Question

1)In the IS–LM model, the impact of a decrease in government purchases in the goods market has ramifications in the money market, because the decrease in income causes a(n) ______ in money ______.

A) Increase; supply;

B) Increase; demand;

C) Decrease; supply;

D) Decrease; demand.

2)If the IS curve is given by r = 18 – .01Y and the LM curve is given by r = -4 + .01Y, if the full employment level of output is 1,200, then in the long run, with no government policy intervention (hint: what is the short run equilibrium Y and think about SRAS and LRAS as well as the IS-LM)

1. The price level decreases and the output level increases;
2. The price level decreases and the output level decreases;
3. The price level increases and the output level increases;
4. The price level increases and the output level decreases.

3)If the IS curve is given by r = 18 – .01Y and the LM curve is given by r = -4 + .01Y, if the full employment level of output is 1,200, then in the long run (hint: what is the short run equilibrium Y and think about SRAS and LRAS as well as IS-LM)

1. The LM curve will shift downwards (to the right) and the interest rate will increase.
2. The LM curve will shift upwards (to the left ) and the interest rate will decreases.
3. The LM curve will shift downwards (to the right) and the interest rate will decrease.
4. The IS curve will shift inwards causing the interest rate to increase

Answer 1

(1) In the IS-LM Model, decrease in the Government expenditure shifts IS curve leftwards indicating decline in the output/income and the interest rate. This adjustment affects LM market where fall in the income causes decline (Decrease) in the money demand since supply of money is unchanged. We know that Money demand generally increases with the level of income. If income/output decline, money demand declines.

(2)First, we need to find the short run equilibirum output, to analyse whether output and price rises or not. We shall equate the IS-LM equation with each other such that

The short run equilibirum level of output (1100) is lower than full equilibirum level of output (1200). Since AD curve can't change its position due to no government intervention and any other autonomous changes. So, to reach full employment level of output, the SRAS curve shall make adjustment by shifting rightwards or downwards which will cause output to rise and price level to decrease.

Thus, the Price level decreases and output increases while moving towards full employment output.

(3) Using calculations from previous part, we know short run equilibirum level of output is 1100. Now, to reach full employment level, the LM curve will shift downward (right) and interest rate will decrease. The LM curve shifts because when SRAS curve shift rightwards, it causes decline in the price level. The decline in the price level affects real money supply (M/P) under the LM curve. An increase in the real money supply, M/P, will reduce the interest rate that clears the asset market and shift the LM curve down and to the right.