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Testbank Chapter 11: Aggregate Demand II
Name
0 points
Question
The interaction of the IS curve and the LM curve together determine:
Answer
Multiple Choice
0 points
Question
Exhibit: IS-LM Fiscal Policy
(Exhibit: IS-LM Fiscal Policy) Based on the graph, starting from equilibrium at interest rate r and income
1
Y1, a decrease in government spending would generate the new equilibrium combination of interest rate
and income:
Answer
r2, Y2
r3, Y2
r2, Y3
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r3, Y3
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Multiple Choice
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Exhibit: IS-LM Fiscal Policy
(Exhibit: IS-LM Fiscal Policy) Based on the graph, starting from equilibrium at interest rate r and income
1
Y1, an increase in government spending would generate the new equilibrium combination of interest rate
and income:
Answer
r2, Y2
r3, Y2
r2, Y3
r3, Y3
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Multiple Choice
0 points
Question
Exhibit: IS-LM Fiscal Policy
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(Exhibit: IS-LM Fiscal Policy) Based on the graph, starting from equilibrium at interest rate r and income
1
Y1, a tax cut would generate the new equilibrium combination of interest rate and income:
Answer
r2, Y2
r3, Y2
r2, Y3
r3, Y3
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Multiple Choice
0 points
Question
In the IS-LM model when government spending rises, in short-run equilibrium, in the usual case, the
interest rate ______ and output ______.
Answer
rises; falls
rises; rises
falls; rises
falls; falls
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Multiple Choice
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Question
In the IS-LM model, a decrease in government purchases leads to a(n) ______ in planned expenditures,
a(n) ______ in total income, a(n) ______ in money demand, and a(n) ______ in the equilibrium interest
rate.
Answer
Multiple Choice
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Question
In the IS-LM model, the impact of an increase in government purchases in the goods market has
ramifications in the money market, because the increase in income causes a(n) ______ in money ______.
Answer
increase; supply
increase; demand
decrease; supply
decrease; demand
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Question
In the IS-LM model when taxation increases, in short-run equilibrium, in the usual case, the interest rate
______ and output ______.
Answer
rises; falls
rises; rises
falls; rises
falls; falls
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Multiple Choice
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Question
If the LM curve is vertical and government spending rises by G, in the IS-LM analysis, then equilibrium
income rises by:
Answer
G/(1 MPC).
more than zero but less than G/(1 MPC).
G.
zero.
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Question
If MPC = 0.75 (and there are no income taxes) when G increases by 100, then the IS curve for any given
interest rate shifts to the right by:
Answer
100.
200.
300.
400.
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Question
If MPC = 0.75 (and there are no income taxes but only lump-sum taxes) when T decreases by 100, then the
IS curve for any given interest rate shifts to the right by:
Answer
100.
200.
300.
400.
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Question
In the IS-LM model under the usual conditions in a closed economy, an increase in government spending
increases the interest rate and crowds out:
Answer
prices.
investment.
the money supply.
taxes.
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Question
The increase in income in response to a fiscal expansion in the IS-LM model is:
Answer
Multiple Choice
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Question
Using the IS-LM analysis, if the LM curve is not horizontal, the multiplier for an increase in government
spending is ______ for an increase in government purchases using the Keynesian-cross analysis.
Answer
Multiple Choice
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Question
The reason that the income response to a fiscal expansion is generally less in the IS-LM model than it is in
the Keynesian-cross model is that the Keynesian-cross model assumes that:
Answer
investment is not affected by the interest rate whereas in the IS-LM model fiscal expansion
raises the interest rate and crowds out investment.
investment is not affected by the interest rate whereas in the IS-LM model fiscal expansion
lowers the interest rate and crowds out investment.
investment is autonomous whereas in the IS-LM model fiscal expansion encourages higher
investment, which raises the interest rate.
the price level is fixed whereas in the IS-LM model it is allowed to vary.
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In the IS-LM model, changes in taxes initially affect planned expenditures through:
Answer
consumption.
investment.
government spending.
the interest rate.
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Question
In the IS-LM analysis, the increase in income resulting from a tax cut is usually ______ the increase in
income resulting from an equal rise in government spending.
