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Flashcards in Macroeconomics exam questions Deck (63):
1

What is a market-clearing model? When is it appropriate to assume that markets clear?

A market-clearing model is one in which prices adjust to equilibrate supply and demand. In this model there are no shortages or surpluses arising from too much or too little demand.

In the short run, prices are sticky, but in the long run prices are flexible and adjust to equate demand and supply, e.g. A labour contract might only be able to be renegotiated after 5 years to bring it in line with equilibrium pricing levels.

Therefore, it is appropriate to assume that markets clear in the long run, but not in the short run.

2

What is microeconomics?

Microeconomics is the study of how individual firms and households make decisions, and how they interact with one another.

Microeconomic models are based on the principle of optimisation: firms decide how much to produce to maximise profits, and households maximise the utility of their purchases within their budget constraints.

3

What is macroeconomics?

Macroeconomics is the study of the whole economy (not only a part of it, like a household or a firm). It handles issues such as output, employment, fiscal and monetary policy and inflation for the entire country, or region.

4

How are microeconomics and macroeconomics related?

Because economy-wide events arise from the interaction of many households and many firms, macroeconomics and microeconomics are inextricably linked.

When we study the economy as a whole, we must consider the decisions of individual economic actors.

Because aggregate variables are the sum of the variables describing many individual decisions, macroeconomic theory rests on a microeconomic foundation.

5

What is the difference between stock and flow variables? Are there any links between them? Use examples to explain your answer.

A stock is a quantity measured at a point in time, e.g. the balance on your credit card statement.

A flow is a quantity measured per unit of time, e.g. the amount of new purchases on your credit card in the last month.

They are linked in the sense that flows accumulate to form a stock, as in the example above.

Further example: the yearly government budget deficit is a flow. These budget deficits accumulate to form Government debt at a point of time, which is a stock.

6

What is the difference between GDP and GNP?

The difference between GDP and GNP boils down to location and ownership (domestic v foreign) of the factors of production (capital, land and labour)

7

What is the GDP?

GDP = Market value of all final goods and services produced by domestically-located factors of production, regardless of which nation's factors of production they are produced by.

8

What is the GNP?

GNP = Market value of all final goods and services produced by the nation's factors of production in a given period of time, regardless of where they are located --> includes all labour and capital working or invested in other countries.

9

Why are there differences in GDP and GNP in some countries?

GNP = GDP + factor payments from abroad (our workers abroad) - factor payments to abroad (foreign owners here).

Factor payments include: wages, profits, rent, interest & dividends on assets.

Differences occur when the income generated by nationals working abroad and domestically owned capital invested abroad does not equal the income generated by foreign workers and foreign capital invested in the country.

10

Suppose a woman marries her butler. After that he continues to wait on her as before (but not as an employee). How does the marriage affect GDP? How should it affect GDP?

Before she marries him, the income that the butler receives for his services is included in the GDP computation. After she marries him, he no longer receives a wage. The value of his services are therefore not computed in the GDP, so the GDP reduces.

The husband however continues to provide the same services, and GDP is the total market value of all goods and services produced domestically. As the market value of his services does not change by his change in marriage status, his marrage should really not affect the GDP.

11

What is the difference between nominal and real GDP?

GDP is the market value of all final goods and services produced in an economy.

Nominal GDP measures this value using current prices = current price * this year's quantity

Real GDP measures this value using the prices of a base year = base year price * this year's quantity. Real GDP is therefore inflation adjusted.

Could provide an example.

12

Is there a difference between the GDP deflator and the CPI?

Yes:
1. Goods and services bought by firms and govt: GDP deflator included, CPI excluded
2. Imported consumer goods and services: GDP deflator excluded, CPI included
3. Basket of goods: GDP deflator changes every year, CPI fixed basket - changes every 5 years or so.

13

Why is it possible that the CPI may overstate inflation?

- Substitution bias: uses fixed weights, so can’t reflect consumer’s ability to substitute with goods whose relative prices have fallen
- Introduction of new goods: Introduction of new goods makes consumers better off and increases the real value of the dollar. BUT it doesn’t reduce CPI, as CPI uses fixed weights.
- Unmeasured changes in quality: Quality improvements increase the value of the dollar but are often not fully measured. The Bureau of Labor and Statistics tries to account for some improvement in quality, but cannot capture all quality improvements.

14

What makes the demand for the economy’s output of goods and services equal the supply? (Use a classical model!)

