Test Bank For Macroeconomics Theories and Policies 10th Edition Froyen
Test Bank For Macroeconomics Theories and Policies 10th Edition Froyen
Test Bank For Macroeconomics Theories and Policies 10th Edition Froyen
52
©2013 Pearson Education, Inc. Publishing as Prentice Hall
KEYNESIAN SYSTEM (II): MONEY, INTEREST, AND INCOME 53
The transaction and precautionary motives are similar to the classical view that money is
solely a medium of exchange. The speculative motive was the most novel part of Keynes’
analysis of money demand. Keynes began with the question of why an individual would hold
any money above that needed for the transactions and precautionary motives when bonds pay
interest and money does not. Such an additional demand for money did exist, Keynes
believed, because of the uncertainty about future interest rates and the relationship between
changes in the interest rate and the market price of bonds. If interest rates were expected to
move in such a way as to cause capital losses on bonds, it was possible that these expected
losses would outweigh the interest earnings on bonds and cause an investor to hold money
instead. Those “speculating” on future changes in the interest rate would hold such money.
6. Suppose that the money supply in addition to money demand increases when the interest
rate increases. How do you think this change from the basic Keynesian money market
would affect the slope of the LM curve? Draw a graph to illustrate.
As a result of this, the money supply curve is upward sloping in the money market. This
means that for an increase in income and a shift in the money demand curve, interest rates
will not change as much. As a result, the LM curve is flatter than before.
7. If the central bank of an economy follows a policy of interest rate targeting, or maintaining
a fixed interest rate, then what will happen to the slope of the LM curve? Draw a graph to
illustrate.
The LM curve will be flat at the interest rate the central bank chooses to target, meaning that
income will have to make the full adjustment for any change in the IS curve.
8. If savings becomes more interest rate elastic, what happens to the slope of the IS curve.
Provide a graph to illustrate.
As savings becomes more responsive to changes in the interest rate, the savings curve
becomes flatter and any change in investment will lead to a smaller change in the interest
rate. As a result, the IS curve becomes flatter.
11. Explain the relationship between the rate of interest and the demand for money within the
Keynesian theory of money demand. How does this differ from the classical quantity theory
of money demand?
In the Keynesian model, an increase in the interest rate increases the opportunity cost of
holding money, reducing money demand. In the quantity theory, money demand (both
velocity and the marginal propensity to hold money) are constant and not affected by
changes in interest rates.
12. What is the condition met by all points along the LM schedule? Demonstrate graphically
the derivation of the LM schedule and explain the properties of the schedule. What is the
condition met by all points along the IS schedule. Demonstrate graphically the derivation of
the IS schedule and explain the properties of the schedule.
13. What factors determine the slope of the IS and LM schedules? Illustrate graphically.
See text.
14. Compare and contrast the effects of an increase in the money supply on interest rates
within the Keynesian and Classical model. Provide graphs to illustrate. Discuss why the
results differ between these models.
In the Keynesian model, an increase in the money supply reduces interest rates in the
money market. This is because money is primarily an asset, and the interest rate is the
opportunity cost of holding money. Because the price level is fixed, any increase in the
money supply does not affect prices. In the classical model, prices are not fixed and will
rise as the money supply rises. Interest rates will rise after an increase in the money supply
because of an increase in the price level and inflation.
15. How would the shape of the IS curve change if:
a. the MPC gets bigger.
b. Investment becomes more elastic.
As the MPC gets bigger and as investment becomes more elastic, the IS curve gets flatter.
16. Assume that the government passes a deficit-financed tax cut. If the central bank would like
to keep interest rates constant, what monetary policy should they follow? Provide an IS/LM
graph to illustrate.
The deficit-financed tax cut would shift the IS curve to the right. In order to prevent the
interest rate from rising, the central bank should increase the money supply and shift the
LM to the right.
17. Suppose that there is an unexpected increase in the demand for money at every level of
interest rates and income. What happens to equilibrium interest rates and income as a
result? Provide an IS/LM curve to illustrate.