Answer
less than
greater than
equal to
sometimes less and sometimes greater than
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Exhibit: IS-LM Monetary Policy
(Exhibit: IS-LM Monetary Policy) Based on the graph, starting from equilibrium at interest rate r and income
1
Y1, a decrease in the money supply would generate the new equilibrium combination of interest rate and
income:
Answer
r2, Y2
r3, Y2
r2, Y3
r3, Y3
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Question
Exhibit: IS-LM Monetary Policy
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(Exhibit: IS-LM Monetary Policy) Based on the graph, starting from equilibrium at interest rate r and income
1
Y1, an increase in the money supply would generate the new equilibrium combination of interest rate and
income:
Answer
r2, Y2
r3, Y2
r2, Y3
r3, Y3
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Multiple Choice
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Question
If the money supply increases, then in the IS-LM analysis the ______ curve shifts to the ______.
Answer
LM; left
LM; right
IS; left
IS; right
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Question
In the IS-LM model when M/P rises, in short-run equilibrium, in the usual case, the interest rate ______ and
output ______.
Answer
rises; falls
rises; rises
falls; rises
falls; falls
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Question
In the IS-LM model when M rises but P remains constant, in short-run equilibrium, in the usual case, the
interest rate ______ and output ______.
Answer
rises; falls
rises; rises
falls; rises
falls; falls
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Question
In the IS-LM model when M remains constant but P rises, in short-run equilibrium, in the usual case, the
interest rate ______ and output ______.
Answer
rises; falls
rises; rises
falls; rises
falls; falls
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Question
If the demand for real money balances does not depend on the interest rate, then the LM curve:
Answer
Multiple Choice
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Question
In the IS-LM model when the Federal Reserve decreases the money supply, people ______ bonds and the
interest rate ______, leading to a(n) ______ in investment and income.
Answer
Multiple Choice
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Question
The monetary transmission mechanism works through the effects of changes in the money supply on:
Answer
Multiple Choice
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Question
The monetary transmission mechanism in the IS-LM model is a process whereby an increase in the money
supply increases the demand for goods and services:
Answer
directly.
by lowering the interest rate so that investment spending increases.
by raising the interest rate so that investment spending increases.
by increasing government spending on goods and services.
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Question
If Congress passed a tax increase at the request of the president to reduce the budget deficit, but the Fed
held the money supply constant, then the two policies together would generally lead to ______ income and
a ______ interest rate.
Answer
lower; lower
lower; higher
no change in; lower
no change in; higher
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Question
According to the IS-LM model, if Congress raises taxes but the Fed wants to hold the interest rate constant,
then the Fed must ______ the money supply.
Answer
increase
decrease
first increase and then decrease
first decrease and then increase
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Question
According to the IS-LM model, if Congress raises taxes but the Fed wants to hold income constant, then the
Fed must ______ the money supply.
Answer
increase
decrease
first increase and then decrease
first decrease and then increase
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If taxes are raised, but the Fed prevents income from falling by raising the money supply, then:
Answer
Multiple Choice
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Question
Exhibit: Policy Interaction
(Exhibit: Policy Interaction) Based on the graph, starting from equilibrium at interest rate r , incomeY , IS ,
3
and LM , if there is an increase in government spending that shifts the IS curve to IS , then in order to keep
1
the interest rate constant the Federal Reserve should ______ the money supply shifting to ______.
Answer
increase; LM
decrease; LM
increase; LM
decrease; LM
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Exhibit: Policy Interaction
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(Exhibit: Policy Interaction) Based on the graph, starting from equilibrium at interest rate r , income Y , IS
3
1,
and LM , if there is an increase in government spending that shifts the IS curve to IS , then in order to keep
1
output constant the Federal Reserve should ______ the money supply shifting to ______.
Answer
increase; LM
decrease; LM
increase; LM
decrease; LM
0 points
Question
Exhibit: Policy Interaction
(Exhibit: Policy Interaction) Based on the graph, starting from equilibrium at interest rate r , income Y , IS ,
3
and LM , if there is an increase in government spending that shifts the IS curve to IS and the Federal
1
Reserve does not change the money supply, the new equilibrium combination of interest and income will be
______.
Answer
r1, Y2
r2, Y3
r3, Y3
r3, Y4
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Question
According to the macroeconometric model developed by Data Resources Incorporated, the response of
GDP four quarters after an increase in government spending, with the nominal interest rate held constant,
will be ______ the response of GDP to a similar change with the money supply held constant.
Answer
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Question
According to the macroeconometric model developed by Data Resources Incorporated, if taxes are
increased by $100 billion, but the money supply is held constant, then GDP will fall by about:
Answer
zero.
$25 billion.
$75 billion.
$100 billion.
