Macroeconomics 9th Edition Mankiw

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1. John Maynard Keynes wrote that responsibility for low income and high unemployment
in economic downturns should be placed on:
A) low levels of capital.
B) an untrained labor force.
C) inadequate technology.
D) low aggregate demand.

2. According to classical theory, national income depends on ______, while Keynes

proposed that ______ determined the level of national income.
A) aggregate demand; aggregate supply
B) aggregate supply; aggregate demand
C) monetary policy; fiscal policy
D) fiscal policy; monetary policy

3. The IS–LM model takes ______ as exogenous.

A) the price level and national income
B) the price level
C) national income
D) the interest rate

4. A 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.

5. In the IS–LM model, which two variables are influenced by the interest rate?
A) supply of nominal money balances and demand for real balances
B) demand for real money balances and government purchases
C) supply of nominal money balances and investment spending
D) demand for real money balances and investment spending

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 6. Two interpretations of the IS–LM model are that the model explains:
A) the determination of income in the short run when prices are fixed, or what shifts
the aggregate demand curve.
B) the short-run quantity theory of income, or the short-run Fisher effect.
C) the determination of investment and saving, or what shifts the liquidity preference
schedule.
D) changes in government spending and taxes, or the determination of the supply of
real money balances.

7. The IS curve plots the relationship between the interest rate and ______ that arises in the
market for ______.
A) national income; goods and services
B) the price level; goods and services
C) national income; money
D) the price level; money

8. For the purposes of the Keynesian cross, planned expenditure consists of:
A) planned investment.
B) planned government spending.
C) planned investment and government spending.
D) planned investment, government spending, and consumption expenditures.

9. In the Keynesian-cross model, actual expenditures equal:

A) GDP.
B) the money supply.
C) the supply of real balances.
D) unplanned inventory investment.

10. In the Keynesian-cross model, actual expenditures differ from planned expenditures by
the amount of:
A) liquidity preference.
B) the government-purchases multiplier.
C) unplanned inventory investment.
D) real money balances.

11. Planned expenditure is a function of:

A) planned investment.
B) planned government spending and taxes.
C) planned investment, government spending, and taxes.
D) national income and planned investment, government spending, and taxes.

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12. When planned expenditure is drawn on a graph as a function of income, the slope of the
line is:
A) zero.
B) between zero and one.
C) one.
D) greater than one.

13. When drawn on a graph with Y along the horizontal axis and PE along the vertical axis,
the line showing planned expenditure rises to the:
A) right with a slope less than one.
B) right with a slope greater than one.
C) left with a slope less than one.
D) left with a slope greater than one.

14. The equilibrium condition in the Keynesian-cross analysis in a closed economy is:
A) income equals consumption plus investment plus government spending.
B) planned expenditure equals consumption plus planned investment plus government
spending.
C) actual expenditure equals planned expenditure.
D) actual saving equals actual investment.

15. With planned expenditure and the equilibrium condition Y = PE drawn on a graph with
income along the horizontal axis, if income exceeds expenditure, then income is to the
______ of equilibrium income and there is unplanned inventory ______.
A) right; decumulation
B) right; accumulation
C) left; decumulation
D) left; accumulation

16. According to the analysis underlying the Keynesian cross, when planned expenditure
exceeds income:
A) income falls.
B) planned expenditure falls.
C) unplanned inventory investment is negative.
D) prices rise.

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 17. When firms experience unplanned inventory accumulation, they typically:
A) build new plants.
B) lay off workers and reduce production.
C) hire more workers and increase production.
D) call for more government spending.

18. The Keynesian cross shows:

A) determination of equilibrium income and the interest rate in the short run.
B) determination of equilibrium income and the interest rate in the long run.
C) equality of planned expenditure and income in the short run.
D) equality of planned expenditure and income in the long run.

Use the following to answer questions 19-21:

Exhibit: Keynesian Cross

19. (Exhibit: Keynesian Cross) In this graph, the equilibrium levels of income and
expenditure are:
A) Y1 and PE1.
B) Y2 and PE2.
C) Y3 and PE3.
D) Y3 and PE4.

