Question

1. Within the IS-LM model if the government increased investment while at the same time the central bank increased the money supply ...

total income would increase.

real interest rates would decrease.

total income would stay the same.

the real interest rate would stay the same.

real interest rates would increase.

total income would decrease.

2. Suppose the central bank decreases the money supply. In the the IS-LM model, this will lead to ...

a rightward shift in the LM curve and an increase in total income.

a leftward shift in the IS curve and a decrease in total income.

crowding out in the money market.

a leftward shift in the LM curve and a decrease in total income.

a rightward shift in the IS curve and an increase in total income.

3. The period real interest rate used to discount future incomes is 10%, so r = 0.1.

What is the present discounted value of an income stream consisting of $100 received one period from now, $100 received two periods from now, and $400 received three period from now?

Answer 1

Solution:

1. With increase in investment spending by the government the Investment-Spending (IS) curve will shift to the right. Also, with increase in the money supply, the LM curve will also shift to the right. As the downward sloping (IS) and upward sloping (LM), both curves shift to the right, with total income on horizontal axis and interest rates on vertical, this will result in increasing the income. Nothing can be said about change in interest rates as it would depend on the extent of shift in IS and LM curves.

So, the correct option is (A) total income would increase.

2. If Central Bank decreases the money supply, the LM curve will shift leftward, and result in decrease in the real total income. Thus, correct option is (C).

3. Given that r = 10% or 0.10, the present discounted value (PDV) of mentioned income streams are:

PDV = amount in one period from now/(1 + r) + amount in two periods from now/(1 + r)² + amount in three periods from now/(1 + r)³

PDV = 100/(1+ 0.1) + 100/(1 + 0.1)² + 400/(1 + 0.1)³

PDV = 100/1.1 + 100/ 1.21 + 400/1.331

PDV = 90.91 + 82.64 + 300.526 = $474.076