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Question
An increase in investment demand for any given level of income and interest ratesdue, for example, to
more optimistic animal spiritswill, within the IS-LM framework, ______ output and ______ interest rates.
Answer
increase; lower
increase; raise
lower; lower
lower; raise
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An increase in consumer saving for any given level of income will shift the:
Answer
Multiple Choice
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Question
An increase in the demand for money, at any given income level and level of interest rates, will, within the
IS-LM framework, ______ output and ______ interest rates.
Answer
increase; lower
increase; raise
lower; lower.
lower; raise
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In the IS-LM model, a decrease in the interest rate would be the result of a(n):
Answer
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In the IS-LM model, a decrease in output would be the result of a(n):
Answer
decrease in taxes.
increase in the money supply.
increase in money demand.
increase in government purchases.
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The U.S. recession of 2001 can be explained in part by a declining stock market and terrorist attacks. Both
of these shocks can be represented in the IS-LM model by shifting the ______ curve to the ______.
Answer
LM; right
LM; left
IS; right
IS; left
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Question
One policy response to the U.S. economic slowdown of 2001 were tax cuts. This policy response can be
represented in the IS-LM model by shifting the ______ curve to the ______.
Answer
LM; right
LM; left
IS; right
IS; left
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One policy response to the U.S. economic slowdown of 2001 was to increase money growth. This policy
response can be represented in the IS-LM model by shifting the ______ curve to the ______.
Answer
LM; right
LM; left
IS; right
IS; left
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Question
When bond traders for the Federal Reserve seek to increase interest rates, they ______ bonds, which
shifts the ______ curve to the left.
Answer
buy; IS
buy; LM
sell; IS
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sell; LM
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When bond traders for the Federal Reserve seek to decrease interest rates, they ______ bonds, which
shifts the ______ curve to the right.
Answer
buy; IS
buy; LM
sell; IS
sell; LM
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Question
The aggregate demand curve generally slopes downward and to the right because, for any given money
supply, M, a higher price level, P, causes a ______ real money supply M/P, which ______ the interest rate
and ______ spending:
Answer
Multiple Choice
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An economic change that does not shift the aggregate demand curve is a change in:
Answer
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A change in income in the IS-LM model for a fixed price level:
Answer
Multiple Choice
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Question
An increase in the money supply shifts the ______ curve to the right, and the aggregate demand curve
______.
Answer
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A tax cut shifts the ______ to the right, and the aggregate demand curve ______.
Answer
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A decrease in the price level shifts the ______ curve to the right, and the aggregate demand curve ______.
Answer
Multiple Choice
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Question
A change in income in the IS-LM model resulting from a change in the price level represents a ______
aggregate demand curve, while a change in income in the IS-LM model for a given price level represents a
______ aggregate demand curve.
Answer
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Exhibit: IS-LM to Aggregate Demand
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(Exhibit: IS-LM to Aggregate Demand) Based on the graph, if LM shifts to LM because the price level
1
Answer
Multiple Choice
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Exhibit: IS-LM to Aggregate Demand
(Exhibit: IS-LM to Aggregate Demand) Based on the graph, if LM shifts to LM because the money supply
3
Answer
Multiple Choice
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Question
Exhibit: IS-LM to Aggregate Demand
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(Exhibit: IS-LM to Aggregate Demand) Based on the graph, which is the correct ordering of the price levels
and money supplies?
Answer
Multiple Choice
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Question
A movement along an aggregate demand curve corresponds to a change in income in the IS-LM model
______, while a shift in an aggregate demand curve corresponds to a change in income in the IS-LM model
______.
Answer
resulting from a change in monetary policy; resulting from a change in fiscal policy
resulting from a change in fiscal policy; resulting from a change in monetary policy
at a given price level; resulting from a change in the price level
resulting from a change in the price level; at a given price level
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A shift in the aggregate demand curve, starting from long-run equilibrium, which increases output in the
short run, will ______ in the long run, as compared to a short-run equilibrium.
Answer
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If the short-run IS-LM equilibrium occurs at a level of income below the natural level of output, then in the
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long run the price level will ______, shifting the ______ curve to the right and returning output to the natural
level.
Answer
increase; IS
decrease; IS
increase; LM
decrease; LM
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If the short-run IS-LM equilibrium occurs at a level of income above the natural level of output, in the long
run the ______ will ______ in order to return output to the natural level.
Answer
Multiple Choice
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Question
Exhibit: Short Run to Long Run
(Exhibit: Short Run to Long Run) Based on the graph, if the economy starts from a short-term equilibrium at
A, then the long-run equilibrium will be at ______ with a ______ price level.