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20. (Exhibit: Keynesian Cross) In this graph, if firms are producing at level Y1, then
inventories will ______, inducing firms to ______ production.
A) rise; increase
B) rise; decrease
C) fall; increase
D) fall; decrease

21. (Exhibit: Keynesian Cross) In this graph, if firms are producing at level Y3, then
inventories will ______, inducing firms to ______ production.
A) rise; increase
B) rise; decrease
C) fall; increase
D) fall; decrease

22. The government-purchases multiplier indicates how much ______ change(s) in response
to a $1 change in government purchases.
A) the budget deficit
B) consumption
C) income
D) real balances

23. In the Keynesian-cross model, if the MPC equals 0.75, then a $1 billion increase in
government spending increases planned expenditures by ______ and increases the
equilibrium level of income by ______.
A) $1 billion; more than $1 billion
B) $0.75 billion; more than $0.75 billion
C) $0.75 billion; $0.75 billion
D) $1 billion; $1 billion

24. According to the Keynesian-cross analysis, when there is a shift upward in the
government-purchases schedule by an amount G and the planned expenditure schedule
by an equal amount, then equilibrium income rises by:
A) one unit.
B) G.
C) G divided by the quantity one minus the marginal propensity to consume.
D) G multiplied by the quantity one plus the marginal propensity to consume.

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25. In the Keynesian-cross model, if government purchases increase by 100, then planned
expenditures ______ for any given level of income.
A) increase by 100
B) increase by more than 100
C) decrease by 100
D) increase, but by less than 100

26. In the Keynesian-cross model, if government purchases increase by 250, then the
equilibrium level of income:
A) increases by 250.
B) increases by more than 250.
C) decreases by 250.
D) increases, but by less than 250.

27. In the Keynesian-cross model, fiscal policy has a multiplied effect on income because
fiscal policy:
A) increases the amount of money in the economy.
B) changes income, which changes consumption, which further changes income.
C) is government spending and, therefore, more powerful than private spending.
D) changes the interest rate.

28. According to the Keynesian-cross analysis, if MPC stands for marginal propensity to
consume, then a rise in taxes of T will:
A) decrease equilibrium income by T.
B) decrease equilibrium income by T/(1 – MPC).
C) decrease equilibrium income by (T)(MPC)/(1 – MPC).
D) not affect equilibrium income at all.

29. In the Keynesian-cross model, if taxes are reduced by 100, then planned expenditures
______ for any given level of income.
A) increase by 100
B) increase by more than 100
C) decrease by 100
D) increase, but by less than 100

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30. In the Keynesian-cross model, if taxes are reduced by 250, then the equilibrium level of
income:
A) increases by 250.
B) increases by more than 250.
C) decreases by 250.
D) increases, but by less than 250.

31. The tax multiplier indicates how much ______ change(s) in response to a $1 change in
taxes.
A) the budget deficit
B) consumption
C) income
D) real balances

32. In the Keynesian-cross model with a given MPC, the government-expenditure multiplier
______ the tax multiplier.
A) is larger than
B) equals
C) is smaller than
D) is the inverse of the

33. In the Keynesian-cross model, if the MPC equals 0.75, then a $1 billion decrease in
taxes increases planned expenditures by ______ and increases the equilibrium level of
income by ______.
A) $1 billion; more than $1 billion
B) $0.75 billion; more than $0.75 billion
C) $0.75 billion; $0.75 billion
D) $1 billion; $1 billion

34. After the Kennedy tax cut in 1964, real GDP:

A) fell and unemployment rose.
B) rose and unemployment fell.
C) and unemployment both rose.
D) and unemployment both fell.

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35. Both Keynesians and supply-siders believe a tax cut will lead to growth:
A) and both agree it works through incentive effects.
B) but Keynesians believe it works through incentive effects whereas supply-siders
believe it works through aggregate demand.
C) but Keynesians believe it works through aggregate demand whereas supply-siders
believe it works through incentive effects.
D) and both agree it works through aggregate demand.

36. Tax cuts stimulate ______ by improving workers' incentive and expand ______ by
raising households' disposable income.
A) velocity; demand for loanable funds
B) demand for loanable funds; velocity
C) aggregate demand; aggregate supply
D) aggregate supply; aggregate demand

37. In the Keynesian-cross model, the equilibrium level of income is determined by:
A) the factors of production.
B) the money supply.
C) planned spending.
D) liquidity preference.

