# Aggregate Demand

## Problem Set #4

Economics 100b; Spring 1996; Brad DeLong

1. Suppose that the marginal propensity to consume is 0.6; what is the multiplier? Suppose the marginal propensity to consume is 0.75; what is the multiplier?

2. Will income and production in the IS-LM model rise or fall if (a) the Federal Reserve decreases the money supply, and (b) taxes rise

3. Suppose that the consumption function (in billions of dollars) is:

C = 200 + 0.75(Y-T)

And suppose that taxes are cut by \$60 billion. What will be the shift in the equilibrium level of incomeand production Y?

4. Banks today pay interest on checking account deposits. Does this tend to make the LM curve flatter or steeper when drawn with income Y on the horizontal and interest rates i on the vertical axis?

5. Suppose that the economy has (with all spending numbers in billions, and with interest rates in percentage points):

Net taxes T of \$1,000 A government deficit D of zero.
An investment function I = \$1,500 - \$50(r) A consumption function C = \$1,400 + 0.6(Y-T)

Derive the I-S curve: use the national income identity Y = C+I+G and the government-budget identity G-T = DEF to solve for output and income Y as a function of the interest rate r. Suppose the Federal Reserve raises r from 4% to 8%. What happens to Y?

6. Consider (with all spending numbers in billions, and with interest rates in percentage points) the IS curve Y = \$7,400 - \$100(r) and the LM curve Y = \$6,800 + \$20(i). Suppose that expected inflation is zero, and there are no anticipated shifts in future monetary policy, so that i = r. What is the equilibrium level of output and income Y? What is the equilibrium level of interest rates i = r?

7. Now suppose the government cuts taxes by \$100 billion, and that the multiplier is 2.4. What is the new IS curve? What are the new equilibrium levels of output and income Y, and of interest rates r? Has Y increased by more or by less than the magnitude of the shift in the LM curve.

8. Now suppose that investors and bond traders suddenly change their expectations, and now expect a future tightening of monetary policy so that r = i + 3%. What is the new equilibrium level of output and income Y? What are the new equilibrium levels of interest rates?

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# Econ 100b

Created 4/30/1996
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