Answer
B; higher
B; lower
C; higher
C; lower
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Exhibit: Short Run to Long Run
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(Exhibit: Short Run to Long Run) Based on the graph, if the economy starts from a short-term equilibrium at
D, then the long-run equilibrium will be at ______ with a ______ price level.
Answer
B; higher
B; lower
C; higher
C; lower
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Question
The macroeconomic model may be completed by adding either the Keynesian assumption that ______ or
the classical assumption that ______.
Answer
Multiple Choice
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Question
Analysis of the short and long runs indicates that the ______ assumptions are most appropriate in ______.
Answer
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Question
The spending hypothesis suggests that the Great Depression was caused by a:
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All of the following events are consistent with the spending hypothesis as contributing to the Great
Depression except:
Answer
Multiple Choice
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The money hypothesis suggests that the Great Depression was caused by a:
Answer
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Question
The Great Depression in the United States:
Answer
was likely caused by a fall in the money supply because it fell by 25 percent from 1929 to 1933.
cannot be attributed to a fall in the money supply because the money supply did not fall.
probably cannot be considered to have started because of a leftward shift in the LM curve
because real balances did not fall between 1929 and 1931.
probably was caused by a leftward shift in the LM curve because interest rates remained high
between 1929 and 1933.
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The Pigou effect:
Answer
suggests that as prices fall and real money balances rise, consumers should feel less wealthy
and spend less.
suggests that as prices fall and real money balances rise, consumers should feel wealthier and
spend more.
suggests that as prices fall and real money balances rise, consumers should feel less wealthy
but spend more.
is generally accepted as adequate proof that the economy must be able to correct itself.
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Question
The Pigou effect suggests that falling prices will increase income because real balances influence ______
and will shift the ______ curve.
Answer
money demand; LM
the money supply; LM
consumer spending; IS
government spending; IS
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If real money balances enter the IS-LM model both through the theory of liquidity preference and the Pigou
effect, than a fall in the price level will shift:
Answer
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If real money balances enter the IS-LM model both through the theory of liquidity preference and the Pigou
effect, than a fall in the price level will result in higher income and:
Answer
Multiple Choice
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Question
The debt-deflation theory of the Great Depression suggests that a(n) ______ deflation redistributes wealth
in such a way as to ______ spending on goods and services.
Answer
unexpected; reduce
unexpected; increase
expected; reduce
expected; increase
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The debt-deflation hypothesis explains the fall in income as a consequence of unexpected deflation
transferring wealth ______ and that creditors have ______ propensity to consume than debtors.
Answer
Multiple Choice
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Question
An unexpected deflation can change demand by redistributing wealth from:
Answer
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Possible explanations put forth for the Great Depression do not include:
Answer
Multiple Choice
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Question
Investment depends on the ______ interest rate, and money demand depends on the ______ interest rate.
Answer
real; real
nominal; nominal
real; nominal
nominal; real
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Question
In the IS-LM model, starting with no expected inflation, if expected inflation becomes negative, then the:
Answer
Multiple Choice
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Question
One explanation for the impact of expected price changes on the level of output is that an increase in
expected deflation ______ the nominal interest rate and ______ the real interest rate, so that investment
spending declines.
Answer
lowers; raises
raises; lowers
raises; raises
lowers; lowers
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In the IS-LM model, a decrease in expected inflation (an increase in expected deflation), leads to a(n):
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Other things equal, an expected deflation can change demand by:
Answer
Multiple Choice
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Question
During the financial crisis of 200809, many financial institutions stopped making loans even to creditworthy
customers, which could be represented in the IS-LM model as a(n):
Answer
Multiple Choice
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Question
All of the following may have contributed to the financial crisis and economic downturn of 200809 except:
Answer
high inflation.
low interest rates.
stock market volatility.
falling house prices.
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Most economists believe:
Answer
Multiple Choice
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Question
All of the following were observed during both the Great Depression of the 1930s in the United States and
the Japanese slump of the 1990s except:
Answer
Multiple Choice
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Question
Even though nominal interest rates were already very low, some economists recommended that the Bank of
Japan increase the growth of the money supply in the 1990s in order to:
Answer
Multiple Choice
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Question
A liquidity trap occurs when:
Answer
banks have too much currency and close their doors to new customers.
the central bank mistakenly prints too much money, generating hyperinflation.
interest rates fall so low that monetary policy is no longer effective.
dams and locks are built to prevent flooding.
