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Economics 3005 Problem Set 2-Answers

Prof. Christainsen

Indicate whether each of the following statements is TRUE, FALSE, or UNCERTAIN and EXPLAIN WHY. 1. If government spending is reduced and taxes are increased, the LM curve will shift left and interest rates will increase. FALSE. The IS curve will shift left. Interest rates will then decrease. 2. If Japan would increase government spending and simultaneously increase the money supply, IS-LM analysis indicates that production and income could increase without a big change in interest rates. TRUE. The increased government spending would shift IS right and, by itself, tend to raise interest rates. The money supply increase would, by itself, shift LM right and lower interest rates. If both curves shift right, production and income clearly increase, but there is no clear net impact on interest rates. 3. If taxes are raised, IS shifts right and production increases. FALSE. IS shifts left and production decreases. 4. If investment is not very sensitive to interest rates, but money demand is sensitive to interest rates, the resulting slopes for IS and LM would mean that fiscal policy would have a rather strong impact on production and income levels. TRUE. If investment is not very sensitive to interest rates, the IS curve becomes steep. If money demand is sensitive to interest rates, the LM curve becomes flat. Fiscal policy (changes in government spending and/or taxes) shifts the IS curve. We get the strongest impact on production levels when the shifting curve is steep and the nonshifting curve is flat. 5. If the LM curve were vertical, there would be complete crowding out of any effort to conduct a stimulative fiscal policy.

TRUE. The IS curve shifts as a result of fiscal policy changes (changes in government spending or taxes), but if LM is vertical, an IS shift will have no impact on production and income levels.

6. If, during the next 6 months, the Federal Reserve conducts a stimulative monetary policy, and if, at the same time, investment shifts down to lower levels, IS-LM analysis indicates that interest rates are likely to go up. FALSE. LM shifts right and IS shifts left. Both shifts would lower interest rates. 7. If there were a liquidity trap, IS-LM analysis indicates that tax cuts would not have any impact on production and income levels. FALSE. In the case of a liquidity trap, monetary policy would not have any impact on production and income levels, but fiscal policy would. Tax cuts shift IS right. If there is a liquidity trap, the LM curve is perfectly flat. An IS shift would then have a significant impact on production and income levels. 8. If investment is very sensitive to interest rates, IS-LM analysis indicates that an increase in government financed by borrowing from the general public will not have a big impact on interest rates. TRUE. If investment is very sensitive to interest rates, then the IS curve is very flat. An increase in government spending shifts IS. If IS shifts, but IS is flat, neither the impact on interest rates nor the impact on production levels, will be very big. 9. If money demand is not very sensitive to interest rates, then IS-LM analysis indicates that, other things equal, monetary policy will have a strong impact on short-run production and income levels. TRUE. If money demand is not very sensitive to interest rates, then the LM curve will be steep. Changes in monetary policy shift the LM curve. If LM shifts, and the LM curve is steep, there will be a strong impact on production and income levels. 10. IS-LM analysis indicates that, the more sensitive money demand is to interest rates, the higher the expenditure multiplier will be. TRUE. If money demand is sensitive to interest rates, the LM curve will be rather flat. The expenditure multiplier involves changes in autonomous spending (e.g., government spending), which shift the IS curve. If LM is flat, IS shifts will have a relatively large impact on production and income levels, which suggests a relatively large multiplier (and not much crowding out).

