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Flashcards in Module 19 - Real and Monetary Sectors Deck (41):
1

A linear consumption function passes through the origin and the point C = 75, Y = 100 where C = consump-tion expenditure and Y = national income.

In constructing an IS curve in which the savings function is derived from the above consumption function which of the following contains the amount of savings associated with a national income level of 250?

A. 12.5
B. 52.5
C. 62.5
D. 187.5

 

The correct answer is C.

When Y = 100, C = 75 and ∴ S = 25 (100 − 75)

∴ when Y = 250, C = 187.5 and ∴ S = 62.5

The consumption function has an average propensity to consume (APC) of .75 since C/Y = APC = .75. The corresponding savings function has an average propensity to save (APS) of .25 since S/Y = .25 and APC + APS = 1.

2

A linear consumption function passes through the origin and the point C = 75, Y = 100 where C = consump-tion expenditure and Y = national income.

Which of the following is correct? At what level of national income will consumption and savings be equal?
A. 0
B. 25
C. 500
D. 1000

The correct answer is A.

Savings (S) equals Y − C and when Y = 100, C = 75 and therefore S = 25.

When Y = 0, C = 0 and S = 0. At all other levels of Y, C = 3S.

3

In the ISLM diagram the real sector comprises
I. the savings function
II. the marginal efficiency of investment schedule
III. the liquidity preference schedule

Which of the following is correct?
A. I and II only
B. II only
C. II and III only
D. I, II and III

The correct answer is A.

In a private sector closed economy national income is in equilibrium when planned savings equals planned investment. The relationship between planned savings and income is given by the consumption function. The marginal efficiency of investment schedule show investment as a function of interest rates. The IS curve traces out the levels of national income and interest rates at which planned savings equals planned investment. Thus I and II are true. The liquidity preference schedule is concerned with society’s demand for money balances. Thus III is wrong.

4

Which of the following correctly states what the speculative demand for money would be if the level of national income lay between Y1 and Y2?

It would be
A. greater than MT + P1 but less than MT + P2.
B. greater than MS2 but less than MS1
C. greater than 0 but less than MS2
D. greater than 0 but less than MT + P1

The correct answer is B.

For an income level between Y1 and Y2 the precautionary plus transaction demand for money would be between MT + P1 and MT + P2 which when subtracted from the total money supply MT + P leaves an amount for speculation purposes between MS2 and MS1.

5

If the transaction demand for money were to increase at each and every level of income this would have the effect of
I. shifting the money supply curve to the right
II. shifting the speculative demand for money to the left
III. shifting the LM curve to the left

Which of the following is correct?
A. I only
B. II and III only
C. III only
D. I, II and III

The correct answer is C.

An increase in the transaction demand for money would have no impact on the size of the money supply nor would it cause a shift in the speculative demand for money but it would create a new set of equilibrium national income/rate of interest points i.e. it would cause a leftward shift of the LM curve.

6

The horizontal portion of the LM curve would extend rightwards beyond point A if
I. the transaction demand for money decreased
II. the money supply decreased
Which of the following is correct?
A. I only
B. II only
C. Both I and II
D. Neither I nor II

The correct answer is D.

If the money supply increased and/or the rate of interest at which people hold only speculative balances increased the horizontal portion of the LM would extend rightwards beyond A. Changes in the transactions demand for money will not affect the position of the money supply curve nor the speculative demand for money curve.

7

If real world numbers for a given country were inserted on the vertical and horizontal axes of the LM diagram what would the limits of those numbers be
I. 4% for the real rate of interest, the maximum growth rate of potential output.
II. potential national output.

Which of the following is correct?
A. I only
B. II only
C. Both I and II
D. Neither I nor II

The correct answer is B.

National income/output is constructed by the quality and quantity of the capital stock and labour force; potential output is the upper limit to national income. Thus II is true. The real rate of interest is the nominal rate minus the inflation rate and is not associated with the growth rate of potential output.

8

The LM curve would shift from LM2 to LM1 if
I. the money supply increased
II. the rate of interest increased

Which of the following is correct?

A. I only
B. II only
C. Both I and II
D. Neither I nor II

The correct answer is D.

An increase in the money supply would shift the LM curve outwards/right; thus I is wrong. The equilibrium interest rate R is derived from the intersection of the ISLM curves; R does not cause them to shift. Thus II is wrong.