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Question
If a liquidity trap does exist, then ______ policy will not be effective in increasing income when interest rates
reach very ______ levels.
Answer
monetary; high
monetary; low
fiscal; high
fiscal; low
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Question
If expected inflation equals 3 percent and monetary policymakers push the nominal interest rate to 1
percent, the real interest rate equals ______ percent.
Answer
4
1
0
2
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Question
When drawn with the interest rate on the vertical axis and income on the horizontal axis, the IS curve will be
steeper the:
Answer
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The slope of the IS curve depends on:
Answer
Multiple Choice
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Question
A given increase in taxes shifts the IS curve more to the left the:
Answer
Multiple Choice
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Question
The LM curve is steeper the ______ the interest sensitivity of money demand and the ______ the effect of
income on money demand.
Answer
greater; greater
greater; smaller
smaller; smaller
smaller; greater
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Question
If the demand function for money is M/P = 0.5Y 100r, then the slope of the LM curve is:
Answer
0.001.
0.005.
0.01.
0.05.
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If the demand function for money is M/P = 0.5Y 100r and if M/P increases by 100, then the LM curve for
any given interest rate shifts to the:
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Answer
left by 100.
left by 200.
right by 100.
right by 200.
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Other things equal, a given change in government spending has a larger effect on demand the:
Answer
Multiple Choice
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Question
Other things equal, a given change in government spending has a larger effect on demand the:
Answer
Multiple Choice
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Question
Other things equal, a given change in money supply has a larger effect on demand the:
Answer
Multiple Choice
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Question
Other things equal, a given change in money supply has a larger effect on demand the:
Answer
Multiple Choice
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Question
If money demand does not depend on the interest rate, then the LM curve is ______ and ______ policy has
no effect on output.
Answer
horizontal; fiscal
vertical; fiscal
horizontal; monetary
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vertical; monetary
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If neither investment nor consumption depends on the interest rate, then the IS curve is ______ and
______ policy has no effect on output.
Answer
vertical; monetary
horizontal; monetary
vertical; fiscal
horizontal; fiscal
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0 points
Question
If money demand is infinite below some certain r (e.g., r*) and zero above r*, then the LM curve is ______
and ______ policy has no effect on output.
Answer
vertical; fiscal
horizontal; fiscal
vertical; monetary
horizontal; monetary
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Multiple Choice
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Question
If investment demand is infinite below some certain r (e.g., r**) and zero above r**, then the IS curve is
______ and ______ policy has no effect on output.
Answer
vertical; monetary
horizontal; monetary
vertical; fiscal
horizontal; fiscal
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Multiple Choice
0 points
Question
If the investment demand function is I = c dr and the quantity of real money demanded is eY fr, then
fiscal policy is relatively potent in influencing aggregate demand when d is ______ and f is ______.
Answer
large; small
small; small
small; large
large; large
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Question
If the investment demand function is I = c dr and the quantity of real money demanded is eY fr, then
monetary policy is relatively potent in influencing aggregate demand when d is ______ and f is ______.
Answer
large; small
small; also small
small; large
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Question
Those economists who believe that fiscal policy is more potent than monetary policy argue that the:
Answer
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Question
Those economists who believe that monetary policy is more potent than fiscal policy argue that the:
Answer
0 points
Question
According to the IS-LM model, when the government increases taxes and government purchases by equal
amounts:
Answer
Multiple Choice
0 points
Question
If consumption is given by C = 200 + 0.75(Y T) and investment is given by I = 200 25r, then the formula
for the IS curve is:
Answer
Multiple Choice
0 points
Question
If the IS curve is given by Y = 1,700 100r and the LM curve is given by Y = 500 + 100r, then equilibrium
income and interest rate are given by:
Answer
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Y = 1,100, r = 6 percent.
Y = 1,200, r = 5 percent.
Y = 1,000, r = 5 percent.
Y = 1,100, r = 5 percent.
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Question
d
If the IS curve is given by Y = 1,700 100r, the money demand function is given by (M/P) = Y 100r, the
money supply is 1,000, and the price level is 2, then if the money supply is raised to 1,200, equilibrium
income rises by:
Answer
Multiple Choice
0 points
Question
If investment does not depend on the interest rate, then the ______ curve is ______.
Answer
IS; vertical
IS; horizontal
LM; vertical
LM; horizontal
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Question
If money demand does not depend on income, then the ______ curve is ______.
