Chapter 12

Aggregate demand in the good and money market

1. A businesswoman, Kathleen Williamson, hires you as an economic consultant to

assist her in her investment decisions.
(a) The government has announced a reduction in income taxes and an increase
in welfare benefits. Interpret these policy actions.
(i) Are they expansionary or contractionary?
(ii) How will they affect the interest rate?
(iii) Importantly, how will they affect planned business investment?
(iv) The following IS-LM diagram shows the economy before the policies
are initiated. Show how the curve(s) shift(s) in response to the
policies.

r
LM 1

r1

IS1

0 Y1 Y
Aggregate output

(b) Ignore the policy actions in Part (a). The Fed announces an immediate
increase in the reserve requirement and decrease in the discount rate.
Interpret these policy actions.
(i) Are they expansionary or contractionary?
(ii) How will they affect the interest rate?
(iii) Importantly, how will they affect planned business investment?
(iv) The following IS-LM diagram shows the economy before the policies
are initiated. Show how the curve(s) shift(s) in response to the
policies.

r
LM 1

r1

IS1

0 Y1 Y
Aggregate output

(c) Ignore the policy actions in Parts (a) and (b). The government initiates an
aggressive program of highway construction and inner-city development,
effective immediately. Simultaneously, the Fed announces an immediate
increase in its purchases of bonds on the open market. Interpret these policy
actions.
(i) Are they expansionary or contractionary?
(ii) Is the Fed action accommodating? Why?
(iii) How will the policy actions affect the interest rate?
(iv) Importantly, how will they affect planned business investment?
(v) Williamson’s business sells to the consumer sector. What other
factor(s) ought she to include in determining her investment plans?
(vi) The following IS-LM diagram shows the economy before the policies
are initiated. Show how the curve(s) shift in response to the policies.

r
LM 1

r1

IS1

0 Y1 Y
Aggregate output
2. (a) The Arbocali Minister of Finance (a confirmed believer in the multiplier)
notes that the marginal propensity to consume out of income is 0.8. Because
Arboc is presently in a recession, he predicts that a 5 million opek increase in
government spending will boost output by 25 million opeks. Although a quite
junior official in the Ministry, you believe that he is incorrect. Indicate as
many assumptions as you can that he had made to arrive at his prediction.
(b) The Minister (also a confirmed believer in IS-LM analysis) suspects that the
economy is at some point above the LM curve but on the IS curve. This must
be a point of disequilibrium. Explain the situation to him.
3. Farview, an economic forecasting firm, has hired you as a promising addition to the
staff. Your assignment is to predict the effect of a given economic change on a
number of variables, where “+” represents increase, “–” represents decrease, “0”
represents no change, and “?” represents ambiguous result. Assume that there are
progressive federal income taxes and that the initial change in a variable is the
dominant one.

(a) The Fed reduces the discount rate. Predict the effect on:

Y r C S I Ms Md federal deficit

(b) The government cuts personal income taxes. Predict the effect on:

Y r C S I Ms Md federal deficit

(c) The capital utilization rate is 70% and firms believe that it should be 85%.
Predict the effect on:

Y r C S I Ms Md federal deficit

(d) There is heightened expectation of an interest rate decrease. Predict the effect
on:

Y r C S I Ms Md federal deficit
4. Determine the effect of each policy and other actions on the following five given
variables. Label it (I) if the variable will increase, (D) if it will decrease, (U) if it will
remain unchanged, and (?) if the result is ambiguous.

Policy/Action r Y Ms Md I
Increase Ms
Increase T
Increase G
An increase in optimism by entrepreneurs
Income and payments become better synchronized
5. Refer to the following diagram to answer this question.

AE
45°

AE

0 1000 2000 Y
Aggregate output

MPC is 0.8 and the full-employment level of production is 2,000.

(a) Draw the money market in equilibrium. Label the curves Md1 and Ms1.

(b) The government spending multiplier is . Using the simple goods

market model, by how much would government spending have to change to
move the economy to the full-employment equilibrium? Increase/decrease
by .
(c) The tax multiplier is . By how much would the tax level have to
change to move the economy to full-employment equilibrium?
Increase/decrease by .
(d) The balanced-budget multiplier is . By how much would government
spending and tax levels have to increase (balanced-budget change) to move
the economy to full-employment equilibrium? Increase by .

Suppose we adopt the balanced-budget policy.

(e) How much will the AE function shift vertically? Increase/decrease by .
Show this on the diagram as AE'.
(f) Unplanned inventory levels will and output will .
(g) Show the changes that occur in the money market. Label any new curves
clearly.
(h) Depict the new AE curve as AE" on the diagram. What has caused the change
you’ve drawn?
(i) Is the balanced-budget multiplier still equal to the value given in (d) above?
(j) Suppose the Fed acts to prevent the crowding out. Amend your money
market picture accordingly.
6. The text provides several examples of “economic shorthand” while tracing through
the effects of given changes. Without referring back to the text, test your knowledge
by indicating how each variable will change in the following examples. Write “I” if
the variable increases and “D” if the variable decreases as a consequence of the
previous step.
(a) Expansionary fiscal policy involving a $100 change in G.
G (I/D) → Y (I/D) → Md (I/D) → r (I/D) → I (I/D) → Y (I/D)
(b) Expansionary fiscal policy involving a $100 change in T.
T (I/D) → Y (I/D) → Md (I/D) → r (I/D) → I (I/D) → Y (I/D)
(c) Will the total change in Y be greater in (a) than in (b)? Why or why not?
(d) Expansionary monetary policy.
Begin by selecting the correct option for each monetary policy tool.

}
Open Market sale/purchase
Discount rate increase/ decrease
Reserve requirement increase/
decrease
Ms (I/D) → r (I/D) → I (I/D) → Y (I/D) → Md (I/D) → r (I/D)

Note that the effects go in the opposite direction for contractionary policies.