Using the classical model:
Assume flexible prices (long-run) and a closed economy (zero net export). So Y = C + I + G

Supply side: Y is a function of Capital K and Labor L. The economy as a fixed amount of labour and a fixed amount of capital, which are factors of production. Therefore, Y is also fixed. Y̅ = F (K̅, L̅)

Demand side: Y = C + I + G
C = C (Y̅ - T), so C depends on disposable income (total income minus tax)
I = I (r) Investment depends on the real interest rate r
G and T are fixed by public policy, so G= G̅, T = T̅ fixed.

Therefore: Y̅ = C (Y̅ - T̅) + I(r) + G̅

So in the long run the real interest rate r and therefore investment I will adjust to equate demand for the economy's output of goods and services with supply.

15

Explain the consequences of an increasing budget deficit by using a classical loanable funds market model

The loanable funds market model considers:
- national savings S = supply of loanable funs, and
- desired investment I = demand for loanable funds. I = I(r); the amount of investment depends on the real interest rate.

National savings S = private savings of households and firms (Y - T - C) + public savings (T - G) = Y - C - G

Assmptions: Y is fixed by a fixed supply of capital and labour (Y = f(K,L)), T and G are fixed through public policy, and as C = C(Y - T), C is fixed too.
--> national savings are fixed.

Equilibrium: I(r) = S fixed

Graph: x axis = S, I; y-axis = r. S is vertical, I(r) slopes down. Shift S to the left.

An increase in the budget deficit will reduce national savings S, which causes the real interest rate to rise, which reduces the level of investment. Increasing the Government deficit therefore crowds out investment in the long run.

16

The government reduces the tax on capital income. What is the effect on investment? Explain your answers by using a classical loanable funds model.

The loanable funds market model considers:
- national savings S = supply of loanable funs, and
- desired investment I = demand for loanable funds. I = I(r); the amount of investment depends on the real interest rate.

National savings = private savings (of households and firms) + public savings (government).
- Private savings: Y - T - C
- Public savings: T - G
- National savings: S = Y - C - G
Assmptions: Y is fixed by a fixed supply of capital and labour (Y = f(K,L)), T and G are fixed through public policy, and as C = C(Y - T), C is fixed too.
--> national savings are fixed.

Equilibrium: I(r) = S fixed

Graph: x axis = S, I; y-axis = r. S is vertical, I(r) slopes down. Shift S to the left.

A decrease in taxes will increase disposable income, increasing consumption and leading to lower savings. This will increase the real interest rate and decrease investment.
↓ T⇒ ↑ C ⇒ ↓ S ⇒ ↑ r ⇒ ↓ I

17

What is money?

Money is the stock of assets that can be readily used to make transactions

18

Explain the function of money.

Money has three functions:
1. Store of value - a way to transfer purchasing power from the present to teh future; I can spend what I earn tomorrow.
2. Unit of account - provides the terms in which prices are quoted and debts are recorded.
3. Medium of exchange - what we use to buy goods and services - we are confident sellers will accept money in payment.

19

Explain the types of money

There are two main types of money:
1. Fiat money: money with no intrinsic value, e.g. paper currency.
2. Commodity money: money with intrinsic value, e.g. gold coins. Gold can be used for various purposes - jewelry, dental fillings etc, as well as for transactions.

20

When does money lose its function?

Hyperinflation causes money to lose its function. This is because money ceases to be a valid store of value. This can lead to sellers not accepting money in payment leading to a barter economy. Money therefore loses its functions as a medium of exchange and a unit of account too.

21

The Central Bank increases money supply. What is the impact on inflation, if the velocity of money and real output is constant?

According to the quantity theory of money: MV = PY.
In growth rates, the quantity equation is:
∆M/M + ∆V/V = ∆P/P + ∆Y/Y

Assuming constant velocity and constant real output, ∆V/V = 0, and ∆Y/Y = 0.

Further, ∆P/P is inflation, so equals π.

Therefore, ∆M/M = π

This implies that increasing the money suppy increases inflation by the same percent. So if the Central Bank increases the money supply by x%, the inflation rate increases by x%.

22

What is the velocity of money?

The velocity of money is the rate at which money circulates in the economy. In other words, velocity tells us the number of times the average currency unit changes hands in a give period of time.

23

How can you calculate the velocity of money? What does it depend on?

MV = T
where M = money supply, V = transaction velocity of money, and T = value of all transactions in the economy. This is an identity.