Answer
IS; vertical
IS; horizontal
LM; vertical
LM; horizontal
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Question
If money demand is extremely sensitive to the interest rate, then the ______ curve is ______.
Answer
IS; vertical
IS; horizontal
LM; vertical
LM; horizontal
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Question
If the government wants to raise investment but keep output constant, it should:
Answer
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Question
A tax cut combined with tight money, as was the case in the United States in the early 1980s, should lead to
a:
Answer
Multiple Choice
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Question
An increase in the money supply:
Answer
increases income and lowers the interest rate in both the short and long runs.
increases income in both the short and long runs, but leaves the interest rate unchanged in the
long run.
lowers the interest rate in both the short and long runs, but leaves income unchanged in the
long run.
lowers the interest rate and increases income in the short run, but leaves both unchanged in
the long run.
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Question
An increase in government spending raises income:
Answer
and the interest rate in the short run, but leaves both unchanged in the long run.
in the short run, but leaves it unchanged in the long run, while lowering investment.
in the short run, but leaves it unchanged in the long run, while lowering consumption.
and the interest rate in both the short and long runs.
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Question
An increase in taxes lowers income:
Answer
and the interest rate in the short run, but leaves both unchanged in the long run.
in the short run, but leaves it unchanged in the long run, while increasing consumption and
lowering investment.
in the short run, but leaves it unchanged in the long run, while lowering consumption and
increasing investment.
and the interest rate in both the short and long runs.
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Essay
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Question
Assume the following model of the economy, with the price level fixed at 1.0:
C = 0.8(Y T)
T = 1,000
I = 800 20r
G = 1,000
Y=C+I+G
Ms = 1,200
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a. Write a numerical formula for the IS curve, showing Y as a function of r alone. (Hint: Substitute out C, I,
G, and T.)
b. Write a numerical formula for the LM curve, showing Y as a function of r alone. (Hint: Substitute out M/P.)
c. What are the short-run equilibrium values of Y, r, Y T, C, I, private saving, public saving, and national
saving? Check by ensuring that C + I + G = Y and national saving equals I.
d. Assume that G increases by 200. By how much will Y increase in short-run equilibrium? What is the
government-purchases multiplier (the change in Y divided by the change in G)?
s
e. Assume that G is back at its original level of 1,000, but M (the money supply) increases by 200. By how
much will Y increase in short-run equilibrium? What is the multiplier for money supply (the change in Y
s
0 points
Question
Assume that an economy is characterized by the following equations:
C = 100 + (2/3)(Y T)
T = 600
G = 500
I = 800 (50/3)r
s
M /P = M /P = 0.5Y 50r
a.
b.
c.
Solve for the equilibrium values of Y and r, assuming P = 1.0 and M = 1,200.
How do they change when P = 2.0? Check by computing C, I, and G.
d.
Write the numerical aggregate demand curve for this economy, expressing Y as
a function of G, T, and M/P.
0 points
Question
Assume that an economy is described by the IS curve Y = 3,600 + 3G 2T 150r and the LM curve Y =
2M/P + 100r [or r = 0.01Y 0.02(M/P)]. The investment function for this economy is 1,000 50r. The
consumption function is C = 200 + (2/3)(Y T). Long-run equilibrium output for this economy is 4,000. The
price level is 1.0 and M = 1,200.
a.
Assume that government spending is fixed at 1,200. The government wants to
achieve a level of investment equal to 900 and also achieve Y = 4,000. What
level of r is needed for I = 900? What levels of T and M must be set to achieve
the two goals? What will be the levels of private saving, public saving, and
national saving? (Hint: Check C + I + G = Y.)
b.
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Now assume that the government wants to cut taxes to 1,000. With G set at
1,200, what will the interest rate be at Y = 4,000? What must be the value of M?
What will I be? What will be the levels of private, public, and national saving?
(Hint: Check C + I + G = Y.)
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c.
Which set of policies may be referred to as tight fiscal, loose money? Which set
of policies may be referred to as loose fiscal, tight money? Which policy mix
most encourages investment?
Answer a. r = 2; T = 1,450; M = 1,900. Private saving = 650; public saving = 250; national saving = 900.
b. r = 8; M = 1,600; I = 600; private saving = 800; public saving = 200; national saving = 600.
c. The policy under part a is tight fiscal, easy money. The policy under part b is loose fiscal, tight
money. The policy under part a most encourages investment.
