the economy to point B.
P LRAS
P
2
P
1
B
A
SRAS
2
AD
1
SRAS
1
Y
Y
2
Y

P LRAS But the Fed accommodates the shock by raising agg. demand.
B C results:
P is permanently higher, but Y remains at its fullemployment level.
P
2
P
1
Y
2
Y
A
SRAS
2
AD
1
AD
2
Y

The IS LM model determines income and the interest rate in the short run when P is fixed

Keynesian
Cross
Theory of
Liquidity
Preference
IS curve
LM curve
IS-LM model
Agg. demand curve
Agg. supply curve
Model of
Agg.
Demand and Agg.
Supply
Explanation of short-run fluctuations

 A simple closed economy model in which income is determined by expenditure.
 Notation:
I = planned investment
PE = C + I + G = planned expenditure
Y = real GDP = actual expenditure
 Difference between actual & planned expenditure = unplanned inventory investment

consumption function: govt policy variables:
)
G G , T T for now, planned investment is exogenous: planned expenditure:
I  I
PE  C Y T ) I G equilibrium condition: actual expenditure = planned expenditure
Y  PE

PE planned expenditure
PE = Y
PE = C + I + G
Equilibrium income income, output,
Y

An increase in government purchases
PE
At
Y
1
, there is now an unplanned drop in inventory…
PE = C + I + G
2
PE = C + I + G
1
 G
…so firms increase output, and income rises toward a new equilibrium.
PE
1
= Y
1
 Y
PE
2
= Y
2
Y


Y  C  I  G
 Y C I G
  C   G

MPC
  Y   G equilibrium condition in changes because
I exogenous because
 C =
MPC
 Y
Collect terms with
 Y on the left side of the equals sign:
(1

MPC)
 Y   G
Solve for
 Y :
 Y 


1
1

MPC


  G

The government purchases multiplier
Definition: the increase in income resulting from a $1 increase in G .
In this model, the govt purchases multiplier equals
 Y
 G

1
1

MPC
Example: If MPC = 0.8, then
 Y
 G

1
1

0.8

5
An increase in G causes income to increase 5 times as much!

 Initially, the increase in G causes an equal increase in Y:  Y =  G .
 But  Y   C
 further  Y
 further  C
 further  Y
 So the final impact on income is much bigger than the initial  G .

PE
Initially, the tax increase reduces consumption, and therefore PE :
PE = C
1
+ I + G
PE = C
2
+ I + G
 C =  MPC  T At
Y
1
, there is now an unplanned inventory buildup…
…so firms reduce output, and income falls toward a new equilibrium
PE
2
= Y
2
 Y
PE
1
= Y
1
Y


 Y C I G
  C

MPC
 Y T  eq’m condition in changes
I and
G exogenous
Solving for
 Y : (1

MPC)
 Y  
MPC
  T
Final result:  Y 



MPC
1

MPC


  T

def: the change in income resulting from a $1 increase in T :
 Y
 T


MPC
1

MPC
If MPC = 0.8, then the tax multiplier equals
 Y
 T


0.8
1

0.8


0.8
0.2
 
4

def: a graph of all combinations of r and
Y that result in goods market equilibrium i.e.
actual output = planned expenditure
The equation for the IS curve is:
Y  C Y T )  I r  G
J.R. Hicks

 r   I
  PE
  Y
PE
PE = Y
PE = C + I ( r
2
)+ G
PE = C + I ( r
1
)+ G
 I
Y
1
Y
2
Y r r
1 r
2
Y
1
Y
2
IS
Y

Shifting the IS curve:

G
At any value of r ,
 G   PE   Y
…so the IS curve shifts to the right.
PE
PE = Y
PE = C + I ( r
1
)+ G
2
PE = C + I ( r
1
)+ G
1
The horizontal distance of the
IS shift equals r r
1
Y
1
Y
2
Y
1
 G
Y
1
 Y
Y
2
IS
1
IS
Y
2

 Due to John Maynard Keynes
 A simple theory in which the interest rate is determined by money supply and money demand

The supply of real money balances is fixed:
 M P  s
 M P interest rate r
 M P  s
M P
M/P real money balances

