Conceptual questions:

1. We call the model of income determination developed in this chapter a Keynesian one. What makes it Keynesian, as opposed to classical?

2. What is an autonomous variable? What components of aggregate demand have we specified, in this chapter, as being autonomous?

3. Why do we call mechanisms such as proportional income taxes and the welfare system automatic stabilizers? Choose one of these mechanisms and explain carefully how and why it affects fluctuations in output.

4. Show analytically what happens to the budget surplus when government increases its expenditures.

Technical Questions:

5. Here we investigate a particular example of the model studied in Sections 9-2 and 9-3 with no government. Suppose the consumption function is given by C = 100 + .8Y, while investment is given by I = 50.

a. What is the equilibrium level of income in this case?

b. What is the level of saving in equilibrium?

c. If, for some reason, output is at the level of 800, what will the level of involuntary inventory (i.e. unplanned inventory investment) accumulation be?

d. If I rises to 100, what will the effect be on the equilibrium income?

e. What is the value of the multiplier here?

f. Draw a diagram indicating the equilibria in both (a) and (d).

6. Suppose the consumption behavior in problem 4 changes so that C = 100 + .9Y, while I remains at 50. Notice that the MPC has increased.

a. Is the equilibrium level of income higher or lower than it was in problem 4(a)? Calculate the new equilibrium level, Y', to verify this?

b. Now suppose investment increases to I = 100, just as in problem 1(d). What is the new equilibrium income?

c. Does this change in investment spending have more or less of an effect on Y than it did in problem 4? Why?

7. Now we look at the role taxes play in determining equilibrium income. Suppose we have an economy of the type in Sections 9-4 and 9-5 (or 10-4 and 10-5 in the new edition of the book), described by the following functions:

a. Calculate the equilibrium level of income and the multiplier in this model.

b. Calculate also the budget surplus, BS.

c. Suppose that t increases to .25. What is the new equilibrium income? The new multiplier?

d. Calculate the change in the budget surplus. Would you expect the change in the surplus to be more or less if c = .9 rather than .8?
e. Can you explain why the multiplier is 1 when t= 1?

8. Suppose Congress decides to reduce transfer payments (such as welfare) but to increase government purchases of goods and services by an equal amount. That is, it undertakes a change in fiscal policy such that ΔG=ΔTR.

a. Would you expect equilibrium income to rise or fall as a result of this change? Why? Check your answer with the following example: Suppose that, initially, c = .8, t = .25, and Y0 = 600. Now let ΔG= 10 and ΔTR= -10.

b. Find the change in equilibrium income, ΔY0.

c. What is the change in the budget surplus, ΔBS? Why has BS changed?

Topic 8: Aggregate Demand I: Building the IS-LM Model Conceptual questions:

9.a. Explain in words how and why the multiplier and the interest sensitivity of aggregate demand affect the slope of the IS curve.

b. Explain why the slope of the IS curve is a factor in determining the working of monetary policy.

10. Explain in words how and why the income and interest sensitivities of the demand for real balances affect the slope of the LM curve.

11. It is possible that the interest rate might affect consumption spending. An increase in the interest rate could, in principle, lead to increases in saving and therefore a reduction in consumption, given the level of income. Suppose that consumption is, in fact, reduced by an increase in the interest rate. How will the IS curve be affected?

12. Between January and December 1991, while the U.S. economy was falling deeper into its recession, the interest rate on Treasury bills fell from 6.3 percent to 4.1 percent. Use the IS-LM model to explain this pattern of declining output and interest rates. Which curve must have shifted? Can you think of a reason-historically valid or simply imagined-that this shift might have occurred?

Topic 9: Aggregate Demand II: Building the IS-LM Model

In topic 7a (Income and Spending), interest rate was assumed constant. I mean, we did not use IS-LM model to explain fluctuations in output. Rather we used AD curve and AD= Y (the 45 degree line) together to explain the fluctuations. But starting from topic 8 we have included interest rate i (or "r" interchangeably) in our analysis to incorporate the fact that interest rate varies in the economy and has a major role to play to clear both the goods market and the money market simultaneously. An inclusion of interest rate in the analysis gives rise to the IS-LM model. Now let's play with the IS and LM curves:

16. Fiscal policy change: Suppose government increases its purchases. Which curve shifts? Is the size of the shift in the curve bigger or smaller than the changes in equilibrium output? What is the economic intuition behind the changes in equilibrium interest rate and output? (Hint: See the notes underneath the slides for economic intuition.)

17. Another fiscal policy change: Suppose the government decreases the tax rate (t). Which curve shifts now? Why? Explain clearly. What happens to equilibrium interest rate and output? What is the economic intuition behind the change in interest rate and output?

18. Monetary policy change: Suppose the Fed decreases the money supply. Which curve is affected? What happens to equilibrium interest rate and output? What is the economic intuition behind the change in interest rate and output?

19. In questions 16-18, we assumed that Fiscal policies are independent of monetary policies. In other words, we assumed that the Fed (the one which is in control of monetary policy) sits idle when government pursues different fiscal policies. But in reality, that is not true. Often the Fed reacts to changes in fiscal policies. The following question addresses this issue:

Suppose government increases its purchases. In response, the Fed can either:

a. Decide to stabilize the interest rate or

b. Decide to stabilize the output.

For each of the above cases, using IS-LM model, show the final impact of the fiscal policy on both interest rate and output.

20. So far, we have analyzed the cases where the IS/LM curve was affected only by fiscal/monetary policy. Now we will see how IS/LM curve can also be affected by exogenous shocks:

a. Suppose there is a stock market crash. Explain using the IS-LM model how that affects equilibrium interest rate and output. Your explanation as usual should include economic intuition as well.

b. Suppose there is wave of credit card fraud. . Explain using the IS-LM model how that affects equilibrium interest rate and output. Your explanation as usual should include economic intuition as well.

21. The aggregate demand curve can be derived from the IS-LM model- Explain.

22. The second part of this course is mainly about explaining the short-run fluctuations in output. In the lecture we have seen how this explanation can be done using both the IS-LM and AD-AS models. Both models can successfully explain the short-run and long-run behavior of output. This question will test your knowledge on this concept:

a. Suppose the stock market has crashed (compare this with 20.a.). Using both the IS-LM and AD-AS curve, show the behavior of output and price level in the short-run and long-run.

b. Suppose there is a decline in the demand for money (maybe due to widespread availability of credit cards). At each output level and interest rate the public now wants to hold lower real balances.

i. In the Keynesian case, what happens to equilibrium output and to prices?

ii. In the classical case, what is the effect on output and on prices?

23. Is the Spending hypothesis explaining the Great Depression consistent with data?

24. "A sufficiently strong Pigou effect can negate The Money Hypothesis."- Explain.

25. Give at least one valid reason why the Fed might have been guilty of worsening the Great Depression.

26. Read the case study titled "The Financial Crisis and Economic Downturn of 2008 and 2009" in Chapter 12, Mankiw. Between IS shock and LM shock, which one do you think initiated the crisis? Why?