9

In Figure (c) the shift in the LM curve from LM1 to LM2 did not cause Y to increase. This was because

I. the economy was at full employment
II. the shift was not caused by an increased in the money supply
III. investment expenditure is interest rate inelastic

Which of the following is correct?
A. I only
B. I and II only
C. III only
D. I, II and III

Y did not increase because the IS curve is vertical; this will occur when the MEI curve is a vertical line, i.e. when investment expenditures are unresponsive to interest rate changes which as Keynes argued was a phenomenon of deep recession. Thus III is true. Figures (a) and (b) indicate levels of Y greater than Y1 in Figure (c) the intersection of IS and LM2. Thus I is wrong. No matter what caused the LM curve to shift had the IS curve been negatively inclined to the Y axis, Y would have increased. Thus II is wrong.

10

In Figure (a) the increase in the money supply shifts the LM curve to the right causing R to decrease from R1 to R2 which in turn causes

I. investment expenditure to increase
II. consumption expenditure to increase.

both of which lead to Y increasing from Y1 to Y2

Which of the following is correct?
A. I only
B. II only
C. Both I and II
D. Neither I nor II

The correct answer is C.

The shape of the IS curve reflects an MEI schedule in which a lower R is associated with higher investment expenditure. Thus I is true. The increase in Y from a given increase in investment (I) depends upon the marginal propensity to consume (MPC), i.e. △Y = 1/1-MPC x △I. The MPC is the increase in consumption for an increase in income. Thus II is true.

11

A linear consumption function passes through the origin and the point C = 75, Y = 100 where C = consump-tion function and Y = national income.

Which of the following contains the description of the savings function which is associated with the above consumption function?

A straight line intercepting the vertical axis at
A. −25
B. 0
C. 25
D. 75

 

The correct answer is B.

Since the consumption function goes through the origin, consumption and savings are both zero when Y = 0. Thus the savings function goes through the origin.

12

A linear consumption function passes through the origin and the point C = 75, Y = 100 where C = consump-tion function and Y = national income.

Which of the following contains the equation of the savings function associated with this consumption function?

A. S = .75Y
B. S = (1 − .75)Y
C. S = .75 + .25Y
D. S = 1 + .25Y

The equation of the consumption function is C = bY where b is the marginal propensity to consume. Since the consumption function goes through the origin and the point C = 75, Y = 100, b = .75

Since S = Y - C and C = bY

then S = Y - bY

= Y(1-b) but since b = 0.75

then S = (1 - 0.75)Y

 

13

In the ISLM diagram the monetary sector comprises

I. the demand for money
II. the supply of money
III. banks reserve requirements

Which of the following is correct?
A. I only
B. I and II only
C. II and III only
D. I, II and III

The correct answer is B.

The LM curve traces out the levels of national income and interest rates at which the demand for money equals the supply of money. The demand for money consists of transactions, speculative and precautionary demands and the supply is determined by the monetary authorities. Thus I and II are correct. No reference is made to the banking system or reserve requirements in this monetary model. Thus III is wrong.

14

Which of the following identifies correctly what the equilibrium rate of interest would be if the level of national income lay between Y1 and Y2?

It would be
A. greater than zero but less than S1
B. greater than S1 but less than S2
C. greater than R1 but less than R2
D. greater than R2 but less than R3

The correct answer is D.

A level of income between Y1 and Y2 would command planned savings between S1 and S2 which in turn would equate with planned investment between I1 and I2 which is associated with an interest rate between R2 and R3.

15

If the consumption function shifted so that the savings function remained linear arising in the origin but passed through the point S1Y2 then the

I. S = I schedule would shift upwards
II. MEI schedule would shift to the right
III. IS curve would shift to the right

Which of the following is correct?
A. I and II only
B. III only
C. I, II and III
D. Not I, not II, not III

The correct answer is B.

The S = I curve merely equates saving to investment and in a simple economy with no government and/or international sectors will always remain a 45% line from the origin. The MEI schedule relates levels of investment to interest rates and is independent of the savings function. Thus I and II are wrong.

However with the savings function shift S1 will equal I1 which is associated with interest rate R3. Thus the point R3Y2 will be part of the new IS curve which compared to the existing IS will be to the right.