As T is difficult to measure, nominal GDP is used as a proxy, where Y is real GDP and P is inflation. The equation becomes:
MV = PY, where V is the income velocity of money.

M/P = Y/v, so money demand = kY where k = 1/v.

Therefore, when people hold lots of money relative to their incomes, money changes hands infrequently, so the velocity of money is small. Velocity of money is determined by the demand for real money balances.

24

In the county of Wiknam, the velocity of money is constant. Real GDP grows by 5%, the money stock grows by 14%, and the nominal interest rate is 11%. What is the real interest rate?

Using the quantity equation:
∆M/M + ∆V/V = ∆P/P + ∆Y/Y.
Velocity is constant, so ∆V/V = 0.
∆M/M = 14%, ∆Y/Y = 5%
∆P/P = π, which is inflation.
14% + 0 = π + 5%, so π = 9%

From fisher's equation r = i - π, where r = real interest rate, i = nominal interest rate and π = inflation:

r = 11% - 9% = 2%.

Therefore, the real interest rate is 2%.

25

The Central Bank announces that it will increase the supply of money. What is the impact on inflation even if the Central Bank does not execute its announcement? Explain your answer in the framework of the classical theory.

From the quantity theory of money, MV = PY. Assuming velocity V is constant and output Y is fixed by the fixed supply of capital and labour in the economy, ∆M/M = ∆P/P. This means if the money suppy M were to increase, we would expect an equal increase in inflation (∆P/P).

Based on classical theory, the supply of real money balances M/P = the demand for real money balances L(i, Y), where M = money supply, P = price level, i = nominal interest rate and Y = output. Demand for real money balances depends on the nominal interest rate, because the nominal interest rate is the opportunity cost of holding real money balances.

The nominal interest rate i is set before the real inflation rate is known. Therefore, the nominal interest rate ex ante i = desired real interest rate r + expected inflation rate Eπ. If Eπ increases, then i increases by the same amount.

Therefore, M/P = L(r + Eπ, Y). So if Eπ increases, the demand for real money balances L(r + Eπ, Y) falls. If M stays constant, P must therefore increase.

By definition, an increase in the price level P is an increase in inflation. Therefore, the announcement will increase inflation even if the Central Bank does not execute its announcement.

26

What are the costs of expected inflation?

The costs of expected inflation are:
1) Shoe leather cost: the costs and inconvenience of reducing real money balances to avoid the inflation tax (e.g. frequent trips to the bank to withdraw smaller amounts of cash)
2) Menu costs: the costs of changing prices, e.g. printing new menus and catalogues
3) Relative price distortions: Firms facing menu costs still change prices infrequently and at different times, leading to changing relative prices. Less is bought after the price change, more is bought once inflation overtakes equilibrium prices. This leads to microeconomic inefficiency in the allocation of resources.
4) Unfair tax treatment: Some taxes are not adjusted to account for inflation, e.g. capital gains tax. You pay taxes even if there is no real capital gain.
5) General inconvenience: inflation complicates long-term financial planning.

27

What are the costs of unexpected inflation?

The costs of unexpected inflation are:
1) The costs of expected inflation
2) Arbitrary redistribution of purchasing power: if actual inflation is greater than expected inflation, then purchasing power shifts from lenders to borrowers. If actual inflation is less than the expected inflation, then purchasing power shifts from borrowers to lenders.
3) Increased uncertainty: The increased likelihood of arbitrary redistribution of purchasing power makes risk-adverse people worse off.

28

Is there a benefit of inflation?

Nominal wage cuts demotivate workers and may lead to other negative effects such as strikes, so it rarely occurs. Moderate inflation allows real wages to reach equilibrium levels without nominal wage cuts (or increases), improving the functioning of the labour market.

29

Why is creating money not creating wealth?

- Increasing money supply: ∆M/M * V = ∆P/P * Y. Therefore, a growth in the money supply without an equal increase in output leads to high inflation, which reduces the purchasing power of the currency. Money supply growth therefore does not create wealth.
- Seigniorage: Similarly, while seigniorage creates revenue and therefore wealth for government, it creates an inflation tax on the money that other people are saving. Though there is more money in the economy, the overall wealth has not increased.
- Fractional reserve banking: Fractional reserve banking system creates money (total money supply = (1/rr) * original deposit where rr = ratio of reserves to deposits). It does not however create wealth, because bank loans give borrowers an equal amount of new debt as new money.

