Romana Kavanova Ji Ovek

Questions to Lecture 7 IS-LM model and Aggregate demand

1. Draw Keynesian cross as a comparison o planned and reali!ed e"penditures. #$at is t$e intercept o planned e"penditure line% #$at is its slope% I go&ernment e"penditures would 'e positi&e unction o output( $ow would t$e Keynesian cross c$ange% #e will go o&er t$is on t$e re&iew session easier to e"plain t$an on paper.

)$e intersect point represents t$e e*uili'rium output. +lac, line planned e"penditures +lue line reali!ed e"penditures I go&ernment e"penditures would 'e positi&e unction o output t$e 'lue line would s$i t up.

-. #$at are t$e tools o iscal policy% Fiscal policy has 3 tools: 1. Increase or decrease government expenditures 2. Cut or increase taxes 3. Increase or decrease transfer payments .. /"plain t$e mec$anism o go&ernment e"penditures multiplier w$y is t$e e ect on t$e output greater t$an initial increase in go&ernment e"penditures% The government purchases multiplier is !" Initially# the increase in " causes an e$ual increase in # so %"# &ut 'ith increasing 'ill (e increasing C) *T+ ,further ,further -C ,further .o government purchases multiplier 'ill (e greater than 1# it is same principal li/e 'ith &an/0s creation of money 'hen lending out. 0. /"plain t$e mec$anism o ta" multiplier w$y is t$e e ect on t$e output greater t$an initial cut in ta"es% Increase in taxes reduces consumer spending# 'hich reduces e$uili(rium income. Firms reduce output# and income falls to'ard a ne' e$uili(rium. Tax multiplier is negative and smaller than " spending multiplier# (ecause consumers save a fraction )1*12C+ of a tax cut so the initial (oost is spending from a tax cut is smaller than from an e$ual increase in
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Romana Kavanova Ji Ovek

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Formula %C3I3"

1. 2ompare ta" and go&ernment e"penditures multiplier. Tax multiplier is smaller than " spending multiplier# (ecause consumers save a fraction )1*12C+ of a tax cut# so the initial (oost is spending from a tax cut is smaller than from an e$ual increase in ". Tax multiplier is negative 'hile government expenditures multiplier is positive. 3. #$at will 'e t$e total e ect on output in case t$at go&ernment leads a 'alanced 'udget i.e. inances increased go&ernment e"penditures 'y $ig$er ta"es% In this case# the spending multiplication effect 'ould not happen. 2eople 'ould receive money through government expenditures (ut their demand 'ould (e suppressed (y higher taxes. Still( t$ere will 'e a 'oost in t$e demand( due to initial in&estment o go&ernment 7. 4ow do you deri&e IS cur&e rom Keynesian cross 5picture6% The e$uation is % C) *T+ 3 I )r+ 3 " and it is a graph of all com(ination of r and result in goods mar/et e$uili(rium. that

7. 4ow is interest rate determined wit$in IS-LM model% Interest rate is 'ithin I.*41 model determined as an intersection point. It is determined on t$e money mar,et t$e interest rate t$at 'alances demand and supply o real money 'alances. 8. 4ow can a central 'an, a ect interest rate in t$e IS-LM model% Through changes in re$uired reserves# open mar/et operations and discount rate. 19. 4ow do you deri&e LM cur&e rom e*uili'rium on money mar,et 5picture6% The 41 curve is a graph of all com(ination of r and that e$uate the supply and demand for real money (alances. The e$uation is as follo's: 1!2 % 4 )r# +

Romana Kavanova Ji Ovek

)$is is a s$i t in LM cur&e I was as,ing or deri&ation can s$ow it on t$e session. 11. #$at are IS s$oc,s : gi&e an e"ample rom t$e real world% I. shoc/ are exogenous changes in the demand for goods and services. For example# change in (usiness or consumer confidence or expectations. This 'ill lead to change in Investments and!or change in Consumption. 1-. #$at are LM s$oc,s : gi&e an e"ample rom t$e real world% 5xogenous changes in the demand for money. For instance# a 'ave of credit card fraud increases demand for money. 1.. /"plain w$y AD cur&e slopes downward 5$int; deri&e AD cur&e rom IS-LM model6. 6s you can see on the picture the shift in 41 causes the 7utcome to decrease and increase in 2rice. Therefore the 68 curve slopes do'n'ard.

