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**Economics 470/570Winter 2005Review Question Set for Week #8**

Definitions

Liquidity trap

Monetary shock

SRAS

Full employment

Wealth effect

Real shock

LRAS

Inflationary and recessionary gaps

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**Short Answer**

1. Use the IS-LM model to show that velocity is constant in the classical version of the model, but not in the Keynesian version.

2. Use the IS-LM model to show and explain how price adjustments return the economy to full employment when output differs from its full employment level.

3. Use the IS-LM model to derive the AD curve. Explain intuitively why the AD curve slopes downward.

4. Use IS-LM and AD diagrams to show how the AD curve shifts when there is a shift in either the IS or LM curve due to any factor except changes in price and income.

5. Use the IS-LM model to show that the model is classical in the LR, i.e. that (a) output does not change in the LR, (b) monetary shocks do not affect the real interest rate in the LR, (b) real shocks do affect the real interest rate in the LR.

6. Explain why the SRAS curve (assuming fixed wages in the SR) slopes upward. Explain why the curve shifts when the fixed wage is reset.

7. Use the fixed wage AD-AS model to show the SR and LR adjustment to AD shocks.

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**Essay**

1. Explain and show graphically using the IS-LM model that wage stickiness can impede the economy’s return to full employment.

2. What is a liquidity trap and how does it arise? Explain your answer intuitively and graphically. Is the economy more likely to be in a liquidity trap near full employment or in a recession? Explain.

3. Explain and show graphically using the IS-LM model how the economy can become stuck in a liquidity trap with output less than its full employment level. How can wealth effects overcome this problem?

4. Explain and show graphically using the IS-LM model that when investment is highly insensitive to changes in interest rates, the automatic adjustment mechanism that returns the economy to full employment can break down.

5. In the classical version of the IS-LM model, show that (a) fiscal policy is ineffective, and (b) monetary policy is fully effective. In what sense is the result for monetary policy inconsistent with the classical view?

6. In the Keynesian liquidity trap version of the IS-LM model, show that, when the economy is in the liquidity trap, (a) monetary policy is ineffective, and (b) fiscal policy is fully effective. Show that the results (a) and (b) also hold in the Keynesian vertical IS version of IS-LM model.

7. Is the private sector inherently stable, i.e. does the economy self correct quickly when there are inflationary or recessionary gaps? Discuss using graphs where appropriate. Is there a role for stabilization policy?