Demand for real money balances:
 M P  d

interest rate r
 M P  s
M P
L ( r )
M/P real money balances

The interest rate adjusts to equate the supply and demand for money:
M P  L r
interest rate r
 M P  s r
1
M P
L ( r )
M/P real money balances

To increase r ,
Fed reduces M interest rate r r
2 r
1
M
2
P
M
1
P
L ( r )
M/P real money balances

Now let’s put function:
Y back into the money demand
 M P  d
 L r Y
The LM curve is a graph of all combinations of r and Y that equate the supply and demand for real money balances.
The equation for the LM curve is:
M P  L r Y

r
2 r
1
r
(a) The market for real money balances
M
1
P
L ( r , Y
2
)
L ( r , Y
1
)
M/P r
2 r
(b) The LM curve
LM r
1
Y
1
Y
2
Y

r
2 r
1

r
(a) The market for real money balances
M
2
P
M
1
P
L ( r , Y
1
)
M/P r
2 r
(b) The LM curve
LM
2
LM
1 r
1
Y
1
Y

The short-run equilibrium is the combination of r and Y that simultaneously satisfies the equilibrium conditions in the goods & money markets:
Y  C Y T )  I r  G
M P  L r Y
Equilibrium interest rate r
LM
IS
Y
Equilibrium level of income

Policy analysis with the IS -LM model
Y  C Y T )  I r  G
M P  L r Y
We can use the effects of
IS-LM model to analyze the
• fiscal policy: G and/or T
• monetary policy: M r
1 r
Y
1
LM
IS
Y

1. IS curve shifts right
1 by
 G causing output & income to rise.
2. This raises money demand, causing the interest rate to rise…
3. …which reduces investment, so the final increase in Y
1 is smaller than
 G r
2
2.
r
1 r
LM
Y
1
3.
Y
2
1.
IS
1
IS
2
Y

Consumers save
(1

MPC ) of the tax cut, so the initial boost in spending is smaller for

T than for an equal

G … and the IS curve shifts by
1.

MPC
 T
2.
r
2 r
1 r
2.
…so the effects on r and Y are smaller for

T than for an equal

G .
LM
Y
1
Y
2
2.
1.
IS
1
IS
2
Y

Monetary policy: An increase in M
1.  M the
> 0 shifts
LM curve down
(or to the right) r
LM
1
LM
2 r
1 r
2
2.
…causing the interest rate to fall
3.
…which increases investment, causing output & income to rise.
Y
1
Y
2
IS
Y


G > 0
 Suppose Congress increases G .
 Possible Fed responses:
1.
2.
3.
hold M constant hold r constant hold Y constant
 In each case, the effects of the  G are different…

Response 1: Hold M constant
If Congress raises G , the IS curve shifts right.
If Fed holds M constant, then LM curve doesn’t shift.
Results:
 Y  Y
2
 Y
1 r r
2
 r
1 r
2 r
1 r
LM
1
Y
1
Y
2
IS
IS
1
2
Y

Response 2: Hold r constant r
If Congress raises G , the IS curve shifts right.
To keep r constant,
Fed increases M to shift LM curve right.
Results:
 Y  Y
3
 Y
1
0 r
2 r
1
LM
1
LM
2
Y
1
Y
2
Y
3
IS
IS
1
2
Y

Response 3: Hold Y constant r
If Congress raises G , the IS curve shifts right.
To keep Y constant,
Fed reduces M to shift LM curve left.
Results:
 Y  0 r r
3
 r
1 r
3 r
2 r
1
LM
2
LM
1
Y
1
Y
2
IS
IS
1
2
Y

from the DRI macroeconometric model
Assumption about monetary policy
Estimated value of

Y /

G
Estimated value of

Y /

T
Fed holds money supply constant
Fed holds nominal interest rate constant
Romer & Bernstein (2009)
Barro & Redlick (2010)
0.60
1.93
1.55
0.90

0.26

1.19

0.90

1.10

IS shocks : exogenous changes in the demand for goods & services.
Examples:
– stock market boom or crash
 change in households’ wealth
  C
– change in business or consumer confidence or expectations
  I and/or  C

LM shocks : exogenous changes in the demand for money.
Examples:
– a wave of credit card fraud increases demand for money.
– more ATMs or the Internet reduce money demand.