38. In the Keynesian-cross model, what adjusts to move the economy to equilibrium
following a change in exogenous planned spending?
A) planned spending
B) the interest rate
C) production
D) the price level

39. The Keynesian-cross analysis assumes planned investment:

A) is fixed and so does the IS analysis.
B) depends on the interest rate and so does the IS analysis.
C) is fixed, whereas the IS analysis assumes it depends on the interest rate.
D) depends on expenditure and so does the IS analysis.

40. The simple investment function shows that investment ______ as ______ increases.
A) decreases; the interest rate
B) increases; the interest rate
C) decreases; government spending
D) increases; government spending

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41. An increase in the interest rate:
A) reduces planned investment, because the interest rate is the cost of borrowing to
finance investment projects.
B) increases planned investment, because people who make money from interest have
more money to invest.
C) has no effect on investment.
D) may be caused by a drop in investment demand.

42. An explanation for the slope of the IS curve is that as the interest rate increases, the
quantity of investment ______, and this shifts the expenditure function ______, thereby
decreasing income.
A) increases; downward
B) increases; upward
C) decreases; upward
D) decreases; downward

43. In the Keynesian-cross model, a decrease in the interest rate ______ planned investment
spending and ______ the equilibrium level of income.
A) increases; increases
B) increases; decreases
C) decreases; decreases
D) decreases; increases

44. 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.

45. Along any given IS curve:

A) tax rates are fixed, but government spending varies.
B) government spending is fixed, but tax rates vary.
C) both government spending and tax rates vary.
D) both government spending and tax rates are fixed.

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46. The IS curve shifts when any of the following economic variables change except:
A) the interest rate.
B) government spending.
C) tax rates.
D) the marginal propensity to consume.

47. An increase in government spending generally shifts the IS curve, drawn with income
along the horizontal axis and the interest rate along the vertical axis:
A) downward and to the left.
B) upward and to the right.
C) upward and to the left.
D) downward and to the right.

48. An increase in taxes shifts the IS curve, drawn with income along the horizontal axis
and the interest rate along the vertical axis:
A) downward and to the left.
B) upward and to the right.
C) upward and to the left.
D) downward and to the right.

49. Based on the Keynesian model, one reason to support government spending increases
over tax cuts as measures to increase output is that:
A) government spending increases the MPC more than tax cuts.
B) the government-spending multiplier is larger than the tax multiplier.
C) government-spending increases do not lead to unplanned changes in inventories,
but tax cuts do.
D) increases in government spending increase planned spending, but tax cuts reduce
planned spending.

50. Gary Becker's criticism of government spending on infrastructure as part of President

Obama's stimulus plan was that:
A) spending on infrastructure would not increase production in the economy.
B) there is a conflict between where spending on infrastructure would benefit
employment and where infrastructure is most needed.
C) government spending on infrastructure is less effective in increasing production
than an equal amount of private spending on infrastructure.
D) government spending on infrastructure only increases demand, but tax cuts
increase demand and supply.

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51. One argument in favor of tax cuts over spending-based fiscal stimulus is that:
A) tax cuts increase the MPC by a larger amount than government spending.
B) tax cuts temporarily increase planned spending, but government spending
permanently increases private spending.
C) in theory the tax multiplier is larger than the government spending multiplier.
D) historically tax cuts have been more successful than spending-based fiscal
stimulus.

52. Changes in fiscal policy shift the:

A) LM curve.
B) money demand curve.
C) money supply curve.
D) IS curve.

53. Along an IS curve all of the following are always true except:
A) planned expenditures equal actual expenditures.
B) planned expenditures equal income.
C) the demand for real balances equals the supply of real balances.
D) there are no unplanned changes in inventories.

54. 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.
D) interest rates and income that bring equilibrium in the market for goods and
services.

55. The IS curve shows combinations of ______ that are consistent with equilibrium in the
market for goods and services.
A) inflation and unemployment
B) the price level and real output
C) the interest rate and the level of income
D) the interest rate and real money balances

56. The IS curve generally determines:

A) income.
B) the interest rate.
C) both income and the interest rate.
D) neither income nor the interest rate.

