Reference no: EM132273602

Questions: 1. Consider a closed economy to which the Keynesian-cross analysis applies. Consumption is given by the equation C = 200 + 2/3(Y - T). Planned investment is 300, as are government spending and taxes.

a. If Y is 1,500, what is planned spending? What is inventory accumulation or decumulation? Should equilibrium Y be higher or lower than 1,500?

b. What is equilibrium Y? (Hint: Substitute the values of equations for planned consumption, investment, and government spending into the equation Y = C + I + G and then solve for Y.)

c. What are equilibrium consumption, private saving, public saving, and national saving?

d. How much does equilibrium income decrease when G is reduced to 200? What is the multiplier for government spending?

2. Assume that the consumption function is given by C = 200 + 0.5(Y - T) and the investment function is I = 1,000 - 200r, where r is measured in percent, G equals 300, and T equals 200.

a. What is the numerical formula for the IS curve? (Hint: Substitute for C, I, and G in the equation Y = C + I + G and then write an equation for Y as a function of r or r as a function of Y.) Express the equation two ways.

b. What is the slope of the IS curve? (Hint: The slope of the IS curve is the coefficient of Y when the IS curve is written expressing r as a function of Y.)

c. If r is one percent, what is I? What is Y? If r is 3 percent, what is I? What is Y? If r is 5 percent, what is I? What is Y?

d. If G increases, does the IS curve shift upward and to the right or downward and to the left?

3. Assume that the equilibrium in the money market may be described as M/P = 0.5Y - 100r, and M/P equals 800.

a. Write the LM curve two ways, expressing Y as a function of r and r as a function of Y. (Hint: Write the LM curve only relating Y and r; substitute out M/P.)

b. What is the slope of the LM curve?

c. If r is 1 percent, what is Y along the LM curve? If r is 3 percent, what is Y along the LM curve? If r is 5 percent, what is Y along the LM curve?

d. If M/P increases, does the LM curve shift upward and to the left or downward and to the right?

e. If M increases and P is constant, does the LM curve shift upward and to the left or downward and to the right?

f. If P increases and M is constant, does the LM curve shift upward and to the left or downward and to the right?

4. a. Suppose Congress decides to reduce the budget deficit by cutting government spending. Use the Keynesian-cross model to illustrate graphically the impact of a reduction in government purchases on the equilibrium level of income. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curve shifts; and v. the terminal equilibrium values.

b. Explain in words what happens to equilibrium income as a result of the cut in government spending and the time horizon appropriate for this analysis.

5. a. Suppose Congress passes legislation that significantly reduces taxes. Use the Keynesian-cross model to illustrate graphically the impact of a reduction in taxes on the equilibrium level of income. Be sure to label:

i. the axes;

ii. the curves;

iii. the initial equilibrium values;

iv. the direction the curve shifts; and

v. the terminal equilibrium values.

b. Explain in words what happens to equilibrium income as a result of the tax cut and the time horizon appropriate for this analysis.

6. a. Use the Keynesian-cross model to illustrate graphically the impact of an increase in the interest rate on the equilibrium level of income. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curve shifts; and v. the terminal equilibrium values.

b. Explain in words what happens to equilibrium income as a result of the increase in the interest rate.

7. a. Graphically illustrate the impact of an open-market purchase by the Federal Reserve on the equilibrium interest rate using the theory of liquidity preference and the market for real money balances. Be sure to label:

i. the axes;

ii. the curves;

iii. the initial equilibrium values;

iv. the direction the curve shifts; and

v. the terminal equilibrium values.

b. Explain in words what happens to the equilibrium interest rate as a result of the open-market purchase.

8. a. As an economy moves into a recession, income falls. Illustrate graphically the impact of a decrease in income on the equilibrium interest rate using the theory of liquidity preference and the market for real money balances. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curve shifts; and v. the terminal equilibrium values.

b. Explain in words what happens to the equilibrium interest rate as a result of the fall in income.

9. In explaining the 2003 bill to cut taxes, President Bush is quoted as saying, "When people have more money, they can spend it on goods and services."

a. In the IS-LM model, will a tax cut change the money supply in the economy? Does a change in the money supply shift the IS or the LM curve?

b. In the IS-LM model, does a tax cut shift the IS or the LM curve?

c. Based on your answers in a and b, how can you reconcile the president's statement with economics? Can you suggest how his statement could be modified to be consistent with the IS-LM model?

10. Explain what force moves the market back to equilibrium if the market is initially in disequilibrium in:

a. the market for goods and services;

b. the market for real money balances.

11. Two identical countries, Country A and Country B, can each be described by a Keynesian-cross model. The MPC is 0.9 in each country. Country A decides to increase spending by $2 billion, while Country B decides to cut taxes by $2 billion. In which country will the new equilibrium level of income be greater?

12. a. The interest rate affects which variable in: (1) the market for goods and services and (2) the market for real money balances?

b. The level of income affects which variable in: (1) the market for goods and services and (2) the market for real money balances?

13. Compare the predicted impact of an increase in the money supply in the liquidity preference model versus the impact predicted by the quantity theory and the Fisher effect. Can you reconcile this difference?

14. The IS-LM model simultaneously determines equilibrium in two markets.

a. Which two markets?

b. What two variables adjust to bring equilibrium in the markets?

15. Explain why a decrease in planned investment, which is a change in the goods market, will upset the equilibrium in the money market.

16. Explain why an increase in the money supply, which is a change in the money market, will upset the equilibrium in the goods market.

17. During a recession, consumers may want to save more to provide themselves with a reserve to cushion possible job losses. Use the Keynesian model to describe the impact of an exogenous decrease in consumption (a decrease in C) on the equilibrium level of income in the economy. Will aggregate national saving increase?

18. a. Graphically illustrate how an increase in income affects the equilibrium levels of saving, investment, and the interest rate in the loanable funds model. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curve shifts; and v. the terminal equilibrium values.

b. Explain in words what happens to the equilibrium levels of saving, investment, and the interest rates as a result of the increase in income.

19. The above figure is a basic representation of the Keynesian cross. Just by looking at the graph, deduce the fundamental prerequisite condition for the Keynesian-cross model to hold true.

20. How can the government expenditure multiplier be reinterpreted in terms of savings?

21. The above diagram shows how a rise in government expenditure (G) shifts the IS curve from IS1 to IS2. What are the levels of investments in Y1 and Y2?

22. Of the following comments related to equilibrium level in an IS-LM model, which best denotes the logical causality, and why?

23. A falling investment function yields a falling IS curve, but a falling demand for real money balance curve yields a rising LM curve. Why?

24. The demand for money (even if we take into account real balances, it is demand for money deflated by price levels) helps determine the equilibrium level of the interest rate, even though holding money does not earn any interest income. How is this possible?

25. Assume that planned expenditure consists of consumption, investment, and government expenditures only. Further, assume that consumption C= c(Y - tY), where tY denotes taxes as a function of income. Calculate the equilibrium level of Y and the government expenditure multiplier.

26. Assume that a government raises its own expenditures and funds those expenditures by printing more money, thereby raising the money supply in the economy. How will this affect the IS-LM curve and the equilibrium level of income and the interest rate

27. Assume that a government decides to maintain a constant interest rate in the money market and adjusts the money supply accordingly. What would be the impact of such a policy on the LM curve and IS curve?

28. Assume an economy where the consumption function is defined as C= CC + cY, and the investment function is defined as I= ir, where Y is total income and r is the interest rate. What does the slope of the IS curve depend on?

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