30

How do central banks control the money supply

M = m x B, where m = (cr + 1)/(cr + rr)
cr (currency deposit ratio) = C/D, rr (reserve deposit ratio) = R/D, C = currency, D = deposit, R = reserves.
B = monetary base, M = total money supply, and M = C + R.

Central banks control the money supply through:
- Open-market operations: buying government bonds from the public increases the money base, while selling government bonds decreases the money base.
- The discount rate (the interest rate the Fed charges bankes for loans). Lowering the discount rate encourages bank to borrow more money, increasing the money base.
- Reserve requirements: Fed regulations impose a minimum reserve-deposit ratio (rr = R/D). Reducing the reserve requirements increases the monetary base.
- Interest on reserves (the Fed pays interest on bank reserves deposited with the Fed). By paying a lower interest rate on reserves, banks reduce their reserves.

31

Why can't central banks control the money supply perfectly?

M = m x B, where m = (cr + 1)/(cr + rr)

Central Banks cannot precisely control the money supply because:
- Households can change the cr by depositing a higher or smaller proportion of their income. For example, a higher cr reduces m, which reduces M.
- Banks often hold excess reserves above the reserve requirements. If banks change their excess reserves, they change rr, which changes m and M. For example, a higher rr reduces m and M.

32

What is a bank run?

A bank run occurs when depositors suspect that a bank may go bankrupt. They therefore "run" to the bank to withdraw their money.

33

Why do governments want to prevent society from a bank run?

Bank runs are a problem for banks under factional-reserve banking. Because a bank holds only a fraction of its deposit in reserve, it cannot satisfy withdrawal requests from all depositors.

Bank runs lead to banks increasing their reserve and decreasing the money they lend to investors. For this reason, governments want to prevent bank runs.

34

How do governments try to prevent society from a bank run?

Governments try to prevent bank runs through:
- Deposit Insurance - promises that even if the bank goes under, the government will guarantee that ordinary people will get their money back.
- Central banks act as a lender of last resort - the central bank guarantees that it will make short term loans to banks. This ensures that, if banks remain economically viable, they will always have enough liquidity to honour their deposits.

35

Some economists say that cash (banknotes and coins) should be abolished. What are the advantages of this proposal?

- Monetary policy would be more effective, as households could not control the currency deposit ratio, even if the interest rate on savings becomes negative. Central banks can and do use negative interest rates to fight deflation by encouraging households to reduce their savings and instead spend, stimulating demand and therefore economic growth. As long as there is cash, households can avoid negative interest rates on savings by hoarding cash, making monetary policy less effective.
- It would prevent issues related to bank runs.
- It would be less of a hastle, as people currently spend time searching for cash points, e.g. ATMs.
- It makes tax avoidance more difficult, bolstering public coffers.

36

Some economists say that cash (banknotes and coins) should be abolished. What are the disadvantages of this proposal?

- Loss of privacy and risk of excessive intrusion by the government
- Could create new security and operational risks
- Would constitute a noticeable change in many people's lives, and change tends to be resisted.

37

Some economics historians have noted that during the period of the gold standard, gold discoveries were most likely to occur after a long period of deflation. The discoveries of 1896 are an example. Why might this be true?

The gold standard meant that the value of a particular currency was defined in terms of gold. A limited supply of gold causes deflation, increasing the real value of the dollar. Therefore during periods of deflation, if an economy is on the gold standard, then gold becomes more valuable. Thus, finding and discovering gold mine is more lucrative, and therefore attractive, after long periods of deflation.

38

Explain the keynesian cross.

Keynesian cross shows actual expenditure and planned expenditure. Equilibrium is where actual expenditure = planned expenditure.

If actual expenditure > planned expenditure (to the right), inventory accumulates, so firms produce less, decreasing real GDP Y. If actual expenditure

39

Use the Keynesian cross to explain why increasing Government spending has a multiplier effect on income.

2 kinds of fiscal policy; change government spending G, or change taxes T.

If Government increases its spending G, planned expenditure shifts up by ∆G. As at equilibrium Y = C(Y - T) + I + G, increasing G increases Y, which increases C by the marginal product of consumption MPC, which increases Y, which increases C and so on. Increasing government spending therefore has a multiplier effect. Y increases by ∆G/(1-MPC), where MPC

40

Use the Keynesian cross to explain why decreasing tax has a multiplier effect on income.

2 kinds of fiscal policy; change government spending G, or change taxes T.