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57. When the LM curve is drawn, the quantity that is held fixed is:
A) the nominal money supply.
B) the real money supply.
C) government spending.
D) the tax rate.

58. According to the theory of liquidity preference, the supply of real money balances:
A) decreases as the interest rate increases.
B) increases as the interest rate increases.
C) increases as income increases.
D) is fixed.

59. According to the theory of liquidity preference, the supply of nominal money balances:
A) is chosen by the central bank.
B) depends on the interest rate.
C) varies with the price level.
D) changes as the level of income changes.

60. The theory of liquidity preference implies that:

A) as the interest rate rises, the demand for real balances will fall.
B) as the interest rate rises, the demand for real balances will rise.
C) the interest rate will have no effect on the demand for real balances.
D) as the interest rate rises, income will rise.

61. If the interest rate is above the equilibrium value, the:

A) demand for real balances exceeds the supply.
B) supply of real balances exceeds the demand.
C) market for real balances clears.
D) demand for real balances increases.

62. According to the theory of liquidity preference, if the supply of real money balances
exceeds the demand for real money balances, individuals will:
A) sell interest-earning assets in order to obtain non-interest-bearing money.
B) purchase interest-earning assets in order to reduce holdings of non-interest-bearing
money.
C) purchase more goods and services.
D) be content with their portfolios.

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 63. According to the theory of liquidity preference, if the demand for real money balances
exceeds the supply of real money balances, individuals will:
A) sell interest-earning assets in order to obtain non-interest-bearing money.
B) purchase interest-earning assets in order to reduce holdings of non-interest-bearing
money.
C) purchase fewer goods and services.
D) be content with their portfolios.

Use the following to answer questions 64-66:

Exhibit: Market for Real Money Balances

64. (Exhibit: Market for Real Money Balances) Based on the graph, the equilibrium levels
of interest rates and real money balances are:
A) r1 and M1/P1
B) r2 and M2/P2
C) r3 and M2/P2
D) r3 and M3/P3

65. (Exhibit: Market for Real Money Balances) Based on the graph, if the interest rate is r1,
then people will ______ bonds and the interest rate will ______.
A) sell; rise
B) sell; fall
C) buy; rise
D) buy; fall

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66. (Exhibit: Market for Real Money Balances) Based on the graph, if the interest rate is r3,
then people will ______ bonds and the interest rate will ______.
A) sell; rise
B) sell; fall
C) buy; rise
D) buy; fall

67. The theory of liquidity preference implies that, other things being equal, an increase in
the real money supply will:
A) lower the interest rate.
B) raise the interest rate.
C) have no effect on the interest rate.
D) first lower and then raise the interest rate.

68. When Paul Volcker tightened the money supply:

A) the inflation rate immediately fell.
B) nominal interest rates fell in the short run.
C) nominal interest rates fell in the long run.
D) real balances rose in the short run.

69. According to the theory of liquidity preference, tightening the money supply will
______ nominal interest rates in the short run, and, according to the Fisher effect,
tightening the money supply will ______ nominal interest rates in the long run.
A) increase; increase
B) increase; decrease
C) decrease; decrease
D) decrease; increase

70. Reducing the money supply ______ nominal interest rates in the short run, and ______
nominal interest rates in the long run.
A) produces no change in; raises
B) raises; produces no change in
C) raises; lowers
D) lowers; raises

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71. In the liquidity preference model, what adjusts to move the money market to
equilibrium following a change in the money supply?
A) planned spending
B) the interest rate
C) production
D) the price level

72. The theory of liquidity preference implies that the quantity of real money balances
demanded is:
A) negatively related to both the interest rate and income.
B) positively related to both the interest rate and income.
C) positively related to the interest rate and negatively related to income.
D) negatively related to the interest rate and positively related to income.

73. With the real money supply held constant, the theory of liquidity preference implies that
a higher income level will be consistent with:
A) no change in the interest rate.
B) a lower interest rate.
C) a higher interest rate.
D) first a lower and then a higher interest rate.