CASE STUDY:
 During 2001,
– 2.1 million jobs lost, unemployment rose from 3.9% to 5.8%.
– GDP growth slowed to 0.8%
(compared to 3.9% average annual growth during 1994-2000).

CASE STUDY:
Causes: 1) Stock market decline   C
1500
1200
S&P 500
900
600
300
1995 1996 1997 1998 1999 2000 2001 2002 2003

CASE STUDY:
Causes: 2) 9/11
–
–
– increased uncertainty fall in consumer & business confidence result: lower spending, left
IS curve shifted
Causes: 3) Corporate accounting scandals
– Enron, WorldCom, etc .
– reduced stock prices, discouraged investment

CASE STUDY:
 Fiscal policy response: shifted IS curve right
–
– tax cuts in 2001 and 2003 spending increases
• airline industry bailout
• NYC reconstruction
• Afghanistan war

CASE STUDY:
 Monetary policy response: shifted LM curve right
7
6
5
4
3
2
1
0
Three-month
T-Bill Rate

Intuition for slope of AD curve:

P
 
( M/P )

LM shifts left
  r
  I
 
Y
P
P
2
P
1 r r
2 r
1
Y
2
Y
2
LM( P
2
)
LM( P
1
)
Y
1
Y
1
IS
Y
AD
Y

The Fed can increase aggregate demand:

M

LM shifts right
  r
  I
 
Y at each value of P r r
1 r
2
P
P
1
Y
1
LM(M
1
/P
1
)
LM( M
2
/P
1
)
Y
2
IS
Y
Y
1
Y
2
AD
2
AD
1
Y

Expansionary fiscal policy (

G and/or

T ) increases agg. demand:

T
 
C

IS shifts right
 
Y at each value of P r r
2 r
1
P
P
1
Y
1
LM
Y
2
IS
1
IS
2
Y
Y
1
Y
2
AD
2
AD
1
Y

Recall from Chapter 9 : The force that moves the economy from the short run to the long run is the gradual adjustment of prices.
In the short-run equilibrium, if
Y  Y
Y  Y
Y  Y then over time, the price level will rise fall remain constant

The SR and LR effects of an IS shock r
LRAS
LM ( P
1
)
A negative shock shifts and AD causing
IS
IS left,
Y to fall.
P
P
1
IS
1
Y
LRAS
IS
2
Y
SRAS
1
Y
AD
1
AD
Y
2

The SR and LR effects of an IS shock r
LRAS
LM ( P
1
)
In the new short-run equilibrium,
P
P
1
IS
1
Y
LRAS
IS
2
Y
SRAS
1
Y
AD
1
AD
Y
2

The SR and LR effects of an IS shock r
LRAS
LM ( P
1
)
In the new short-run equilibrium,
Over time, P gradually falls, causing
•
SRAS to move down
•
M/P to increase, which causes LM to move down
P
P
1
IS
1
Y
LRAS
IS
2
Y
SRAS
1
Y
AD
1
AD
Y
2

The SR and LR effects of an IS shock r
LRAS
LM ( P
1
)
LM ( P
2
)
Over time, P gradually falls, causing
•
SRAS to move down
•
M/P to increase, which causes LM to move down
P
P
1
P
2
IS
1
Y
LRAS
IS
2
Y
Y
SRAS
1
SRAS
2
AD
1
AD
2
Y

The SR and LR effects of an IS shock r
LRAS
LM ( P
1
)
LM ( P
2
)
This process continues until economy reaches a long-run equilibrium with
P
P
1
P
2
IS
1
Y
LRAS
IS
2
Y
Y
SRAS
1
SRAS
2
AD
1
AD
2
Y

NOW YOU TRY:
of

M a.
Draw the IS-LM and AD-AS diagrams as shown here. r
LRAS
LM (
M
1
/ P
1
) b.
Suppose Fed increases M .
Show the short-run effects on your graphs.
IS c.
Show what happens in the transition from the short run to the long run.
P
Y
LRAS
Y d.
How do the new long-run equilibrium values of the endogenous variables compare to their initial values?
P
1
Y
SRAS
1
AD
1
Y

240 30
220
200
Unemployment
(right scale) 25
20
180 15
160
140
Real GNP
(left scale)
120
1929 1931 1933 1935 1937 1939
10
5
0

THE SPENDING HYPOTHESIS:
 asserts that the Depression was largely due to an exogenous fall in the demand for goods
& services – a leftward shift of the IS curve.
 evidence: output and interest rates both fell, which is what a leftward IS shift would cause.