If Government decreases taxes, it raises disposable income, which increases consumption by MPC, as C = C(Y - T). Planned expenditure therefore shifts up by ∆T * MPC. Just has before, this increases Y, which increases C, which increases Y and so on. Decreasing tax therefore has a multiplier effect on income. Y increases by ∆T * -MPC / (1 - MPC).

Graph: x-axis: Income, output, Y. y-axis: Planned expenditure, PE. Actual expenditure 45º angle, Y = PE. Planned expenditure start higher, flatter line, PE = C(Y-T) + I + G.

Shift planned expenditure up by ∆T * MPC, show Y increases by ∆T * -MPC/(1-MPC)

41

Use the theory of liquidity preference to explain why an increase in the money supply lowers the interest rate.

The theory of liquidity preference assumes M is fixed by the Fed, and P is fixed, as prices are sticky in the short run. The supply of real money balances is therefore also fixed, and does not depend on the interest rate. (M/P)s = M/P, with M and P fixed.

The theory of liquidity preference posits that the interest rate is one determinant of how much money people choose to hold, as the interest rate is the opportunity cost of holding money. (M/P)d = L(r). The interest rate adjusts to bring supply and demand for real money balances into equilibrium.

Graph: x-axis: real money balances, M/P. y-axis: real interest rate r. Vertical supply line, M/P fixed. Demand curve L(r) slopes down, curved. Shift supply curve to the right, show lower interest rate.

If the Fed increases money supply, this increases the supply of real money balances M/P, shifting the supply curve to the right. This reduces the interest rate to bring supply and demand into equilibrium.

42

An increase in government purchases raises national income by (1 / (1-MPC)), a cut in taxes by the same amount raises national income by (- MPC / (1-MPC)) only. Why is the impact of an increase in government purchases on national income larger than a cut in taxes?

Y = C(Y - T) + I + G in a closed economy.

When Government increases its spending G, increases planned expenditure by ∆G.

When Government decreases taxes T, it increases disposable income, which increases consumption and therefore planned expenditure by ∆T * -MPC, where MPC = the marginal propensity to consume. At equilibrium, planned expenditure = real GDP. For this reason, an increase in government purchases has a greater impact on national income than a cut in taxes.

When planned expenditure and therefore Y increases, C increases, which increases Y, which increases C then Y and so on. From this process, Y increases by a further 1/(1 - MPC) times in both cases, which does not affect the conclusion above.

43

Use the Keynesian cross to predict the impact of:

a) an increase in government purchases

b) an increase in taxes,

c) an equal increas in government purchases and taxes

Using the Keynesian cross:

a) For an increase in G:
∆ Y = ∆G/(1 - MPC)

b) For an increase in T:
∆Y = ∆T * -MPC/(1 - MPC)

c) For an equal increase in government purchases and taxes:
∆Y = ∆G/(1-MPC) + ∆T*-MPC/(1-MPC) but ∆T = ∆G
∆Y = ∆G * (1 - MPC)/(1-MPC)
∆Y = ∆G.
Therefore, real GDP increases by the same amount the government spending or tax increases.

44

In the Keynesian cross, assume that the consumption function is given by C = 200 + 0,75 (Y - T). Planned investment is 100, government purchases and taxes are both 100.

a) What is the equilibrium level of income?

b) If the government purchases increase to 125, what is the new equilibrium income?

c) What level of government purchases is needed to achieve an income of 1.600?

At equilibrium PE = C + I + G

a) I = G = T = 100
Y = 200 + 0,75(Y - 100) + 100 + 100
Y = 400 + 0,75 (Y - 100)
Y = 400 + 0,75Y - 75
0.25Y = 325.
Y = 1.300
Therefore, equilibrium level of income = 1.300.

b) ∆G = 25, ∆Y = ∆G/(1-MPC)
MPC = 0.75
∆Y = 25/(1-0.75) = 100
New equilibrium income = 1.300 + 100 = 1.400.

c) ∆Y = 300 = ∆G/(1-0.75)
∆G = 75.
Need G = 100 + 75 = 175.
Need government spending G of 175.

45

Suppose the consumption function in the Keynesian cross is C = Ca + c(Y - T), where Ca is “autonomous consumption” and c is the marginal propensity to consume.

a) What happens to equilibrium income when the society becomes more thrifty as represented by a decline in Ca?