74. According to the theory of liquidity preference, holding the supply of real money
balances constant, an increase in income will ______ the demand for real money
balances and will ______ the interest rate.
A) increase; increase
B) increase; decrease
C) decrease; decrease
D) decrease; increase

75. The LM curve, in the usual case:

A) is vertical.
B) is horizontal.
C) slopes down to the right.
D) slopes up to the right.

76. An explanation for the slope of the LM curve is that as:

A) the interest rate increases, income becomes higher.
B) the interest rate increases, income becomes lower.
C) income rises, money demand rises, and a higher interest rate is required.
D) income rises, money demand rises, and a lower interest rate is required.

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77. An LM curve shows combinations of:
A) taxes and government spending.
B) nominal money balances and price levels.
C) interest rates and income, which bring equilibrium in the market for real money
balances.
D) interest rates and income, which bring equilibrium in the market for goods and
services.

78. A decrease in the real money supply, other things being equal, will shift the LM curve:
A) downward and to the left.
B) upward and to the left.
C) downward and to the right.
D) upward and to the right.

79. A decrease in the nominal money supply, other things being equal, will shift the LM
curve:
A) upward and to the right.
B) downward and to the right.
C) downward and to the left.
D) upward and to the left.

80. A decrease in the price level, holding nominal money supply constant, will shift the LM
curve:
A) upward and to the right.
B) downward and to the right.
C) downward and to the left.
D) upward and to the left.

81. An increase in income raises money ______ and ______ the equilibrium interest rate.
A) demand; raises
B) demand; lowers
C) supply; raises
D) supply; lowers

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82. At a given interest rate, an increase in the nominal money supply ______ the level of
income that is consistent with equilibrium in the market for real balances.
A) raises
B) lowers
C) does not change
D) may either raise or lower

83. Changes in monetary policy shift the:

A) LM curve.
B) planned spending curve.
C) money demand curve.
D) IS curve.

84. The LM curve shows combinations of ______ that are consistent with equilibrium in the
market for real money balances.
A) inflation and unemployment
B) the price level and real output
C) the interest rate and the level of income
D) the interest rate and real money balances

85. For any given interest rate and price level, an increase in the money supply:
A) lowers income.
B) raises income.
C) has no effect on income.
D) lowers velocity.

86. The LM curve generally determines:

A) income.
B) the interest rate.
C) both income and the interest rate.
D) neither income nor the interest rate.

87. The IS and LM curves together generally determine:

A) income only.
B) the interest rate only.
C) both income and the interest rate.
D) income, the interest rate, and the price level.

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88. The interest rate determines ______ in the goods market and money ______ in the
money market.
A) government spending; demand
B) government spending; supply
C) investment spending; demand
D) investment spending; supply

89. The intersection of the IS and LM curve determines the values of:
A) r, Y, and P, given G, T, and M.
B) r, Y, and M, given G, T, and P.
C) r and Y, given G, T, M, and P.
D) p and Y, given G, T, and M.

90. Equilibrium levels of income and interest rates are ______ related in the goods and
services market, and equilibrium levels of income and interest rates are ______ related
in the market for real money balances.
A) positively; positively
B) positively; negatively
C) negatively; negatively
D) negatively; positively

91. The IS–LM model is generally used:

A) only in the short run.
B) only in the long run.
C) both in the short run and the long run.
D) in determining the price level.

92. The IS curve provides combinations of interest rates and income that satisfy equilibrium
in the market for ______, and the LM curve provides combinations of interest rates and
income that satisfy equilibrium in the market for ______.
A) saving and investment; planned spending
B) real-money balances; loanable funds
C) goods and services; real money balances
D) real-money balances; goods and services

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93. According to the Keynesian-cross analysis, if the marginal propensity to consume is 0.6,
and government expenditures and autonomous taxes are both increased by 100,
equilibrium income will rise by:
A) 0.
B) 100.
C) 150.
D) 250.

94. In the Keynesian-cross analysis, if the consumption function is given by C = 100 +

0.6(Y – T), and planned investment is 100, G is 100, and T is 100, then equilibrium Y is:
A) 350.
B) 400.
C) 600.
D) 750.

95. Using the Keynesian-cross analysis, assume that the consumption function is given by C
= 100 + 0.6(Y – T). If planned investment is 100 and T is 100, then the level of G needed
to make equilibrium Y equal 1,000 is:
A) 200.
B) 240.
C) 250.
D) 260.

