Problem set 2.  Intermediate Macroeconomics
IS-LM model.

1) Graphically derive the IS curve using the market for loanable funds.
2) Graphically derive the LM curve using the money market for real money balances.

3)  Show how the following changes affect the IS curve:

a) Income taxes are reduced.
b) Consumers expect a tax cut next year.
c) Consumers expect higher inflation (compared to what it is currently).
d) Dow Jones stock market price index increases by 30%
e) Increase in firms' expectations about future profitability
f) Military expenditure increases.
g) Consumer confidence falls.
h) Commercial banks tighten lending standards.

4) Show how the following changes affect the LM curve:

a) Money supply is increased.
b) Price level increases (because of higher oil prices).
c) Money supply is increased by 5% and prices also rise by 5%. (hint: consider the effects on real money supply)
d) Velocity of money increases (hint: consider the effects on money demand)..

5) Using the IS-LM model, show graphically how the changes in (3) and (4) affect the real interest rate (r) and real GDP (Y) in the SHORT-RUN.
Also, in each case briefly explain the effects on consumption and investment (i.e. increase/decrease/no change) and the logic.

6) Read the case study on p. 295 (Did Paul Volcker's monetary tightening raise or lower interest rates) and consider the following questions.
a) Use the IS-LM model to predict the effects on the real interest rate and real GDP.
b) The following table shows data for nominal rates (Federal Funds Rate), GDP deflator and real GDP (Y) for the years 1979 and 1980.  Is the data consistent with the IS-LM model's predictions, i.e. does the data show what the model predicts with respect to income (Y) and the REAL interest rate (r)?   (HINT:  real interest rate = nominal interest rate - inflation)

Year    FFR    GDP deflator.   GDP (1996 $, trillions)
1978                  48.2
1979    11.2       52.2                      4912.1
1980    13.4       57.0                      4900.9

c) Why would a monetary tightening lead to higher nominal rates in the short-run but lower nominal interest rates in the long-run?   (Hint: use the Fisher equation for the long run prediction)

7) Read the case study on p. 287 (Kennedy, Keynes and the 1964 Tax cut) and consider the following questions.
a) The effects of this tax cut on output and the unemployment rate are given in the case study.  Are they consistent with the predictions of the IS-LM model?
b) According to the IS/LM model, what should the effects be on the real interest rate from a tax cut?
c) Do you think the effect (described in the case study), on real GDP (i.e. output) are permanent?  What about the effect on the real interest rate? Explain.

8) Use the IS-LM model and show how the economy will self correct itself in the long-run (the adjustment from the short-run equilibrium to the long-run equilibrium) when:
a) Money supply increases.
b) Government expenditure increases.
c) Taxes increase.

9) Show graphically the short-run effects on income when government expenditure increases by $30 billion dollars using (i)  the IS-LM model and (ii) the AD/AS model 
More specifically, show the effects assuming:
a) the price level and interest rates are sticky.  Is the effect on Y greater/less/equal to $30 billion?
b) the price level is sticky but interest rates can change. Is the effect on Y greater/less/equal than in (a)?
c) the price level and interest rates change.  Is the effect on Y greater/less/equal than in (b)?