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Spring 2015

Econ 2102.12
Name: _____________________
Problem Set 5 (ABC ch. 9)
Due: Wednesday, March 4 at 8:00 am
I. Multiple Choice: Circle the correct answer.
1) The FE line is vertical because the level of output at full employment doesn't depend on the
A) real wage rate.
B) level of employment.
C) marginal product of labor.
D) real interest rate.
2) Any change that reduces desired saving relative to desired investment (for a given level of
output) causes the real interest rate to ________ and shifts the IS curve ________.
A) increase; down and to the left
B) increase; up and to the right
C) decrease; down and to the left
D) decrease; up and to the right
3) A temporary decline in productivity would cause the IS curve to
A) shift up and to the right.
B) shift down and to the left.
C) remain unchanged.
D) shift up and to the right only if people face borrowing constraints.
4) Looking only at the asset market, an increase in output would cause
A) the LM curve to shift down and to the right.
B) the LM curve to shift up and to the left.
C) an increase in the real interest rate along the LM curve.
D) a decrease in the real interest rate along the LM curve.
5) Banks decide to raise the interest rate they pay on checking accounts from 1% to 2%. This
action would
A) increase money demand, shifting the LM curve up and to the left.
B) increase money demand, shifting the LM curve down and to the right.
C) decrease money demand, shifting the LM curve up and to the left.
D) decrease money demand, shifting the LM curve down and to the right.
6) An increase in wealth that doesn't affect labor supply would cause the IS curve to ________
and the FE line to ________.
A) shift down and to the left; be unchanged
B) shift down and to the left; shift left
C) shift up and to the right; be unchanged
D) shift up and to the right; shift left
7) The IS-LM model predicts that a temporary beneficial supply shock
A) increases output, national saving, and investment, but not the real interest rate.
B) increases output, national saving, and the real interest rate, but not investment.
C) increases the real interest rate, investment, and output, but not national saving.
D) increases output, national saving, investment, and the real interest rate.

Spring 2015
Econ 2102.12
8) An adverse supply shock that is permanent shifts which curve in addition to the curves shifted
by one that is temporary?
A) The LM curve
B) The IS curve
C) The FE line
D) The labor demand curve
9) Classical economists think general equilibrium is attained relatively quickly because
A) the real interest rate adjusts quickly.
B) the level of output adjusts quickly.
C) the real wage rate adjusts quickly.
D) the price level adjusts quickly.
10) When the money supply rises by 10%, in the short run, output ________ and the price level
________.
A) rises; is unchanged
B) declines; falls
C) is unchanged; falls
D) declines; is unchanged
II. Short Answer: Please show all your work for full credit.
1. Desired consumption and investment are:
! = 4000 4000 + 0.20
! = 2400 4000
Government purchases, G, are 2000.
a. Find an equation relating desired national savings, Sd, to r and Y.
b. What value of the real interest rate clears the goods market when Y = 10,000? Use both
forms of the goods market equilibrium condition. What value of the real interest rate
clears the goods market when Y = 10,200? Graph the IS curve.
c. Government purchases, G, increase to 2400. How does this increase change the question
for national savings in part a? What value of the real interest rate clears the goods market
when Y = 10,000? Use both forms of the goods market equilibrium condition. How is
the IS curve affected by the increase in G?
2. Use the IS-LM model to determine the effects of each of the following on the general
equilibrium values of the real wage, employment, output, real interest rate, consumption,
investment, and price level. Draw a graph(s) and briefly explain the outcome in words for each
part.
a. A reduction in the effective tax rate on capital increases desired investment.
b. The expected rate of inflation increases.
c. An influx of working-age immigrants increases the supply of labor (ignore any other
possible effects of increased population).
d. Increased usage of automatic teller machines reduces the demand for money.
3. Suppose that the price level is fixed in the short run so that the economy doesnt reach general
equilibrium immediately after a change in the economy. For each of the following changes, what
are the short-run effects on the real interest rate and output? Assume that, when the economy is

Spring 2015
Econ 2102.12
in disequilibrium, only the labor market is out of equilibrium; assume also that for a short period
firms are willing to produce enough output to meet the aggregate demand for output. Draw a
graph(s) and briefly explain the outcome in words for each part.
a. A decrease in the expected rate of inflation.
b. An increase in consumer optimism that increases desired consumption at each level of
income and the real interest rate.
c. A temporary increase in government purchases.
d. An increase in lump-sum taxes, with no change in government purchases (consider both
the case in which Ricardian equivalence holds and the case in which it doesnt).
e. A scientific breakthrough that increases the expected future MPK.

4. Consider the following economy:


Desired consumption:
! = 1275 + 0.5 200
Desired investment:
! = 900 200
Real money demand:
= 0.5 200
Full-employment output:
= 4600
Expected inflation:
! = 0
a. Suppose that = = 450 and that = 9000. Find an equation describing the IS
curve, the LM curve, and the aggregate demand curve. What are the general equilibrium
values of output, consumption, investment, the real interest rate, and price level?
b. Suppose that money supply falls, so that = = 450 and that = 4500. What is the
equation for aggregate demand curve now? What are the general equilibrium values of
output, consumption, investment, the real interest rate, and price level? Assume that full
employment output is fixed.
c. Now suppose that taxes and government expenditure falls, so that = = 330 and that
= 9000. What is the equation for aggregate demand curve now? What are the
general equilibrium values of output, consumption, investment, the real interest rate, and
price level? Assume that full employment output is fixed.

III. Practical Application


Read the February 7, 2015 New York Times article by Robert J. Shiller, Anxiety and Interest
Rates: How Uncertainty is Weighing on Us
(http://www.nytimes.com/2015/02/08/upshot/anxiety-and-interest-rates-how-uncertainty-isweighing-on-us.html?rref=upshot&abt=0002&abg=0&smid=tw-upshotnyt&_r=0). How can
uncertainty affect interest rates according to our model? What does the model expect to happen
with low interest rates? What is actually happening? This is not a new idea from economic
research. Summarize previous work mentioned in the article.