96. In the Keynesian-cross analysis, assume that the analysis of taxes is changed so that
taxes, T, are made a function of income, as in T = T + tY, where T and t are parameters
of the tax code and t is positive but less than 1. As compared to a case where t is zero,
the multiplier for government purchases in this case will:
A) not change.
B) be smaller.
C) be bigger.
D) be equal to 1.

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 97. Consider the impact of an increase in thriftiness in the Keynesian-cross analysis.
Assume that the marginal propensity to consume is unchanged, but the intercept of the
consumption function is made smaller so that at every income level saving is greater.
This will:
A) lower equilibrium income by the decrease in the intercept multiplied by the
multiplier.
B) lower equilibrium income by the decrease in the intercept.
C) raise equilibrium income by the decrease in the intercept.
D) raise equilibrium income by the decrease in the intercept multiplied by the
multiplier.

98. Consider the impact of an increase in thriftiness in the Keynesian-cross analysis.

Assume that the marginal propensity to consume is unchanged, but the intercept of the
consumption function is made smaller so that at every income level saving is greater.
This will:
A) increase saving by the decrease in the intercept.
B) lead to no change in saving.
C) decrease saving by the decrease in the intercept.
D) lead to an increase in investment.

99. Assume that the money demand function is (M/P)d = 2,200 – 200r, where r is the
interest rate in percent. The money supply M is 2,000 and the price level P is 2. The
equilibrium interest rate is ______ percent.
A) 2
B) 4
C) 6
D) 8

100. Assume that the money demand function is (M/P)d = 2,200 – 200r, where r is the
interest rate in percent. The money supply M is 2,000 and the price level P is 2. If the
price level is fixed and the supply of money is raised to 2,800, then the equilibrium
interest rate will:
A) drop by 4 percent.
B) drop by 2 percent.
C) drop by 1 percent.
D) remain unchanged.

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101. Assume that the money demand function is (M/P)d = 2,200 – 200r, where r is the
interest rate in percent. The money supply M is 2,000 and the price level P is 2. If the
price level is fixed and the Fed wants to fix the interest rate at 7 percent, it should set the
money supply at:
A) 2,000.
B) 1,800.
C) 1,600.
D) 1,400.

102. 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
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?

103. 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
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?

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104. 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
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?

105. 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.

106. 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.

107. 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.

Page 22
108. 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.

109. 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.

110. 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?

111. 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.

112. 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?

113. 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?

Page 23
114. 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?

115. 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?

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

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

118. 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?

119. 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.

Page 24
Use the following to answer question 120:

120. 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.

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

Page 25
Use the following to answer question 122:

122. 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?

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

A. The goods and services market as denoted by IS curve gives an equilibrium level of Y, which
when posited in the LM curve gives the equilibrium level of r.

B. The goods and services market as denoted by the IS curve gives an interest rate as a function
of Y which helps solve for equilibrium in the money market.

C. The equilibrium rate of interest as determined by the demand for real balances for a given
level of money supply in the money market helps determine the equilibrium level of investment
that finally helps reach an equilibrium level of income.

Page 26
124. A falling investment function yields a falling IS curve, but a falling demand for real money
balance curve yields a rising LM curve. Why?

125. 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?

126. 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.

127. 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

128. 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?

129. 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?

Page 27
Answer Key
1. D
2. B
3. B
4. B
5. D
6. A
7. A
8. D
9. A
10. C
11. D
12. B
13. A
14. C
15. B
16. C
17. B
18. C
19. B
20. C
21. B
22. C
23. A
24. C
25. A
26. B
27. B
28. C
29. D
30. B
31. C
32. A
33. B
34. B
35. C
36. D
37. C
38. C
39. C
40. A
41. A
42. D
43. A
44. D

Page 28
45. D
46. A
47. B
48. A
49. B
50. B
51. D
52. D
53. C
54. D
55. C
56. D
57. B
58. D
59. A
60. A
61. B
62. B
63. A
64. B
65. D
66. A
67. A
68. C
69. B
70. C
71. B
72. D
73. C
74. A
75. D
76. C
77. C
78. B
79. D
80. B
81. A
82. A
83. A
84. C
85. B
86. D
87. C
88. C
89. C
90. D

