Problem Set 6

Chapter 6: IS – LM Model
1. An economy has following functions:
C = 100 + 0.7Yd I = 240 + 0.2Y – 175r G = 1850
T = 100 + 0.2Y X = 400 M = 70 + 0.11Y
H = 750 DM = 1000 + 0.2Y – 100r
c = 0.8 d = 0.1
a. Define IS, LM curve.
b. Determine the equilibrium output and interest rate.
c. Suppose the government increases spending by 175. Determine the new IS curve.
d. Determine the new equilibrium output and interest rate.
e. At equilibrium, if the central bank conducts monetary expansion, how will the new
equilibrium interest rate and output change?
f. If Yp = 5000, how should fiscal and monetary policy be applied so that Yt = Yp.
2. Figure 6.1 shows the IS and LM curves for a closed economy with fixed prices.
a. AB and CD are two lines IS, LM. Show the IS and LM curves, respectively.
b. Comment on the equilibrium/imbalance of the commodity and money markets at
points E, F, G, H, and J.
c. How do you predict the economy will react if it is at point J?
d. For each of the following situations, show whether the IS and LM curves will shift?
And in what direction (assuming other factors are constant in each case):
(i) Increased confidence in the business world
(ii) Increase in the nominal money supply
(iii) Reduce government spending
(iv) One-time price increase
(v) Redistribution of income from the rich to the poor
(vi) Increase the amount of wealth that households hold
3. Figure 6.2 illustrates the effects of fiscal policy on income and equilibrium interest
rates with different assumptions about the slope of the LM curve. In each case, fiscal
policy is represented by the shift of the IS curve from IS0 to IS1.
a. Determine the initial equilibrium level of income and interest rate.
b. What caused the shift from IS0 to IS1?

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 c. Determine the full multiplier effect of fiscal policy, i.e. if interest rates remain
unchanged.
d. If fiscal policy is financed by bonds and the LM curve is relatively elastic, what is
the effect of fiscal policy on the equilibrium position?
e. If fiscal policy is financed by bonds and the LM curve is relatively inelastic, what
is the effect of fiscal policy on the equilibrium position?
f. Determine the degree of crowding out effect in each case.
g. What determines the elasticity of the LM curve?
h. How should the government adjust policy to achieve the full multiplier effect?
r r
A D IS0 IS1 LM0
r3 E F r3
r2 LM
r2 H r1
r1 J G
B
C
Y1 Y2 Y3 Y Y1 Y2Y3Y4
Figure 6.1 Figure 6.2
4. Figure 6.3 illustrates the effect of contractionary monetary policy on equilibrium
income and interest rates with different assumptions about the slope of the IS curve.
Here monetary policy is represented by the shift of LM from LM0 to LM1.
a. Determine the initial equilibrium level of income and interest rate.
b. What caused the shift from LM0 to LM1?
c. Show the effect of monetary policy on equilibrium when the IS curve is relatively
steep.
d. What will be the impact if the IS curve is relatively flat?
e. What determines the slope of the IS curve and therefore the efficiency of monetary
policy?

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 r IS0
LM1
r3 IS1
r2 LM0
r1 Figure 6.3

O Y1 Y2 Y3 Y
5. Suppose that the following equations show the behavior in the money and commodity
markets of a closed economy with fixed prices.
Commodity market: Money market:
Consumption: C = Co + Cm(Y – T) – dR Money supply: Ms = M
Investment: I = Io – iR Money demand: Md = kPY + N - mR
Tax: T = tY Equilibrium: Ms = Md
Equilibrium: Y = C + I + G
a. Define IS curve.
b. Define LM curve.
Suppose the variables and parameters in the model have the following values:
Co = 700; Io = 400; Cm = 0.8; d = 5; G = 649.6; i = 15; k = 0.25; M = 1200; m = 10; N =
200; P = 1; t = 0.2.
c. Plot IS and LM curve, then calculate the equilibrium interest and income.
d. Given these equilibrium values, calculate consumption and investment and assert that
the market for goods is in equilibrium.
e. Check if the money market is in equilibrium.
f. The government’s budget is surplus or deficit?
6. True/False? Explain.
a. Inflation targeting is a common policy in many countries.
b. Defining an inflation target reduces the role of a GDP target.
c. An increase in the inflation target rate will increase long-term interest rates.
d. Changes in interest rates affect the position of the aggregate demand curve in the
income-expenditure model.

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e. When the money market and interest rate effects are taken into account, the
government spending multiplier increases.
f. The movement along the IS curve tells us that the change in equilibrium income due
to a change in the interest rate shifts the aggregate demand curve.
g. The position of the LM line depends on the price level.
h. Fiscal and monetary policy affect aggregate demand through different ways, but
have similar effects.