The LM curve shifts to the left, equilibrium interest rates increase and income falls.
18. Household consumption likely depends upon accumulated wealth and not just current
income as it does in the basic Keynesian model examined in this chapter. How would the
IS/LM model respond to a decline in housing prices, such as what occurred in the US
during the 2008 global financial crisis, if consumption was a function of wealth. Provide a
graph to illustrate.
A decline in wealth would reduce consumption demand, shifting the IS curve down and
reducing equilibrium interest rates and income.
Multiple-Choice Questions:
1. In calculating the IS curve, _______ is taken as exogenous
a. the interest rate.
b. aggregate income.
c. the price level.*
d. planned investment.
e. a and d.
2. If people increase their expected rate of interest, the speculative demand for money curve
will _____ and money supply will _____.
a. shift downward, remain unchanged.*
b. shift upward; remain unchanged.
c. not be affected; shifts upward.
d. not be affected; not be affected.
3. In the Keynesian money market, velocity is
a. negatively related to the interest rate.
b. independent of the interest rate.
c. positively related to the interest rate.*
d. is positively related to the money supply.
e. is not related to the interest rate but income.
4. If the consumption function is given by C = 100 + 0.75(Y-T), then an increase of 10 units
in taxes will cause the IS schedule to shift to the right by
a. -30 units.*
b. -10 units.
c. 30 units.
d. 40 units.
5. A decline in the money stock will
a. shift the LM schedule to the right.*
b. shift the LM schedule to the left.
c. not have any effect on the LM schedule.
d. shift the IS schedule downward and to the right.
6. In the Keynesian theory, an exogenous decrease in the demand for money shifts
a. the LM curve to the right.
b. the LM curve to the left.*
c. the IS curve to the right.
d. the IS curve to the left.
e. neither the IS or LM curves.
7. A fall in autonomous investment will shift the
a. IS curve to the right toward higher interest rates and output.
b. LM curve to the right towards lower interest rates and higher output.
c. IS curve to the left towards higher interest rates and output.
d. None of the above*
8. An decrease in the velocity of money for given levels of income and the interest rate would
shift the a. LM curve up.*
b. IS curve up.
b. IS curve down.
c. LM curve down.
9. If the consumption function is given by C = 200 + 0.6YD, then an increase in taxes of 50
units will cause the IS schedule to
a. shift to the right by 75 units..
b. shift to the left by 50 units.
c. shift to the left by 75 units.*
d. shift to the left by 125.
10. If the money demand function is given by Md = 10 + 0.2Y − 10r then a 10-unit increase in
the quantity of money will cause the LM schedule to shifts to
a. to the right by 10 units.
b. the right by 50 units.*
c. to the left by 40 units.
d. to the left by 50 units.
e. to the right by 40 units.
11. If the MPC is 0.6, then a 50-unit rise in taxes and a 50-unit rise in government spending
will shift the IS curve
a. to the right by 50 units.*
b. to the right by 75 units.
c. to the left by 125 units.
d. to the left by 75 units.
12. According to Keynes' theory of money demand, a low interest rate increases the likelihood
of a capital ________ and ______ the interest elasticity of money demand.
a. gain on bonds; reduces.
b. gain on money; increases.
c. loss on bonds; reduces.*
d. loss on money; increases.
e. none of the above.
13. The LM curve slopes upward because
a. as income rises, savings rise, increasing output.
b. as interest rates rise, the money supply rises, increasing output.
c. as interest rates rise, planned investment must fall, increasing output.
d. as income increases, money demand rises, which increases interest rates.*
e. none of the above.
14. Assume that the economy is presently in equilibrium. A decline in the interest rate
a. increases planned investment, aggregate demand, and equilibrium income.*
b. increases unplanned investment, reducing aggregate demand and equilibrium income.
c. increases unplanned investment, increasing aggregate demand and equilibrium income.
d. increases money demand, the money supply, aggregate demand, and equilibrium
income.
64 CHAPTER 6