Page 29
 91. A
92. C
93. B
94. C
95. D
96. B
97. A
98. A
99. C
100. B
101. C
102. a. Planned spending is 1,600. Inventory decumulation is 100. Equilibrium Y should be higher
than 1,500.
b. Equilibrium Y is 1,800.
c. Consumption is 1,200, private saving is 300, public saving is 0, and national saving is 300.
d. Equilibrium Y decreases by 300. The multiplier is 3.
103. a. Y = 2,800 – 400r or r = 7 – 0.0025Y.
b. The slope of the IS curve is –0.0025.
c. If r is 1 percent, I is 800 and Y is 2,400. If r is 3 percent, I is 400 and Y is 1,600. If r is 5
percent, I is 0 and Y is 800.
d. IS shifts upward and to the right.
104. a. Y = 1,600 + 200r, or r = –8 + 0.005Y.
b. The slope of the LM curve is 0.005.
c. If r is 1 percent, Y is 1,800. If r is 3 percent, Y is 2,200. If r is 5 percent, Y is 2,600.
d. The LM curve shifts downward and to the right.
e. The LM curve shifts downward and to the right.
f. The LM curve shifts upward and to the left.
105. a.

b. The equilibrium level of income falls. This analysis is appropriate in the short run when
prices and the interest rate are constant.
106. a.

Page 30
 b. The equilibrium level of income increases. This analysis is appropriate in the short run when
prices and the interest rate are constant.
107. a.

b. The equilibrium level of income falls.

108. a.

b. The equilibrium interest rate falls.

Page 31
109. a.

b. The equilibrium interest rate falls.

110. a. Tax cuts do not change the money supply, which is controlled by the central bank (Federal
Reserve). Changes in the money supply shift the LM curve.
b. Tax cuts shift the IS curve.
c. The president used the word money as it is popularly understood, but his use was not
according to its macroeconomic meaning. Rephrasing the statement to say “when people
have more disposable income as a result of the tax cut, they can spend more on goods and
services” would make the statement consistent with the economic model.
111. a. In the market for goods and services if planned spending exceeds actual spending, for
example, then inventories will become depleted, firms will increase production, hire more
workers, and increase income and output until equilibrium is achieved.
b. In the market for real money balances if the supply of real money balances exceeds the
demand, for example, households will buy bonds, driving bond prices up and interest rates
down. Interest rates will continue to decline until households are eventually willing to hold
the amount of real money balances supplied.
112. Income in Country A will increase more. The government-spending multiplier in
Country A equals 10, so income in Country A will increase by $20 billion. The tax
multiplier in Country B equals 9, so income in Country B will only increase by $18
billion.
113. a. The interest rate affects (1) investment in the market for goods and services, and (2) the
demand for money in the market for real money balances.
b. The level of income affects (1) consumption in the market for goods and services, and (2)
the demand for money in the market for real money balances.
114. The liquidity preference model predicts that an increase in the money supply will
decrease interest rates. The quantity theory predicts that an increase in the money supply
will increase inflation, which, via the Fisher effect, will increase the nominal interest
rate. The liquidity preference model emphasizes the short-run effect when prices are
fixed, while the quantity theory and Fisher effect are long-run effects when prices are
flexible.
115. a. The IS–LM model simultaneously determines equilibrium in the goods market and the
money market.
b. The interest rate (r) and real output (Y) are the two variables that adjust to bring equilibrium
in both markets.
116. A decrease in planned investment spending decreases planned spending, which will

Page 32
 reduce the equilibrium level of income in the goods market. A decrease in income
decreases the demand for real money balances in the money market, which will decrease
the equilibrium level of the interest rate in the money market. Graphically, this is
represented by a shift in the IS curve to the left and a movement down the LM curve.
117. An increase in the money supply will decrease the equilibrium interest rate in the money
market. A lower interest rate will increase investment spending in the goods market,
which will increase the equilibrium level of income in the goods market. Graphically,
this is represented by a shift in the LM curve to the right and a movement down the IS
curve.
118. A decrease in exogenous consumption reduces planned spending, which reduces the
equilibrium level of income by a greater amount via the consumption spending
multiplier, i.e., a decrease in consumption spending leads to a decrease in income, which
leads to another decrease in consumption spending, and so on. At the new lower
equilibrium level of income, both income and consumption spending will have
decreased by the same amount, so that national saving (Y – C – G) will be unchanged.
119. a.