Graph: x-axis: Income, output, Y. y-axis: Expenditure, E. Actual expenditure 45º angle, Y = PE. Planned expenditure start higher, flatter line, PE = Ca + c(Y - T) + I + G. Shift planned expenditure down by ∆Ca, show reducing in Y of ∆Ca/(1 - c)

From the Keynesian cross, a reduction in Ca shifts PE down by ∆Ca, reducing equilibrium income Y by ∆Ca/(1 - c).

Also seen by:
Y = Ca + c(Y - T) + I + G
Y = Ca + cY - cT + I + G
Y - cY = Ca - cT + I + G
Y = (Ca - cT + I + G)/(1 - c)

46

Suppose the consumption function in the Keynesian cross is C = Ca + c(Y - T), where Ca is “autonomous consumption” and c is the marginal propensity to consume.

b) What happens to equilibrium savings when the society becomes more thrifty as represented by a decline in Ca?

Equilibrium savings remains unchanged. THe national accounts identity tells us that saving equals investment, or S = I. In the Keynesian-cross model, we assumed that desired investment is fixed. This implies that investment is the same in the new equilibrium as it was in the old. Therefore, savings is exactly the same in both equilibria.

b) At equilibrium, Y = Ca + c(Y - T) + I + G.
Solving for I:
I = Y - Ca - c(Y - T) - G
National savings S = Y - Ca - c(Y - T) - G.
If Ca decreases:
Ca --> Ca - ∆Ca
Y = Y - ∆Ca/(1 - c)

The new national savings S1 = Y - ∆Ca/(1 - c) - (Ca - ∆Ca) - C(Y - ∆Ca/(1 - c) - T) - G
S1 = Y - ∆Ca/(1-c) - Ca + ∆Ca - cY + c * ∆Ca/(1 - c) + cT - G

∆S = -∆Ca/(1 - c) + ∆Ca + c * ∆Ca/(1 - c)
∆S = (-∆Ca - ∆Ca(1 - c) - c * ∆Ca)/(1 - c)
∆S = (-∆Ca + ∆Ca - c*∆Ca + c * ∆Ca)/(1 - c)
∆S = 0

Therefore, if a society becomes thriftier by reducing Ca, equilibrium national savings do not change.

47

Suppose the consumption function in the Keynesian cross is C = Ca + c(Y - T), where Ca is “autonomous consumption” and c is the marginal propensity to consume.

Reducing Ca leads to no change in national savings according to the Keynesian cross.

c) Why do you suppose this result is called the paradox of thrift?

The paradox of thrift is that even though thriftiness increases, saving is unaffected. Increased thriftiness leads only to a fall in income. For an individual, we usually consider thriftiness a virtue. From the perspective of the Keynesian cross however, thriftiness is a vice.

48

Does the paradox of thrift arise in the classical model of chapter 3? Why or why not?

This paradox does not arise in the classical model. In that model, output is fixed by the factors of production and the production technology, and the interest rate adjusts to equilibrate savings and investment, where investment depends on teh interest rate. An increase in thriftiness decreases consumption and increases savings for any level of output. Since output is fixed, the savings schedule shifts to the right. At the new equilibrium, the interest rate is lower, and investment and saving are higher.

Graph: x-axis: real interest rate r. y-axis: investment, savings, I, S. Vertical savings line S (shift right), sloping curve down for I(r). Show decrease in r.

49

Derive the IS-curve from the Keynesian cross.

Draw investment/savings graph to the bottom left: x-axis, Investment, Savings, I, S. y-axis: real interest rate, r. Downward sloping line I(r), vertical line S (shift S left by ∆I, S). Show: 1) An increase in the interest rate ...2) lowers planned investment and savings...

Draw Keynesion cross on top right: x-axis: income, output, Y. y-axis: planned expenditure, PE. Actual expenditure 45º angle Y = PE, planned expenditure starts higher, flatter PE = C + I + G. Shift PE down by ∆I. Show: 3)...which shifts planned expenditure downward...4)...and lowers income.

Draw IS curve on bottom right: x-axis: income, output, Y. y-axis: real interest rate, r. Show: 5. The IS curve summarises these changes. The higher the interest rate, the lower the level of income.

The IS curve shows the combinations of the interest rate and the level of income that are consistent with equilibrium in the market for goods and services and the market for loanable funds for a given fiscal policy.

50

What shifts the IS-curve to the left, what shifts it to the right?

The following shift the IS curve to the right:
- increase of govt expenditure G
- Tax cuts (decreased T)

The following shift the IS curve to the left:
- Tax increase
- Reduction in government expenditure

51

Derive the LM-curve from the market for real money balances.

