1. What are the current values of the three main macroeconomic indicators?
2. Why does it matter whether the tax rate times the multiplier (assuming constant interest rates, in the simplest case) is less than 1, equal to 1, or greater than 1?
3. Why does the demand curve for money increase (more money demanded at all interest rates) when GDP increases?
4. Why does the quantity of money demanded (along a given demand curve) fall as interest rates rise (and vice versa)?
5. What does the following equation from Chapter 4 mean: ?
6. Do the reserves of commercial banks count directly as part of the money supply? Explain.
7. Why would the money supply change when households convert bank Deposits to Currency? Does the money supply go up or down? Explain.
8. In a cashless economy, what happens to the ratio of Reserves to Deposits when commercial banks increase lending? Is this more likely to happen when interest rates rise or fall?
9. What is the IS schedule and which way does it slope?
10. What is the LM schedule and which way does it slope?
11. How can a risk premium be incorporated into the IS/LM model?
Use the following data for the remaining questions concerning fiscal and monetary policy in the IS/LM model:
marginal tax rate: t1 = .20
marginal propensity to consume: c1 = .9
marginal propensity to invest: b1 = .18
response of Investment to changes in interest rates: b2 = 500 response of Money Demand to changes in GDP: d1= .4
response of Money Demand to changes in interest rates: d2 = 2,000
12. Use the formula for the slope of the IS schedule to calculate its value, Δi ⁄ΔY. You will need to calculate z1, so that you can find the slope -(1-z1)⁄b2.
13. Use the formula for the slope of the LM schedule (when the Money Supply is held constant) to calculate its value. This is just an application of money market equilibrium (d1ΔY must equal d1Δi so that the quantity of money demanded is unchanged following an increase in the hold demand curve) to find Δi ⁄ΔY = d1/d2.
14. If interest rates are held constant by Federal Reserve policy whenever GDP changes, what is the multiplier for a change in Government spending? This is just the old multiplier from Chapter 3, incorporating a marginal tax rate, marginal propensity to consume, and marginal propensity to invest. Therefore, the answer is just -(1-z1) because constant interest rates can be interpreted as a horizontal LM schedule (a zero slope).
15. If the money supply is held constant when GDP changes, what is the multiplier for a change in Government spending? This multiplier is smaller than 1/ (1-z1) because you are adding b2d1/d2 to the denominator to account for the fall in Investment that occurs when higher demand for money (from higher GDP) increases interest rates.
16. What is the multiplier for a change in the money supply, with no change in fiscal policy? This multiplier is the one in question 15 multiplied by d1/d2 because it is this ratio that translates a change in the money supply into a change in Investment. It is this change in Investment which shocks the goods market, in effect, taking the place of an increase in Government spending in the previous question.
The answers to the previous three questions are easily found to be 10, 5, and 1.25, respectively.
17. When interest rates are held constant, what is the product of the tax rate times the multiplier? Use the answer to question 14.
18. If government spending rises by 100 with no change in interest rates, calculate the changes in Consumption and Investment. You need to know the change in output (interest rates are constant) rates to answer the question so use the multiplier from question 14. Note that if you then discover that the numbers do not add up, you can go back and correct your answer to 14.
19. If government spending rises by 100 with no change in the money supply, calculate the change in Consumption and Investment. Now you need to know both the change in output and the change in the interest rate, so use your answer from 15 to get and also the slope of the LM schedule Δi ⁄ΔY = d1/d2 to then get Δi. The rest should be straightforward, using the parameter values:
marginal tax rate: t1 = .20
marginal propensity to consume: c1 = .9
marginal propensity to invest: b1 = .18
20. If the money supply increases by 200 with no change in fiscal policy, calculate the initial drop in interest rates (just 200 divided by -d2 to clear the money market and place the economy on the new lower LM, to the left of IS) and also calculate the initial stimulus to Investment (just the drop in interest rates times -b2).
21. If the money supply increases by 200 with no change in fiscal policy, calculate the changes in Consumption and Investment. Question 20 got you started. To find the change in GDP either use the multiplier in 15 times the change in Investment in 20; or use the multiplier in 16 times the change in the money supply. The two approaches are the same, in view of question 20.
22. What happens to the IS/LM multipliers if 15 and 16 if Investment becomes more sensitive to changes in interest rates (an increase in b2 to, say, 1,000)?
23. What happens to the IS/LM multipliers if 15 and 16 if Money demand becomes more sensitive to changes in interest rates (an increase in d2 to, say, 3,000)?