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 MULTIPLE CHOICES
1. The IS curve illustrates that when income increases, the
a. Interest rate must fall to restore equilibrium in the goods market
b. Interest rate must rise to restore equilibrium in the asset market
c. Interest rate must fall to restore equilibrium in the asset market
d. Interest rate must rise to restore equilibrium in the goods market
2. As we move down along the IS curve:
a. Investment spending and savings both increase
b. Investment spending and savings both decline
c. Investment spending declines but savings increases
d. Investment spending increases but savings does not change
3. A fall in expected future output that doesn’t affect labor supply would ship the IS
curve…………
4. The LM curve will shift down when the
a. Expected inflation declines
b. Nominal money supply declines
c. Real money demand declines
d. Price level rises
5. A decrease in money demand causes the real interest rate to _____ and output to _____
in the short run, before prices adjust to restore equilibrium
a. Fall, rise c. Rise, fall
b. Rise, rise d. Fall, fall
6. In the IS-LM analysis, the effects of a temporary adverse supply shock do not include
a. An increase in the consumption level
b. A lower output level
c. An increase in price level
d. An increase in real interest rate
7. Classical economists contend that an increase in the nominal money supply will
a. shift the LM curve up, causing output to decline
b. not increase the real money supply
c. shift the LM curve down, causing output to increase
d. shift the LM curve up, causing output to increase
8. A decrease in taxes (when Ricardian equivalence holds) causes the real interest rate to
_____ and output to _____ in the short run, before prices adjust to restore equilibrium.
a. fall; fall c. fall; rise
b. rise; fall d. remain constant; remain constant
9. An increase in expected inflation causes the real interest rate to _____ and the price
level to _____ in general equilibrium.
a. remain unchanged; fall c. rise; rise
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 b. fall; fall d. remain unchanged; rise
10. A decrease in the nominal interest rate on money causes
a. the short run aggregate supply curve to shift up
b. the short run aggregate supply curve to shift down
c. the aggregate demand curve to shift down and to the left
d. the aggregate demand curve to shift up and to the right
11. Classical economists argue that money is neutral because
a. prices adjust quickly to a monetary expansion
b. prices are fixed in the short run
c. prices are slow to adjust to a monetary expansion
d. prices adjust to a monetary expansion only in the long run
12. If investment does not depend on the interest rate, then the ______ curve is ______.
a. IS; vertical c. LM; vertical
b. IS; horizontal d. LM; horizontal
13. In the IS-LM model, a decrease in government purchases leads to a(n) ______ in
planned expenditures, a(n) ______ in total income, a(n) ______ in money demand, and
a(n) ______ in the equilibrium interest rate.
a. decrease; decrease; decrease; decrease
b. increases; increase; increases; increase
c. decrease; decrease; increase; increase
d. increase; increase; decrease; decrease
14. If the short-run IS-LM equilibrium occurs at a level of income above the natural rate of
output, in the long run the ______ will ______ in order to return output to the natural
rate.
a. price level; increase
b. interest rate; decrease
c. money supply; increase
d. consumption function; decrease
15. The variable that links the market for goods and services and the market for real money
balances in the IS-LM model is the:
a. consumption function.
b. interest rate.
c. price level.
d. nominal money supply.
16. An IS curve shows combinations of:
a. taxes and government spending.
b. nominal money balances and price levels.
c. interest rates and income that bring equilibrium in the market for real balances.

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 d. interest rates and income that bring equilibrium in the market for goods and
services.
17. When drawn on a graph with income along the horizontal axis and the interest rate
along the vertical axis, the IS curve generally:
a. is vertical.
b. is horizontal.
c. slopes upward and to the right.
d. slopes downward and to the right.
18. Other things being equal, a reduction in government spending on goods and services
would:
a. Shift the IS to the right
b. Shift the IS to the left
c. Shift the IS to the left and the LM to the right
d. Shift the LM to the left and the IS to the right
Use the following information to answer question 19 and 20
In a closed economy assuming prices, interest rates, and exchange rates are constant,
give the following expected functions:
C = 200 + 0.8Yd I = 150 – 40r G = 700
T = 100 + 0.2Y SM = 1500 DM = 800 + 0.3Y – 35r
19. IS and LM curve’s equations are:
a. IS: r = -20 + 0.0086Y LM: Y = 2695 – 111r
b. IS: Y = 2695 – 111r LM: r = -20 + 0.0086Y
c. IS: r = 300 – 0.32Y LM: Y = 29 – 120r
d. All are wrong
20. Commodity and money markets will be in equilibrium at the level of output and interest
rates:
a. Y = 2514 billion and r = 1.62% c. Y = 243 billion and r = 2.2%
b. Y = 914 billion and r = 7.37% d. All are wrong