11. If the short-run aggregate supply curve is somewhat flat, but the long-run aggregate supply curve is vertical, then monetary policy may have a significant impact on real production levels in the short-term, but not in the long-term. TRUE. Wages tend to be somewhat rigid in the short run and do not adjust as much as prices. In the case of a stimulative monetary policy, for example, if prices move up faster than wages in the short run, then real wages will decline. Labor is then relatively cheap in real terms, and employers are encouraged to hire more of it and step up production levels. In the long run, however, if wages more or less fully adjust, then employers have no special incentive to hire extra labor. Thus, in the long run monetary policy affects only prices and not employment or the level of production. 12. If government spending is cut drastically, the aggregate demand curve would shift to the right. FALSE. It would shift to the left. 13. If, in the very long run, technology were to improve, if there is significant new capital formation, and if the money supply were not increased, aggregate demand-aggregate supply analysis indicates that there could be at least a mild deflation. TRUE. Aggregate supply would move to the right while aggregate demand would not be moving. Thus, prices would fall. 14. If, in the very long run, the aggregate supply curve is vertical, and if, generally speaking, the government sector is less efficient than the private sector, then generally speaking, government programs lower real production and income levels and the real expenditure multiplier is negative in the very long run. TRUE. In the short run, government spending may at least have some rightward impact on aggregate demand. If the aggregate supply curve is somewhat flat, the rightward shift in aggregate demand cause production and income to increase; the expenditure multiplier is above zero. There is also some upward pressure on prices. In the long term, crowding out may become greater; the aggregate demand curve may not end up much farther to the right than would have been the case without the increase in government spending. If the aggregate supply curve were vertical, real production and income levels would not end up any higher than they would have been without the increase in government spending. If government programs are generally inefficient, the aggregate supply curve may actually end up somewhat to the left of where it would have been without the programs. In this case, the real expenditure multiplier would, in the very long term, be negative. 15. If, in the short run, the aggregate supply curve is somewhat, but not perfectly flat, and if government spending gets partially, but not completely crowded out, the aggregate demand curve will shift a little (but not a lot), and some of the impact of the government spending will be to increase prices rather than real production levels.

TRUE. If there were no crowding out, the aggregate demand curve would shift to the right by an amount determined by the simple Keynesian multiplier (1/1-b). If the aggregate supply curve were perfectly flat (extreme Keynesian), real output would go up by the change in G multiplied by 1/1-b. However, crowding out implies that the aggregate demand curve will not shift out as much as simple Keynesian theory would suggest, and if the aggregate supply curve is not perfectly flat some of the impact will be to raise prices rather than real output. 16. If supply-siders are correct, a big cut in tax rates is quite inflationary. FALSE. If supply-siders are correct, a cut in tax rates will shift aggregate supply significantly to the right. If aggregate supply shifts to the right, prices will end up lower than they otherwise would. 17. High levels of government spending, high tax rates to pay for it, and a stimulative monetary policy can ensure permanently high levels of production and income without inflation. FALSE. Increased government spending financed by taxation may shift aggregate demand slightly to the right in the short term, but probably not in the long term. Moreover, the government spending (if inefficient) may have negative impacts on aggregate supply in the long term. High tax rates may also have negative impacts on aggregate supply. A stimulative monetary policy will shift aggregate demand to the right, and this may stimulate more production in the short term (assuming that the aggregate supply curve is somewhat flat), but if the aggregate supply curve is steep in the long term, the stimulative monetary policy will just end up causing higher inflation; it will not stimulate production in the long term. 18. If a very restrictive monetary policy is launched and maintained, it is possible to reduce inflation permanently, but aggregate demand-aggregate supply analysis indicates that a recession would be experienced for a while. TRUE. The restrictive monetary policy will shift the aggregate demand curve to the left. If the aggregate supply curve is rather flat in the short run, the leftward shift in the aggregate demand curve will cause real output to decrease (a recession), and prices will be somewhat lower than they otherwise would have been. In the long run, if the aggregate supply curve is steep, the leftward shift in the aggregate demand curve will not cause real output to be any lower than it would have otherwise been, but prices will be permanently and significantly lower than they otherwise would have been. 19. If the aggregate supply curve were always flat, policymakers could always act to push the economy to potential GDP without fear of inflation. TRUE. If the economy were at less than potential GDP, both fiscal and monetary policy could be used to shift aggregate demand to the right (e.g., increase government spending

and create money to pay for it). If the aggregate supply curve is flat, any rightward shift in aggregate demand will not be inflationary. It will just increase real GDP and employment. 20. If wages were flexible, even in the short run, the aggregate supply curve would always be flat. FALSE. Flexible wages help to make for a steep aggregate supply curve. To be perfectly vertical there would also have to be no money illusion.

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