b. The equilibrium levels of saving and investment increase. The interest rate falls.
120. The slope of the planned expenditure line has to be less than 45° in order to intercept the
actual expenditure curve. Given that the slope of the planned expenditure curve is the
marginal propensity to consume (MPC) and that a 45° line has a slope = 1, this implies
that the MPC has to be less than 1. This in turns means that not all of the income earned
is spent on consumption, and people have an intention to save.
121. We know that Y / G = 1/(1MPC). Rearranging the equation, we have Y =
G/(1MPC). MPC denotes how many people are willing to spend on consumption for
every dollar earned. (1-MPC) denotes how many people save out of every dollar earned.
Therefore, for every increase of government expenditure, the income rise is inversely
related to the propensity to save; the lower the propensity to save the greater is the rise
in total income.

Page 33
122. The investment level remains same in both cases. The shift in the IS curve denotes that for the
same levels of investment and consumption, the economy is now at a higher level of output Y
because of a rise in government expenditure G.
123. Option (c) is correct. IS-LM analysis assumes prices to be fixed. Given that money supply is
autonomously determined by the central bank, the supply of real balances is fixed. This helps
determine the equilibrium level of the interest rate in the money market in the short run, thereby
determining the level of investment in the economy. As government expenditure is parametric
and consumption is a function of total income, the equilibrium level of investment helps
determine the equilibrium level of output Y in the economy.
124. Both the IS and the LM curves plot relationships between output level Y and interest rate r in the
goods and services market and money market respectively. Both are logically derived from the
investment function and real money demand curve, respectively, and are not functions of these

Page 34
 demand schedules.

In the goods and services market, a higher rate of interest would lower the investment level and
thereby reduce total output Y, and hence the IS curve is falling. In the money market, a higher
level of interest rate denotes higher demand for real balances, which can only happen under
higher levels of income (given prices are assumed constant) and is hence an upward rising
curve.
125. Money is just one form of financial asset that we hold. At every point of time, individuals
calculate a tradeoff between holding their assets in the most liquid form and potential income
revenue they could earn from other asset forms. This is why the LM curve is called the
liquidity preference and money supply curve, as the demand for real balance reflects the demand
for liquidity. Because of this constant tradeoff, the demand for liquid money is intrinsically
linked to the interest rate, and the equilibrium level of money demand is ultimately linked to the
equilibrium level of interest rate in the economy.
126. For equilibrium, Actual Expenditure + Planned Expenditure
or Y = c (Y - tY) + I + G

or Y = cY –ctY + I + G

or Y +ctY –cY = I + G

or (1 + ct – c)Y = I + G

or Y = (I + G)/ (1 + ct – c)

The government expenditure multiplier will be = 1/ (1 + ct – c)

127. The rise in government expenditures will shift the IS curve to the right.
[insert figure here]
In the money market, the demand for real balances will rise, raising interest rates, but a rise in
money supply will shift the supply of real balances to the right thereby reducing interest rates.
Consequently, the LM curve will become flatter and more horizontal.

Under equilibrium, the higher level of output Y will be attained at a lower level of interest rate r,
as compared to the level of r it would reach under the old LM curve if the money supply were
not raised.
128. If the government policy decided to maintain the constant interest rate, the money supply curve
would be a horizontal line and not a vertical line. Moreover, as the interest rate is fixed for all
levels of output, the LM curve too would be a flat horizontal line.

There would be no change in the IS curve. The IS curve plots the relationship between interest
rate and output level in the goods and services market. The relationship between interest rate
and investment does not change, and hence the IS curve retains its characteristic shape.
129. IS plots the equilibrium levels of interest rate and output in the goods and services market. Here,
c denotes the marginal propensity of consumption, which relates consumption to levels of output
and is not related to interest rates. The slope of the IS curve depends on i as it is the only factor
in the expenditure side that relates to interest rates.

Page 35
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