Chapter 5

Question 1

What does investment primarily depend upon?

Answer 1

1. The level of sales (if a firm wants to increase sales, it needs to invest in new machines)
2. The interest rate (if a firm is deciding if it’s going to or not going to buy a new machine and it needs to borrow money, the higher the interest rate, the less attractive it is for the firm to borrow and buy the machine)

Question 2

Why is demand an increasing value of output, for a given value of the interest rate?

Answer 2

Because when demand goes up, income goes up, disposable income goes up and consumption goes up.

And when demand goes up, investment goes up.

Question 3

What happens when taxes are increased?

Answer 3

At a given interest rate, YD decreases –> C decreases –> Demand for goods decreases –> decrease in eq. output (IS relation)

Question 4

How is interest rate (in financial markets) determined?

Answer 4

By the equality of the supply and demand for money:
M = $Y L(i)

M = nominal money stock 
$Y = nominal income
i = nominal interest rate

Question 5

(Financial markets) What happens with demand when $Y increases?

Answer 5

Demand increases

Question 6

(Financial markets) What happens with demand when i increases?

Answer 6

Demand decreases

Question 7

How is real interest rate determined?

Answer 7

M/P = Y L(i) = LM relation

Question 8

How is monetary policy characterized in the short run?

Answer 8

The LM function tells us that real money demand must be equal to given real money supply. For ex. when real income increases, money demand increases –> the real interest rate must increase so as money demand remains equal to the given money supply. Because money supply can’t be changed in SR, so a bigger demand of money will generate higher interest rate so people will invest instead to just keep their higher income in money.

Question 9

What does the IS and LM curve together determine?

Answer 9

Output

Question 10

What is fiscal contraction?

Answer 10

When the government decides to reduce the budget deficit by increasing taxes while keeping government spending unchanged. Leads to a decrease in G-T.

Question 11

What is fiscal expansion?

Answer 11

Increase in government deficit, either due to increase in G spending or decrease in taxes.

Question 12

What happens during a fiscal contraction?

Answer 12

Taxes go up –> less purchasing power for the consumer –> less output –> shifting IS to the left

The decrease in demand leads through the multiplier to a decrease in output and income.

Question 13

What is monetary expansion?

Answer 13

The increase of money supply, which decreases the interest rate.

Question 14

What is monetary contraction?

Answer 14

The decrease in money supply, which increases the interest rate.

Question 15

What happens in a monetary expansion?

Answer 15

The lower interest rate –> increase in investment –> increase in demand and output

The increase in output and decrease in interest rate both lead to an increase in investment. The increase in income leads to an increase in disposable income and in turn in consumption.

Question 16

If government wants to reduce deficit (increase in T or decrease in G) and reduce interest rate (to avoid recession), what happens to consumption?

Answer 16

• If change appear to G spending and not T, YD is unaffected –> C is unchanged
• If change appear in increase of T –> YD is lower –> C is lower
• What happens to investment is unambigous….

Question 17

What does investment depend on?

Answer 17

Interest rate (-):
the higher the interest rate, the more expensive it is to borrow and the lower is the level of investment.

Production (+):
the higher its sales, the more a firm wants to investment in order to increase production

Question 18

What happens to equilibrium output when the interest rate increases?

Answer 18

If the interest rate increases, investment drops which pushes down the demand for goods. Graphically, the demand curve shifts down. Production decreases. The equilibrium level of output is lower. We move rightwards along the IS curve.

Question 19

What happens when taxes increase?

Answer 19

Disposable income drops, consumption drops, demand drops. The demand curve shifts down.
Supply must drop too to maintain the equilibrium
Equilibrium output is lower for any level of the interest rate.
Shifts IS curve

Question 20

Fiscal policy: when taxes increase

Answer 20

Consumption goes down, leading to a decrease in demand.

This decrease in demand leads to a decrease in output, which leads to a decrease in income, which leads to both a decrease in consumption and investment, which leads to a decrease in demand… (MULTIPLIER)

Through the multiplier, the increase in taxes leads to a decrease in output. We go from A to A’.