16

If businesses become pessimistic about the future in light of rising unemployment and postponed investment expenditures they were about to make this would cause

I. the MEI schedule to shift to the right
II. the savings function to shift downwards
III. the IS curve to shift to the right

Which of the following is correct?
A. I only
B. II only
C. I and III only
D. Not I, not II, not III

The correct answer is D.

Pessimism in the business community would shift the MEI schedule to the left and cause the IS to move left. Thus I and III are wrong. With a rise in unemployment and a possible decrease in national income there could be a movement down the consumption and savings curves but no reason exists for a shift in these functions. Thus II is wrong.

17

If an international sector with a balance of trade surplus were to be added to the figure, which of the following would be true?

A. The S = I line would no longer be a 45° line
B. The S = I line would no longer pass through the origin
C. The MEI schedule would shift to the right
D. The savings function would have a different slope

The correct answer is B.

Suppose the amount of trade surplus were equal to the amount 0S1 in (b). The effect would be to shift upwards the S = I line in (b) so that it remained at 45% but originated at S1. Assuming 0S1 = S1S2, then a level of national income of Y2 would generate savings of 0S2; in (b) 0S2 would ‘finance’ a trade surplus of 0S1 and investment expenditure of 0I1, i.e.

Y = C + S

Y = C + I + (X-Z)

In equilibrium S = I + (X − Z)

The IS curve would shift to the right passing through R3Y2. The savings function and MEI schedule would not move. Thus A, C and D are wrong.

18

The shift in the IS curve from IS1 to IS2 could have resulted from

I. an increase in government expenditure
II. an increase in the income tax rate
III. an increase in exports

Which of the following is correct?
A. I and III only
B. II only
C. I, II and III
D. Not I, not II, not III

The correct answer is A.

Any stimulating fiscal policy will shift the IS curve to the right, i.e. an increase in government expenditure, a reduction in tax rates, a positive shift in the investment function and an increase in net exports. Thus II is wrong. I and III are true.

19

Which of the following identifies the diagram in which a given cut in the tax rate would have the largest impact on national income and explains why?

A. Diagram (a) because the increase in Y is equal approximately to the increase in R

B. Diagram (b) because there is no negative monetary/interest rate multiplier

C. Diagram (c) because the economy has reached full employment

D. Diagram (b) because the increase in demand is matched by an increase in the money supply thus keeping R constant

The correct answer is B.

In diagram (a) the tax cut causes national income to increase but also R and thus the full tax multiplier effect is partially offset. In diagram (c), there is no increase in Y; the increase in R cancels out completely the increase in Y caused by the tax decrease. In diagram (b) the liquidity trap exists and as a consequence the full tax multiplier is in effect; R does not increase and thus there is no negative monetary multiplier; an increase in the money supply is not required in the trap to match any increase in aggregate demand.

20

Crowding out is in evidence in the figure. When IS shifts because of an increase in government expenditure

I. there is partial crowding out in (a)
II. there is complete crowding out in (b)
III. there is complete crowding out in (c)

Which of the following is correct?
A. I only
B. II only
C. I and II only
D. I and III only

The correct answer is D.

Only in diagram (b) where there is no increase in R will there be no crowding out. Thus II is wrong. In diagram (c) there is no expansion in Y; the increase in R from R1 to R3 leads to complete crowding out of private investment expenditure. Thus III is true. In diagram (a), there is some expansion on Y from Y1 to Y2 but less than the increase from Y1 to Y3 in diagram (c) as a result of the increase in R from R1 to R2, i.e. partial crowding out. Thus I is true.

21

Which of the following statements describes the liquidity trap?

A. An increase in the money supply lowers the interest rate and stimulates investment expenditure.

B. An increase in the money supply has no effect on the interest rate and aggregate demand.

C. An increase in government expenditure increases aggregate demand and household savings and lowers the interest rate.

D. A decrease in government expenditure decreases aggregate demand and household savings and increases the interest rate.

The correct answer is B. The liquidity trap is a floor below which the interest rate does not fall. Holders of speculative balances expect the interest rate to rise and are unwilling to commit such balances to investment purposes. Thus any increase in the money supply is held in idle balances.

22

It can be stated that

I. the LM curve represents equilibrium values of the rate of interest and national income.

II. at any point on the LM curve, the government budget is balanced. Which of the following is correct?

A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.

