Topic 8

Question 1

What is the Keynesian cross model?

Answer 1

A closed economy model where income is determined by expenditure

Question 2

See

Answer 2

Top of page 1 notation and diagram

Question 3

How would an increase in G spending affect the KC diagram?

Answer 3

Shifts PE upwards

Increase G -> fall in unplanned inventories -> increase output tf Y increases too

Question 4

Define government purchases multiplier?

Answer 4

The increase in income resulting from a £1 increase in G

Question 5

How would an increase in T spending affect the KC diagram?

Answer 5

See notes

Question 6

Prove the Gov PM and Tax PM equations

Answer 6

Now (see slides)

Question 7

3 points about the tax multiplier?

Answer 7

…is negative:
A tax increase reduces C, which reduces income.
…is greater than one (in absolute value):
A change in taxes has a multiplier effect on income.
…is smaller than the govt spending multiplier:
Consumers save the fraction (1–MPC) of a tax cut, so the initial boost in spending from a tax cut is smaller than from an equal increase in G.

Question 8

Define tax multiplier?

Answer 8

The change in income resulting from a £1 increase in T

Question 9

What does the IS curve show?

Answer 9

All the combinations of r and Y that result in goods market equilibrium

Question 10

Derive the IS curve

Answer 10

Now - see notes

Question 11

Why is the IS curve negatively sloped?

Answer 11

Because a fall in r -> increase in investment spending -> increase planned expenditure

Question 12

What is the theory of liquidity preference?

Answer 12

A theory in which the interest rate is determined by money supply and money demand

Question 13

See

Answer 13

Slides: how FP affects the IS curve

Question 14

Draw supply and demand of RMB curve?

Answer 14

Now: see notes

Question 15

How does the CB change r?

Answer 15

The supply of RMB is fixed, so the interest rate adjusts to equate the supply and demand for money; by changing the money supply they affect money demand and tf the real interest rate

Question 16

What is the LM curve?

Answer 16

A graph of all combinations of r and Y that equate supply and demand for RMB

Question 17

Derive the graph for the LM curve

Answer 17

Now (see notes)

Question 18

Why is the LM curve UWS?

Answer 18

Increase in Y -> increase money demand -> increase in r (since supply of RMB is fixed)

Question 19

Explain how a change in the money supply would affect the LM diagram?

Answer 19

It’d shift supply of RMB left, tf causing the LM curve to shift up

Question 20

Draw SREQ of IS-LM diagram

Answer 20

Now (see notes)

Question 21

See

Answer 21

top of page 2 notes recap bit

Question 22

Explain how an increase in government purchases would affect the IS-LM diagram?

Answer 22

IS shifts right by (1/(1-MPC)).ΔG
Tf increase in Y -> increase in money demand -> increase r -> decrease in investment
TF overall increase in Y is less than (1/(1-MPC)).ΔG (see diagram)

Question 23

Explain how a decrease in tax would affect the IS-LM diagram?

Answer 23

Consumers save (1-MPC) of the tax cut tf initial spending boost is less for ΔT than an equal ΔG

IS curve shifts right by (-MPC/(1-MPC))ΔT (see diagram)

Question 24

Explain how an increase in money supply would affect the IS-LM diagram?

Answer 24

Downward shift of LM curve -> decrease in r -> increase in investment and increase in Y

Question 25

3 possible responses the CB may use to an increase in government spending and their explanations? Draw their diagrams.

Answer 25

1) Hold M constant:
LM doesn’t shift, Y and r increase
2) Hold r constant:
Increase in G -> increase in IS curve. To keep r the same, CB increase M tf LM shifts down tf Y increases further and Δr=0
3) Hold Y constant:
Increase in G -> increase in IS curve. To keep Y constant CB decrease the money supply tf left shift of LM curve, tf ΔY=0, r raises further

Question 26

What causes the IS curve to shift?

Answer 26

Exogenous changes in the demand for goods and services (shocks):
eg. change in consumer confidence
stock market boom/crash

Question 27

What causes the LM curve to shift?