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Question
Suppose Congress wishes to reduce the budget deficit by reducing government spending. Use the IS-LM
model to illustrate graphically the impact of the reduction in government spending on output and interest
rates. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curves
shift; and v. the terminal equilibrium values.
Answer
0 points
Question
Suppose Congress passes legislation that reduces taxes. Use the IS-LM model to illustrate graphically the
impact of the tax reduction on output and interest rates. Be sure to label: i. the axes; ii. the curves; iii. the
initial equilibrium values; iv. the direction the curves shift; and v. the terminal equilibrium values.
Answer
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Question
How can the Fed keep the economy from falling into a recession if the budget deficit is reduced? Use the
IS-LM model to illustrate graphically the impact of both the fiscal policy reducing the deficit and the
monetary policy, which prevents output from falling. Be sure to label: i. the axes; ii. the curves; iii. the initial
equilibrium values; iv. the direction the curves shift; and v. the terminal equilibrium values.
Answer
0 points
Question
Use the IS-LM model to illustrate graphically the impact on output and interest rates of a one-time increase
in the price level due to a large increase in oil prices. Be sure to label: i. the axes; ii. the curves; iii. the initial
equilibrium values; iv. the direction the curves shift; and v. the terminal equilibrium values.
Answer
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Question
Suppose that people finally realize that they must save a larger proportion of their income in order to retire
and that they simultaneously begin to use new technology, which allows them to reduce their holdings of
real cash balances as a proportion of their income. Use the IS-LM model to illustrate graphically the impact
of these two changes in household behavior on output and interest rates. Be sure to label: i. the axes; ii. the
curves; iii. the initial equilibrium values; iv. the direction the curves shift; and v. the terminal equilibrium
values.
Answer
The interest rate decreases, but the impact on output is ambiguous, depending on whether the IS
or LM curve shifts more.
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Question
Use the IS-LM model to illustrate graphically the impact of the Pigou effect on the equilibrium level of
income and interest rate during the Great Depression, when prices were falling.
Answer
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Both the interest rate and income increase because the falling prices increase money balances,
thus making consumers feel wealthier. The increase in wealth causes consumers to consume
more, thereby shifting the IS curve to the right.
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Question
Assume that initially everyone expects the price level to stay the same. Now the Federal Reserve
announces that it will increase the rate of money growth in one year. People now expect inflation. Use the
IS-LM model to illustrate graphically the impact of expected inflation on the level of output and on the real
and nominal interest rates.
Answer
The increase in expected inflation increases output and the nominal interest rate and lowers the
real interest rate.
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Question
Assume that the economy is initially in short-run equilibrium at a level of output above the natural rate. Use
the IS-LM model to illustrate graphically how the levels of income and interest rates change as the economy
returns to the natural rate of output in the long run.
Answer
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Prices increase, reducing real money balances and resulting in lower output and a higher
interest rate.
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Question
Two identical countries, Alpha and Beta, can be described by the IS-LM model in the short run. The
governments of both countries cut taxes by the same amount. The Central Bank of Alpha follows a policy of
holding a constant money supply. The Central Bank of Beta follows a policy of holding a constant interest
rate. Compare the impact of the tax cut on income and interest rates in the two countries.
Answer The interest rate will increase in Alpha, but remain constant in Beta. The increase in output will be
larger in Beta because the Central Bank of Beta will increase the money supply to keep the
interest rate constant in the face of the tax cut. Thus, there will be no crowding out of investment in
Beta, but there will be crowding out in Alpha because of the higher interest rate.
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Question
Policymakers are contemplating undertaking either an increase in government spending or an increase in
the money supply. Either policy is forecast to have the same impact on income in the short run. Use the
IS-LM model to compare the impact on consumption and investment of the two policy alternatives.
Answer The increase in government spending will increase interest rates, but the increase in the money
supply will lower interest rates. The amount of consumption will be the same under either policy.
There will be less investment if the policy of increasing government spending is chosen because
some investment will be crowded out to accommodate the higher level of government spending.
There will be more investment if the monetary supply expansion is chosen, because interest rates
will be lower.
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Question
A decrease in government spending reduces output more in the Keynesian-cross model than in the IS-LM
model. Explain why this is true.
Answer In the Keynesian-cross model, both the price level and interest rate are held constant. A decrease
in government spending reduces output by 1/(1 MPC) times the change in government spending.
In the IS-LM model, the reduction in output caused by the decrease in government spending is
partially offset by an increase in investment (crowding in). In the IS-LM model, the decrease in
government spending reduces income as in the Keynesian-cross model, but the reduction in
income also reduces the demand for money, which in turn reduces the interest rate for a given
money supply. The lower interest rate stimulates the off-setting investment spending.