The correct answer is A. Option I is the definition of the LM curve. The LM curve is concerned only with equilibrium in the money market and has no relationship whatsoever with factors affecting the IS curve. Thus option II is wrong.

23

If the IS curve is almost vertical, it means that I. the marginal propensity to consume is large. II. the marginal efficiency of investment curve is elastic.

Which of the following is correct?

A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.

The correct answer is D. If the marginal propensity to consume were large, a small increase in autonomous expenditure would bring about a relatively large increase in national output, reflected in an elastic IS curve. Thus option I is wrong. If the marginal efficiency of investment curve were elastic, a change in the rate of interest would bring about a relatively large change in the volume of investment. Thus option II is wrong.

24

Assuming the IS and LM curves do not intersect in the horizontal or vertical portions of the LM curve, which of the following would happen to the interest rate (R) and the level of national income (Y) if an increase in the money supply were accompanied by a
decrease in taxes?

A. R would decrease; Y would increase.

B. R would decrease; Y could increase, remain constant or decrease.

C. R could increase, remain constant or decrease; Y would increase.

D. R could increase, remain constant or decrease; Y would decrease.

The correct answer is C. The increase in the money supply would shift the LM curve to the right. The cut in taxes would shift the IS curve to the right. Thus the new intersection point of the IS and LM curves would be to the right of the original intersection point. Thus the equilibrium level of Y would be higher than the original. However, the impact on R would be determined by the relative shifts: R could increase, remain constant or decrease.

25

Which of the following is correct in relation to Figure 19.15?

A. To achieve full employment using only monetary policy, the money supply
would have to be increased by the amount BC.

B. To achieve full employment using only monetary policy, the money supply would have to be increased by the amount AC.

C. To achieve full employment using only monetary policy, the money supply
would have to be decreased by an amount BC − AB.

D. It is not possible to achieve full employment just by increasing the money supply.

The correct answer is D. The interest rate consistent with full employment occurs when the IS curve intersects the dotted YF line at point C in Figure 19.15. However, C is below the interest rate R0, which represents the liquidity trap. Thus increase in the money supply will not produce a low enough interest rate to achieve full employment.

26

Which of the following statements is correct with respect to point D in Figure 19.15?

A. Point D cannot be reached because it implies a level of national income greater
than full-employment national income.

B. Point D can be achieved, but it would produce an inflationary gap.

C. Point D can be achieved by a combination of tax cuts and increases in government expenditure with the money supply constant.

D. Point D can produce equilibrium in both the money and real goods markets by
an increase in the money supply with no changes in fiscal policy.

The correct answer is B. To reach point D in Figure 19.15 and to achieve equilibrium in both the real goods and monetary sectors, both the IS curve and LM curve would have to shift to the right. Thus answers C and D are wrong. It can be reached, however, but since point D lies to the right of YF, point D represents an inflationary gap situation.

27

On the basis of Figure 19.15, the government desires to achieve full employment YF, to raise the rate of interest to R3, and to have equilibrium in both the real goods and money markets. Which of the following policies could achieve all of these goals?

A. An increase in government expenditure and increase in the money supply.

B. A decrease in taxes and a decrease in the money supply.

C. An increase in government expenditure and decrease in taxes.

D. A decrease in the money supply.

The correct answer is B. To achieve all stated goals, the IS and LM curves must intersect at point E in Figure 19.15. This requires a decrease in the money supply to shift the LM curve to the left, accompanied by expansionary fiscal policy.

28

Government economists calculate that the value of the government expenditure multiplier is 4. The government increases expenditure by $1 million but the resultant increase in national income is only $3 million. The shortfall can be explained by I. an increase in the demand for money. II. an increase in potential output. Which of the following is correct?

A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.

The correct answer is A. The increase in government expenditure in the absence of offsetting factors would increase the demand for money and, in the absence of an increase in the money supply, raise interest rates, thereby producing a negative money multiplier on investment and consumption expenditure. Thus option I is correct. If the gap between potential and actual output were not large enough, this could prevent the full value of the multiplier being realised. Thus, any increase in potential output would help rather than hinder the full multiplier effect occurring. Thus option II is incorrect.

29

The following can be stated:

I. An increase in the money supply must always cause national income to rise.

II. A decrease in taxes must always cause the rate of interest to rise.

Which of the following is correct?

A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.