Answer 27

Exogenous changes in the demand for money:

eg. -credit card fraud -> increase demand for money
- internet shopping reduces demand for money

Question 28

Use the IS-LM model to analyze the effects of
1. a housing market crash that reduces consumers’ wealth
2. consumers using cash in transactions more frequently in response to
an increase in identity theft

Answer 28

do it

Question 29

Explain how the FED controls interest rates?

Answer 29

They set a target for the federal funds rate, which is the interest rate banks charge each other on overnight loans. They then change the money supply accordingly to shift the LM curve to achieve their target. Other short term rates then typically move with the federal funds rate.

Question 30

Derive the AD curve using the LM curve? Explain the intuition behind it.

Answer 30

See slide 20
Increase in P -> decrease in (M/P) -> LM curve shifts left -> increase in real interest rate -> fall in investment and tf a fall in Y
Tf increase in P -> decrease in Y tf DWS AD

Question 31

How can the FED increase aggregate demand?

Answer 31

By increasing money supply, they shift LM curve right -> fall in r -> increase in I -> increase in Y AT EACH LEVEL OF P tf AD has shifted right

Question 32

Explain how expansionary fiscal policy will affect the IS-LM model?

Answer 32

Inc. G or dec. T:

-> inc. C -> IS shifts right -> inc. Y and r

Question 33

Explain, with diagrams, the SR and LR effects of an IS shock?

Answer 33

See slides 24-28

also do slides 29-30

Question 34

What is the spending hypothesis?

Answer 34

Hypothesis that the US depression was largely due to an exogenous fall in demand for goods and services; a leftward shift of the IS curve. The evidence for this is that output and interest rates both fell, which is what a leftward shift of the IS curve would cause

Question 35

In the spending hypothesis, explain the 3 causes of the IS curve shift?

Answer 35

1) Stock market crash reduced consumption:
- Oct 1929–Dec 1929: S&P 500 fell 17%
- Oct 1929–Dec 1933: S&P 500 fell 71%

2) Drop in investment:
- Correction for overbuilding in the 1920s
- Widespread bank failures made it difficult to attain finance

3) Contractionary fiscal policy:
Politicians raised taxes and cut spending to reduce increasing deficits

Question 36

What is the money hypothesis and evidence?

Answer 36

Hypothesis that the depression was largely due to a huge fall in the money supply tf shifting LM curve left. Evidence is that M1 fell 25% from 1929-1933

Question 37

Explain 2 issues with the money hypothesis?

Answer 37

1) P fell further than M in this period so M/P technically rose a bit
2) Nominal interest rates fell, which is the opposite of what a leftward shift of the LM curve would cause

Question 38

Explain the improved money hypothesis?

Answer 38

Money supply falling might’ve led to a fall in the price level, tf deflation

Question 39

What are the 4 possible effects of deflation?

Answer 39

• The stabilizing effects of deflation
• The Pigou effect
• The destabilizing effects of expected deflation
• The destabilizing effects of unexpected deflation

Question 40

Explain the stabilizing effects of deflation?

Answer 40

Decrease P -> Increase M/P -> LM shifts right -> inc. Y

Question 41

Explain the Pigou effect?

Answer 41

Decrease P -> increase M/P -> increase consumer wealth -> increase C -> IS curve shifts right -> increase in Y

Question 42

Explain the destabilizing effects of expected deflation?

Answer 42

Decrease expected inflation -> increase in r for each value of i -> decrease investment -> fall in AD -> fall in Y

Question 43

Explain the destabilizing effects of expected deflation?

Answer 43

Debt deflation theory:
Decrease in P unexpectedly -> transfer of purchasing power from borrowers to lenders -> lenders spend more, borrowers spend less
tf if borrowers have a higher propensity to spend than lenders, then aggregate spending falls
Tf IS shifts left, Y falls

Question 44

4 reasons another depression is unlikely?

Answer 44

Policymakers (or their advisers) now know much more about macroeconomics:
◦ The Fed knows better than to let M fall so much, especially during a
contraction.
◦ Fiscal policymakers know better than to raise taxes or cut spending during a
contraction.
ALSO:
-Federal deposit insurance makes widespread bank failures very unlikely.
-Automatic stabilizers make fiscal policy expansionary during an economic
downturn