Draw market for real money balances to the left: x-axis, real money balances, M/P. y-axis, real interest rate r. Vertical line supply of real money balances = fixed M/P. Sloping down curve demand for real money balances = L(r, Y). Shift demand curve up. Show: 1) an increase in income raises real money balances demand...2) increasing the interest rate.

Draw the LM curve: x-axis: income, output, Y. y-axis: real interest rate, r. Upwards sloping curve called LM.

The LM curve shows the combinations of the interest rate and the level of income that are consistent with equilibrium in the market for real money balances, for a given real money balance.

52

What shifts the LM-curve to the right, what shifts it to the left?

A decrease in the supply of real money balances (for example the Fed reducing the money supply) shifts the LM curve to the left.

An increase in the supply of real money balances (e.g., the Fed increasing the money supply), shifts the LM curve to ther right.

53

In contrast to the classical theory which says that money tightening leads to lower interest rates, the theory of liquidity preference predicts higher interest rates by money tightening. Explain this contradiction.

Classical theory (long run): MV = PY, so ∆M/M + ∆V/V = ∆P/P + ∆Y/Y, and V and Y are fixed. Therefore: ∆M/M = ∆P/P. A decrease in M gives an equal decrease in ∆P/P, the inflation rate, π

Fisher equation: nominal interest rate i = real interest rate r + inflation π. Therefore, if M decreases, π decreases leading to lower nominal interest rates.

Theory of liquidity preference (short run):
Prices are sticky, and the real interest rate is determined by the market for real money balances. The higher the interest rate, the lower the demand for real money balances, as the interest rate is the opportunity cost of holding real money balances. If supply of real money balances decreases, the real interest rate increases.

Graph real money balances market: x-axis: real interest rate r. y-axis: real money balances M/P. Vertical supply curve (shift left). sloping down demand curve of L(r, Y) (curve).

54

What is the impact of an increase in taxes on the interest rate, income, consumption, and investment in the short run?

Short run (sticky prices):
From the Keynesian cross, we know that an increase in tax causes consumption and income to fall by ∆T * -MPC/(1 - MPC), shifting the IS curve to the left by ∆T * -MPC/(1 - MPC).

Graph of IS-LM model: x-axis: output, income Y. y-axis: real interest rate r. Sloping up LM curve. Sloping down IS curve. Shift IS curve to the right by ∆*-MPC/(1 - MPC). Label equilibrium points A and B.

On the IS-LM model, this causes the equilibrium to move from A to B. The tax hike reduces the interest rate and reduces national income from Y1 to Y2, which is less than ∆T*-MPC/(1 - MPC). Consumption falls because disposable income falls (Y falls and T increases), and investment rises because the interest rate falls.

55

What is the impact of an increase in taxes on the interest rate, income, consumption, and investment in the long run?

Classical model (long run, prices are flexible, closed economy, G and T are fixed by public policy, Y is fixed by the fixed supply of capital and labour and the fixed production technology).

Y = C(Y - T) + I(r) + G

If T increases, disposable income decreases, so C decreases. Real interest rate reduces and investment increases. Income stays the same.

56

What is the impact of a decrease in the money supply on the interest rate, income, consumption and investment?

Short run, sticky prices so P is fixed, market for real money balances:

A decrease in M leads to a decrease in the supply of real money balances, which increases the real interest rate and shifts the LM curve upwards.

Graph of IS-LM model:
x-axis: Income, output, Y. y-axis: real interest rate r. Sloping down IS line, sloping up LM line. Shift LM up and left, label equilibriums A and B.

The equilibrium therefore moves from point A to point B.

The decrease in the money supply the income. Consumption falls because disposable income falls, while investment falls because the interest rate rises.

57

Use the IS-LM model to predict the effects of each of the following shocks on income, the interest rate, consumption and investment. In each case, explain what the central bank should do to keep income at its initial level.

a) After the invention of a new high-speed computer chip, many firms decide to upgrade their computer systems.

The invention of the new high-speed chip increases investment, which shifts the IS curve out. That is, at every interest rate, firms want to invest more, raising income and employment.

Graph of IS-LM model: x-axis: income, output, Y. y-axis: real interest rate. IS curve sloping down, LM line sloping up. Shift IS curve to the right.

The increase in income from the higher investment demand also raises interest rates, because the higher income raises demand for money. As the supply of money does not change, the interest rate must rise to restore equilibrium in the money market.