THE SPENDING HYPOTHESIS:
 Stock market crash  exogenous  C
– Oct-Dec 1929: S&P 500 fell 17%
– Oct 1929-Dec 1933: S&P 500 fell 71%
 Drop in investment
–
–
“correction” after overbuilding in the 1920s widespread bank failures made it harder to obtain financing for investment
 Contractionary fiscal policy
– Politicians raised tax rates and cut spending to combat increasing deficits.

THE MONEY HYPOTHESIS:
 asserts that the Depression was largely due to huge fall in the money supply.
 evidence:
M 1 fell 25% during 1929-33.
 But, two problems with this hypothesis:
–
–
P fell even more, so M / P actually rose slightly during 1929-31. nominal interest rates fell, which is the opposite of what a leftward cause.
LM shift would

THE MONEY HYPOTHESIS AGAIN:
 asserts that the severity of the Depression was due to a huge deflation:
P fell 25% during 1929-33.
 This deflation was probably caused by the fall in M , so perhaps money played an important role after all.
 In what ways does a deflation affect the economy?

THE MONEY HYPOTHESIS AGAIN:
 The stabilizing effects of deflation:
  P   ( M/P )  LM shifts right   Y
 Pigou effect :
 P   ( M/P )
 consumers’ wealth 
  C
 IS shifts right
  Y

THE MONEY HYPOTHESIS AGAIN:
 The destabilizing effects of expected deflation:
 E 

 r  for each value of i
I  because I = I ( r )
 planned expenditure & agg. demand 
 income & output 

THE MONEY HYPOTHESIS AGAIN:
 The destabilizing effects of unexpected deflation: debt-deflation theory
 P (if unexpected)
 transfers purchasing power from borrowers to lenders
 borrowers spend less, lenders spend more
 if borrowers’ propensity to spend is larger than lenders’, then aggregate spending falls, the IS curve shifts left, and Y falls

 Policymakers (or their advisors) now know much more about macroeconomics
 Federal deposit insurance makes widespread bank failures very unlikely.
 Automatic stabilizers make fiscal policy expansionary during an economic downturn.

2008-2009
 NBER: December 2007 to June 2009
– Real GDP fell by 4%, u-rate hit 10.6%
 Important factors in the crisis:

7
6
5
4
3
9
8
2
1
0
2000
Interest rates and house prices
Federal Funds rate
30-year mortgage rate
2001 2002 2003 2004
170
150
130
110
90
70
2005
50

Change in U.S. house price index and rate of new foreclosures, 1999-2009
14%
12%
US house price index
New foreclosures
1,4
10% 1,2
8%
6%
1,0
0,8
4%
2%
0%
0,6
0,4
-2%
-4%
0,2
-6%
1999 2001 2003 2005 2007 2009
0,0

House price change and new foreclosures, 2006:Q3 – 2009Q1
20%
18%
16%
14%
12%
10%
8%
6%
4%
2%
0%
-40%
Nevada
California
Florida
Arizona
Rhode Island
New Jersey
Michigan
Hawaii
Illinois
Oregon
Ohio
Alaska
Georgia
Colorado
N. Dakota
-30% -20% -10% 0% 10%
Cumulative change in house price index
Texas
S. Dakota
Wyoming
20%

U.S. bank failures by year, 2000-2010
180
160
140
120
100
80
60
40
20
0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

140%
120%
100%
80%
60%
40%
20%
0%
-20%
-40%
-60%
-80%
Major U.S. stock indexes
(% change from 52 weeks earlier)
DJIA
S&P 500
NASDAQ

Consumer sentiment and growth in consumer durables and investment spending
20%
15%
10%
5%
0%
-5%
110
100
90
80
-10%
70
-15%
Durables
-20%
Investment
UM Consumer Sentiment Index
-25%
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
60
50

10% 10
8%
Real GDP growth rate (left scale)
Unemployment rate (right scale)
9
8
6%
7
6
4%
2%
0%
-2%
-4%
1995 1997 1999 2001 2003 2005 2007 2009
3
2
1
0
5
4

