King’s College

Secondary 7A (2008-2009)
Economics
Assignment

Source: Supplementary Exercise on IS-LM Model

Date of submission: 11/11/2008 (Tue)

Attempt the following questions on single-lined paper.

1. In recent years, Japan has been described as having fallen into a liquidity trap.
(a) What is liquidity trap? (3 marks)
(b) In a liquidity trap situation, why would an expansionary monetary policy fail to stimulate output? (3
marks)
(c) If monetary policy does not work, fiscal policy may be a good alternative. But fiscal measures do not
seem to work in Japan either. Does the ineffectiveness of fiscal policy imply that a liquidity trap does
not really exist in Japan? Why or why not? (4 marks)

2. The LM curve is usually derived from the assumption that money supply is constant. Monetary policy is then
viewed as exogenous changes in the money supply – accompanied by endogenous changes in the interest
rate – that will induce shifts in (rather than movements along) the LM curve.
(a) Derive the LM curve, and show why it is in general upward sloping. (3 marks)
(b) When the monetary authority tightens its monetary policy, the money supply will be reduced. How
will the LM curve be affected? (3 marks)

3. Explain how each of the following affects the IS curve.

(a) an increase in the marginal propensity to consume (3 marks)
(b) a decrease in government expenditure and an increase in transfer payments by the same amount (5
marks)

4. Consider the following economy.

C = 10 + 0.8Y Y = real income
I = 30 C = consumption
Md = kPY I = investment
Md = money demand
P = price
Suppose k is a constant.

(a) Find the equilibrium real income. (1 mark)

(b) Show how changes in the money supply affect nominal income. (3 marks)
(c) Suppose the money supply is 200 and k = 1. Find the equilibrium price. (1 mark)
(d) Explain the impact of each of the following on the equilibrium real income and the equilibrium price.
(i) an increase in the money supply (3 marks)
(ii) an increase in investment (3 marks)
(e) Using the results in (d), explain the relationship between the money supply and the equilibrium price.
(2 marks)

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Suggested Solutions
The answers below are for reference only. They are not the only possible answers. Alternative answers are
acceptable so long as they are well reasoned.
1. (a) A liquidity trap refers to the situation where money demand becomes perfectly interest elastic
when the interest rate reaches a sufficiently low level. Under this situation people are trapped
into 100% money holding because the liquidity service money provides is well worth the
extremely low opportunity cost of holding money.
(b) Under normal situations, if there is an expansionary monetary policy, the LM curve will shift to
the right which will lead to a fall in interest rate and an increase in investment. As a result,
output will increase.
However, in a liquidity trap situation, the LM curve will be a horizontal line. With an
expansionary monetary policy, the LM curve will remain unchanged. Thus, both the interest
rate and investment demand will not be affected. Hence, an expansionary monetary policy
cannot stimulate output.
(c) With a fiscal expansion, the IS curve will shift upward to the right. It will fail to stimulate
output only if the LM curve is a vertical line. Since a vertical LM curve is inconsistent with a
horizontal LM curve that prevails in the presence of a liquidity trap, we can conclude that the
ineffectiveness of fiscal implies that a liquidity trap does not really exist in Japan.

2. (a) Given the money supply, a rise/fall in the transaction demand for money (induced by, say, an
increase/decrease in real income) has to be offset by a fall/rise in the asset demand for money
(induced by, say, an increase/decrease in the interest rate) in order to maintain money market
equilibrium. This means that the LM curve, which is a locus of (r, Y) combinations that clear
the money, is in general upward sloping.

(b) If there is a reduction in money supply, the money market can restore equilibrium only if there
is a fall in transactions demand for money (requiring a fall in real income), or only if there is a
fall in asset demand for money (requiring a rise in the interest rate). This implies that the LM
curve will shift to the left.
3. (a) With an increase in the marginal propensity to consume, the value of multiplier will rise. Since
the slope of the IS curve measures the change in income following a change in interest rate, a
fall in interest rate will lead to an increase in investment. The final change in income depends
on the multiplier effect, i.e. [ 1 / (1-c) ] × –b∆r. Hence, if there is an increase in the marginal
propensity to consume, the change in income will be greater. Thus, the IS curve will also
become flatter.
(b) Since the position of the IS curve depends on the amount of autonomous spending, with a
decrease in government expenditure, the IS curve will shift to the left which is equal to
[ 1 / (1-c) ×∆G* ]. If there is an increase in transfer payments by the same amount, the IS curve
will shift to the right. However, since the amount of consumption spending will only rise by a
portion of the transfer payments, the rightward shift will only be equal to [ 1 / (1-c) ] × c∆R*.
Eventually, the IS curve will shift to the left by the amount ∆G*.

4. (a) Y=C+I
Y = 10 + 0.8Y + 30
0.2Y = 40
Y = 200
(b) At equilibrium, money demand equals to money supply, i.e. Md = Ms. Given that k is a
constant, if there is an increase in money supply (Ms), money demand will increase by the same
percentage. As Md = kPY where PY denotes nominal income, nominal income will also rise by
the same percentage.
(c) At equilibrium, money demand equal to money supply. Thus if money supply is 200 and
k = 1, then
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 Md = Ms
(1) P (200) = 200
P=1
(d) (i) An increase in money supply will increase nominal income. Equilibrium real income
remains the same. Equilibrium price increases.
(ii) An increase in investment will increase real income. As money supply remains the
same, nominal income will not change. There will be a fall in price.
(e) Other things being constant, an increase in money supply will lead to a proportional increase in
price. However, price can change even money supply does not change. For instance, with
constant money supply, if there is an increase in equilibrium real income, price will decrease,
vice versa.

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