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Essay
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Question
Compare the impact of a tax cut on consumption, investment, output, and interest rates in the classical
model of Chapter 3 versus the IS-LM model.
Answer Output increases in the IS-LM model, but is fixed at the natural level in the classical model
because it is determined by the factors of production and technology. In both models, consumption
increases because the tax cut increases disposable income. The interest rate increases in both
models. In the classical model, the tax cut reduces saving, which increases the interest rate and
reduces the equilibrium quantity of investment. In a closed classical economy, since income is
fixed, the increase in consumption exactly offsets the decrease in investment. In the IS-LM model,
the increase in income increases money demand, which results in a higher interest rate to bring
money demand into equilibrium with the constant money supply. The higher interest rate partially
crowds out investment in the IS-LM model (for the usual interest sensitivities of investment and
money demand).
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Question
a. An economy is initially at the natural level of output. There is an increase in government spending. Use
the IS-LM model to illustrate both the short-run and long-run impact of this policy change. Be sure to label: i.
the axes; ii. the curves; iii. the initial equilibrium, iv. the short-run equilibrium, and v. the terminal equilibrium.
b. Explain in words the short-run and long-run impact of the change in government spending on output and
interest rates.
Answer a.
b. The economy is initially at output Y and interest rate r . As a result of the increase in
n
government spending in the short run, output increases to Y and the interest rate increases to r
1
as the IS curve shifts from IS to IS . In the long run, the price level increases, shifting the LM
1
curve from LM to LM . Output returns to Y and the interest rate eventually increases to r in the
1
long run.
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Question
An increase in money supply shifts the LM curve to the right, but an increase in money demand shifts the
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Question
Assume the economy is initially in a short-run equilibrium at a level of output below the natural rate.
a. Use the IS-LM model to graphically illustrate:
1. how the economy will adjust in the long-run if the no-policy
action is taken.
2. the long-run equilibrium if fiscal policy is used to return the
economy to the natural rate of output.
b.
Explain how investment, the interest rate, and the price level differ in the new
long-run equilibrium in the two cases.
Answer
a.
b.
If no policy is used to resotre full employment, the interest rate and the price
level fall. Since the long-run interest rate will be lower, investment will be larger.
If fiscal policy is used, the IS curve will shift to the right. The price level will not
change, but the long-run interest rate will increase. This will reduce the amount
of private investment at the new equilibrium, C.
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Question
If inflation is bad, why isn't deflation good? Use the IS-LM model to explain how deflation could result in a
contraction in output.
Answer An unexpected deflation will reduce output by transferring wealth from debtors to creditors. If
creditors have a lower propensity to spend than debtors, then the reduction in spending by debtors
will be more than the increase in spending by creditors. This reduction in consumption will shift the
IS curve to the left, resulting in a lower equilibrium level of output.
If there is an expected deflation, this increases the real interest rate at every level of nominal
interest rate and reduces investment spending. The decrease in investment spending shifts the IS
curve to the left and results in a lower equilibrium level of income.
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Question
The LM curve can shift to the right if there is an increase in the supply of money or a fall in the price level. In
which case is this movement along the aggregate demand curve and in which case this is a shift of the
aggregate demand curve? Explain.
Answer The aggregate demand curve shows the relationship between income and the price level, holding
other factors constant, including the money supply. An increase in the money supply which shifts
the LM curve to the right also shifts the aggregate demand curve to the right because the money
supply is not constant as it is along any given aggregate demand curve. A reduction in the price
level that shifts the LM curve to the right is a movement down the demand curve, because the
money supply is held constant along the aggregate demand curve and the aggregate demand
curve shows how income changes as the price level changes.
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Question
Use the IS-LM model to predict the short-run impact on the interest rate and output if the Fed pushes
interest rates down at the same time that both consumption and investment fall due to a financial crisis.
Illustrate your answer graphically. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium; and iv.
the direction the curves shift. Explain your answer in words.
Answer
Starting from A with interest rate r and income Y , the reduction in interest rates by the Fed
1
moves the LM curve to the right. The fall in consumption and investment spending moves the IS
curve to the left. At the new equilibrium the interest rate will be lower, but the impact on output will
depend on the relative magnitudes of the shifts. If the IS curve shifts relatively more than the LM
curve, output will be lower. If the LM curve shifts relatively more than the IS curve, output will
increase.
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