2008-2009
 NBER: December 2007 to June 2009
– Real GDP fell by 4%, u-rate hit 10.6%
 Important factors in the crisis:
–
–
– early 2000s Federal Reserve interest rate policy sub-prime mortgage crisis bursting of house price bubble, rising foreclosure rates
–
–
– falling stock prices failing financial institutions declining consumer confidence, drop in spending on consumer durables and investment goods

 Fiscal Policy
– Economic Stimulus Act of 2008
–
–
–
–
TARP (2008)
American Recovery and Reinvestment Act of 2009
Cash for Clunkers (2009)
Additional UI
 Monetary Policy
– Quantitative Easing I, II
– New Credit Facilities
 Financial Regulation
– Stress tests
– Dodd-Frank (2010)
 International Trade Policy

Over the business cycle, investment spending
______ consumption spending.
a) is inversely correlated with b) is more volatile than c) has about the same volatility as d) is less volatile than

Most economists believe that prices are: a) flexible in the short run but many are sticky in the long run.
b) flexible in the long run but many are sticky in the short run.
c) sticky in both the short and long runs.
d) flexible in both the short and long runs.

The vertical long-run aggregate supply curve satisfies the classical dichotomy because the natural rate of output does NOT depend on: a) the labor supply.
b) the supply of capital.
c) the money supply.
d) technology.

If the short-run aggregate supply curve is horizontal, then a change in the money supply will change ______ in the short run and change ______ in the long run.
a) only output; only prices b) only prices; only output c) both prices and output; only prices d) both prices and output; both prices and output

Assume that the economy is initially at point A with aggregate demand given by AD
2
. A shift in the aggregate demand curve to
AD
0 could be the result of either a(n) ______ in the money supply or a(n) ______ in velocity.
a) increase; increase b) increase; decrease c) decrease; increase d) decrease; decrease

In the IS-LM model, which two variables are influenced by the interest rate?
a) supply of nominal money balances and demand for real balances b) demand for real balances and government purchases c) supply of nominal money balances and investment spending d) demand for real money balances and investment spending

The equilibrium condition in the Keynesiancross analysis in a closed economy is: a) income equals consumption plus investment plus government spending.
b) planned expenditure equals consumption plus planned investment plus government spending.
c) actual expenditure equals planned expenditure.
d) actual saving equals actual investment.

In the Keynesian-cross model with a given MPC, the government-expenditure multiplier ______ the tax multiplier.
a) is larger than b) equals c) is smaller than d) is the inverse of the

An increase in taxes shifts the IS curve, drawn with income along the horizontal axis and the interest rate along the vertical axis: a) downward and to the left.
b) upward and to the right.
c) upward and to the left.
d) downward and to the right.

A decrease in the price level, holding nominal money supply constant, will shift the LM curve: a) upward and to the right.
b) downward and to the right.
c) downward and to the left.
d) upward and to the left.

In the Keynesian-cross analysis, if the consumption function is given by C = 100 + 0.6(Y – T), and planned investment is 100, G is 100, and T is 100, then equilibrium
Y is: a) 350 b) 400 c) 600 d) 750

Based on the graph, starting from equilibrium at interest rate r
1 and income Y
1
, a tax cut would generate the new equilibrium combination of interest rate and income: a) r
2
, Y
2 b) r
3
, Y
2 c) r
2
, Y
3 d) r
3
, Y
3

Based on the graph, starting from equilibrium at interest rate r
3
, income Y
2
, IS
1
, and LM
1
, if there is an increase in government spending that shifts the IS curve to IS
2
, then in order to keep the interest rate constant the Federal Reserve should _____ the money supply shifting to _____.
a) increase; LM
2 b) decrease; LM
2 c) increase; LM
3 d) decrease; LM
3

Based on the graph, if the economy starts from a shortterm equilibrium at A, then the long-run equilibrium will be at ____ with a _____ price level.
a) B; higher b) B; lower c) C; higher d) C; lower

A tax cut combined with tight money, as was the case in the United States in the early 1980s, should lead to a: a) rise in the real interest rate and a fall in investment.
b) fall in the real interest rate and a rise in investment.
c) rise in both the real interest rate and investment.
d) fall in both the real interest rate and investment.