The rise in interest rates partially offsets the increase in investment demand, so that output does not rise by the full amount of the rightward shift in the IS curve. Consumption increases as disposable income increases.

Overall, income, interest rates, consumption and investment all rise.

To keep income at the initial level, the central bank should decrease the money supply, shifting the LM curve up.

58

Use the IS-LM model to predict the effects of each of the following shocks on income, the interest rate, consumption and investment. In each case, explain what the central bank should do to keep income at its initial level.

b) A wave of credit-card frauds increases the frequency with which people make transactions in cash.

The wave of credit-card frauds increases the demand for real money balances at any interest rate, raising the real interest rate to equilibrate the money market, and shifting the LM curve up.

Graph of IS-LM model: x-axis: income, output, Y. y-axis: real interest rate. IS curve sloping down, LM line sloping up. Shift LM curve up.

The higher interest rate reduces investment and therefore income. Because income falls, disposable income falls and so does consumption.

To restore income to the initial level, the central bank should raise the money supply.

59

Use the IS-LM model to predict the effects of each of the following shocks on income, the interest rate, consumption and investment. In each case, explain what the central bank should do to keep income at its initial level.

c) A best-seller entitled "Retire Rich" convinces the public to increase the percentage of their income devoted to savings.

The book causes consumers to save more, causing consumption to decrease, and therefore causing income to decrease and the IS curve to shift to the left.

Graph IS-LM model: x-axis: income, output, Y. y-axis: real interest rate, r. Upwards sloping LM curve, downwards sloping IS curve. Shift IS to the left, label equilibriums A and B.

Income, interest rates, and consumption all fall, while investment rises.

Income falls because at every level of the interest rate, planned expenditure falls.

The interest rate falls, because the fall in income reduces demand for money; since the supply of money is unchanged, the interest rate must fall to restore money-market equilibrium.

Consumption falls both because of the shift in the consumption function and because income falls.

Investment rises because fo the lower interest rates and partially offsets the effect of the fall in consumption.

The central bank should increase the money supply to restore income to its initial levels.

60

Explain why each of the following statements is true. Discuss the impact of monetary and fiscal policy in each of these special cases.

a) If investment does not depend on the interest rate, the IS curve is vertical.

The IS curve represents the relationship between the interest rate and the level of income that arises from equilibrium in the market for goods and services, when Y = C(Y - T) + I(r) + G.

If investment does not depend on the interest rate, then nothing in the IS equation depends on the interest rate. Income must therefore adjust to ensure that the quantity of goods produced, Y, equals the quantity of goods demanded, C + I + G.

In this case, the IS curve is vertical.

Monetary policy has no effect on output, because the IS curve determines Y; it can only affect the interest rate.

Fiscal policy is effective: output increases by the full amount that the IS curve shifts.

61

Explain why each of the following statements is true. Discuss the impact of monetary and fiscal policy in each of these special cases.

b) If money demand does not depend on the interest rate, the LM-curve is vertical.

The LM curve represents the combinations of income and the interest rate at which the money market is in equilibrium. If money demand does not depend on the interest rate, then we can write the LM equation as M/P = L(Y).

For any given level of real balances M/P, there is only one level of income at which the money market is in equilibrium. Thus, the LM curve is vertical.

Fiscal policy has no effect on output; it can affect only the interest rate.

Monetary policy is effective; a shift in the LM curve increases output by the full amount of the shift.

62

Explain why each of the following statements is true. Discuss the impact of monetary and fiscal policy in each of these special cases.

c) If money demand does not depends on income, the LM-curve is horizontal.

If money demand does not depend on income, we can write the LM equation as M/P = L(r). For any given level of real money balances M/P, there is only one level of the interest rate at which the money market is in equilibrium. Hence the LM curve is horizontal.

Fiscal policy is very effective: output increases by the full amount that the IS curve shifts.

Monetary policy is also effective: an increase in the money supply causes the interest rate to fall, so the LM curve shifts down.

63

Explain why each of the following statements is true. Discuss the impact of monetary and fiscal policy in each of these special cases.

d) If money demand is extremely sensitive to the interest rate, the LM-curve is horizontal.

If money demand is extremely sensitive to the interest rate, then a small change in interest rate will cause a large change in money demanded, meaning that money demand is very elastic. This means the LM curve must be almost flat, or horizontal.

Monetary policy is now completely ineffective: an increase in the money supply does not shift the LM curve at all.

Fiscal policy is very effective: output changes by the full amount that the IS curve shifts.