The correct answer is D. If the IS curve is vertical and/or if the economy is operating at full employment, an increase in the money supply will not result in an increase in national income. Thus option I is incorrect. If the LM curve is horizon- tal, i.e. the economy is in the liquidity trap, a decrease in taxes shifting the IS curve to the right may leave the rate of interest unchanged. Thus option II is incorrect.

30

An economy is in equilibrium in both the real goods and money markets. The government decides to increase both taxes and government expenditure. At the same time trade, which was balanced, now shows a trade surplus. What is the impact of these events combined on the IS and LM curves?

A. IS shifts to the right, LM shifts to the left.
B. IS shifts indeterminately, LM curve unaffected.
C. IS shifts to the left, LM curve unaffected.
D. IS shifts indeterminately, LM shifts indeterminately.

The correct answer is B. Since all the changes are in the real goods sector, the LM curve is not affected. Thus responses A and D are wrong. The increase in taxes would shift the IS curve to the left, and the increase in government expenditure would shift the IS curve to the right, as would the trade surplus. However, since we do not know the magnitude of the relative changes, we cannot tell where the IS curve will finish up.

31

Give an intro on The ntegration of the Real and Monetary Sectors of the Economy

The ‘real sector’ comprising of the consumption function and the marginal efficiency of investment and the ‘monetary sector’ comprising the supply and demand for money, interact together to influence the level of national income and the rate of interest. The equilibrium national income (Y) and the equilibrium interest rate depend on simultaneous equilibrium in both sectors. The equilibrium thus occurs if planned savings and planned investment are the same and the demand and supply for money are the same.

32

Define The liquidity trap

The liquidity trap is the floor below that the interest rate does not fall. The liquidity trap exists, because for any interest rate below the liquidity trap rate all the speculative money is held in cash, nothing in bonds, as everybody expects the interest rate to go up.

33

Intro of The liquidity-money (LM) curve

The liquidity-money (LM) curve  shows the relationship between the interest rate and the national income for which the monetary sector of the economy is in equilibrium, given a certain fixed money supply

34

Intro of the investment-savings (IS) curve

The investment-savings (IS) curve constructed below shows the combination of interest rate R and national income (Y) for which the real goods sector is in equilibrium, that is for which the planned investment of business consistent with the planned savings of households. The IS curve is constructed out of the combination of the consumption function (and this the savings function) (S in relationship to Y) and the marginal efficiency of investment function (I in relationship to R).

35

Discuss a steep IS cuve

Steep IS curve:
- Low marginal propensity to consume
- Interest inelastic marginal efficiency to invest (changes in interest provoke small changes in investment)
Interest has low impact on national income

36

Discuss a flat IS curve

Flat IS curve:
- High marginal propensity to consume
- Interest-elastic MEI
Interest has high impact on national income

37

What does the intersection of LM and IS mean?

Intersection of LM and IS: equilibrium of
- LM: Demand and supply of money (liquidity)
- IS: Planned saving equals planned investment

38

Increase in government spending (G) shifts IS curve ___

Increase in government spending (G) shifts IS curve up/right

- Value of G reduced if offset by increased taxes
- Trade surplus increases G

39

What does the IS/LM approach combine?

IS/LM approach combines:
- Monetary factors: supply/demand for money
- Real factors:  consumption, investment, government expenditure, net exports

 

40

Shift of IS up/right give higher equilibrium values of ___ and ___ in mid-range of LM; caused by:

Discuss the low/left and right/upper range of LM.

 

Shift of IS up/right give higher equilibrium values of Y and R in mid-range of LM; caused by:
- Upward lift of MEI (higher volume of investment at interest rate)
- Upward shift in consumption
- Budget deficit

 

In low/left range of LM
- Liquidity trap means shift of IS increases Y, leaves R constant

In right/upper-range of LM
- Crowding-out effect means G increase is offset by consumption 

41

Shift in LM impact depends on slope of IS, discuss.

Shift in LM impact depends on slope of IS:
- Shift of LM to right implies increase in money supply

- Flat IS
o High interest elasticity (firms undertake all expenditures only at given interest rate R
o LM shift (right) to equates to income increase
o Favoured by extreme monetarists

- Steep IS
o Interest inelasticity – same investment regardless of interest
o LM shift (right) equates to decrease in interest rate
o Favoured by extreme Keynesians

- Typical IS
o Downward sloping IS
o Shift of LM to right increases income, decreases interest