Essay Questions:

1. The principal method used by the Federal Reserve to change money supply is
through open-market operations. Use the aggregate demand-aggregate supply
model to illustrate graphically the impact in the short run and the long run of a
Federal Reserve decision to increase open-market purchases. Be sure to label: 1.
The axes; 2. The curves; 3. The initial equilibrium values; 4. The direction the curves
shift; 5. The short-run equilibrium values; 6. The long-run equilibrium values. State
in words what happens to prices and output in the short run and the long run.
2. 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? 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 the equilibrium consumption, private saving, public saving, and
national saving?
d. How much does equilibrium income decreases when

is reduced to 200?

What is the multiplier for government spending?

3. 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: 1. The axes; 2. The curves; 3. The initial equilibrium values; 4. The direction
the curve shifts; and 6. The terminal equilibrium values.
b. Explain in words what happens to the equilibrium income as a result of the cut
in government spending and the time horizon appropriate for this analysis.
4. a. Graphically illustrate the impact of an open-market purchases 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: 1. The axes; 2. The curves; 3.
The initial equilibrium values; 4. The direction the curve shifts; and 6. The terminal
equilibrium values.
b. Explain in words what happens to the equilibrium interest rate as a result of
the open-market purchase.
5.

a. An economy is initially at the natural level of output. There is an increase in

ISLM

government spending. Use the

model to illustrate both the short-

run and long-run impact of this policy change. Be sure to label: 1. The axes;
2. The curves; 3. The initial equilibrium; 4. The short-run equilibrium; and 5.
The long-run equilibrium.
b. Explain in words the short-run and long-run impact of the change in
government spending on output and interest rates.

6. Assume the following model of the economy, with the price level fixed at 1.0:

C=0.8 ( Y T ) T =1,000
I =80020 r G=1,000

Y =C + I +G M s / P=M d / P=0.4 Y 40 r
M s=1,200
a. Write a numerical formula for the
alone. (Hint: Substitute out

curve, showing

LM

curve, showing

as a function of

C+ I +G=Y

and

I .

increases by 200. By how much will

increase in short-run

equilibrium? What is the government-purchases multiplier (the change in

divided by the change in

Y ,r , Y T , C , I , private saving,

public saving, and national saving? Check by ensuring that

d. Assume that

M /P . )

c. What are the short-run equilibrium values of

national saving equals

as a function of

C , I , G ,T .)

b. Write a numerical formula for the

alone. (Hint: Substitute out

IS

G )?

e. Assume that

is back at its original level of 1,000, but

supply) increases by 200. By how much will

M s )?

(the money

increase in short-run equilibrium?

What is the multiplier for money supply (the change in

in

divided by the change