10. #$at is t$e impact o decrease in money supply on t$e interest rate( income( consumption and in&estment% 6n increase in 2rice causes the decrease in 1oney (alance 'hich affects the 41 curve )shifts left in this case+ 'hich then causes increase of Interest rate and decrease of Investment and 7utput. 9 picture<

Romana Kavanova Ji Ovek

11. #$at is t$e impact o increase in ta"es on t$e interest rate( income( consumption and in&estment% Increase in taxes decreases consumption# increase in interest rate# decreases in investment and increase in income. IS cur&e goes le t => lower cons( lower int rate( lower output( $ig$er in&estment 5picture6 13. 4ow does t$e e iciency o iscal policy depend on t$e s$ape o LM cur&e 5and w$y6% The flatter the 41 curve the more effective the fiscal policy is )Income 'ill rise much+. 6s the rise in "overnment expenditures 'ill cause rise in income# the increase in money demand does not raise interest rate much: so the investment is not cro'ded that much. 17. 4ow does t$e e iciency o monetary policy depend on t$e s$ape o IS cur&e 5and w$y6% The flatter the I. curve the more effective monetary policy is )again# income 'ill rise much+. 6s a rise in 1oney supply lo'ers the interest rate# investments rise more in response to the fall in interest rate# so output rises more. 17. /"plain w$y eac$ o t$e ollowing statements is true 5draw $e picture o Keynesian cross?money mar,et and e"plain6. Discuss t$e impact o monetary and iscal policy in eac$ o t$ese special cases. again( need to co&er during session a. I in&estment does not depend on t$e interest rate( IS cur&e is &ertical. This assumes that any change in interest rate 'ouldn0t affect the Investment resulting in sta(ili;ed outcome. This could (e achieved (y changes in fiscal policy. 7utcome 'ould only shift to the left or to the right (ut I. curve 'ould remain vertical.

r IS curve

'. I money demand does not depend on t$e interest rate( LM cur&e is &ertical. This assumes that any change in interest rate 'ouldn0t affect the money demanded. This could (e achieved (y applying various monetary policies. The outcome 'ould again shift only to right or left.

Romana Kavanova Ji Ovek

r LM curve

c. I money demand does not depend on income( LM cur&e is $ori!ontal. This could (e achieved through different monetary policies and the 41 curve 'ould only shift up or do'n.

r LM curve

d. I money demand is e"tremely sensiti&e to t$e interest rate( LM cur&e is $ori!ontal. It could (e descri(ed again 'ith the previous picture. 41 curve 'ould (e again <ust shifting up and do'n. 18. Descri'e t$e s$ort run and long run e ect o a positi&e IS s$oc, in IS-LM and ADAS ramewor,. 6 positive I. shoc/ shifts I. and 68 to the right and causing the 7utcome to increase 4ong run 9 same output# higher prices

Romana Kavanova Ji Ovek

-9. Descri'e t$e s$ort run and long run e ect o a negati&e LM s$oc, in IS-LM and ADAS ramewor,. 6 negative 41 shoc/ shifts 41 up and 68 to the left and causing the 7utcome to decrease. -1. /"plain t$e spending $ypot$esis o determinants o t$e @reat Depression. 6sserts that the 8epression 'as largely due to an exogenous fall in the demand for goods and services# a left'ard shift of the I. curve. 7utput and interest rates (oth fell# 'hich is 'hat a left'ard shift of the I. curve. --. /"plain t$e money $ypot$esis o determinants o t$e @reat Depression. 6sserts that the 8epression 'as largely 'as due to huge fall in the money supply. 11 fell (y 2=> during 1?2?*33