**Economics 470/570**

Winter 2006

Review Questions Through Week 9

[pdf file.]

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**Definitions**

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Consumption, disposable income, MPC and MPS

Investment

Government spending

Aggregate demand or expenditures

Autonomous expenditures

Expenditure multiplier

Autonomous money demand

IS curve

LM curve

Policy effectiveness

Crowding out

**Essay**

1. Show graphically using a money demand – money supply diagram and explain
intuitively how the interest rate changes if (a) the nominal money supply
increases, (b) the price level increases, (c) real income increases, and (d)
autonomous money demand increases.

2. Derive the LM curve graphically and explain intuitively why the LM curve
slopes upward.

3. Explain why the LM curve is vertical when money demand is unaffected by
changes in the interest rate (as in the classical model). More generally, show
graphically and explain intuitively how the slope of the LM curve changes when
the responsiveness of money demand to the interest rate (|L_{i}|) increases.

4. What factors cause the LM curve to shift? In what direction do they shift
the LM curve? Show the shifts graphically using money demand - money supply and
LM curve diagrams.

5. Explain why setting income equal to expenditures is equivalent to setting
saving equal to investment.

6. What does the 45 degree line diagram show? Show the equilibrium on the 45
degree line diagram and explain how the economy moves to equilibrium if output
differs from its equilibrium value. How will the equilibrium level of output
change if there is a change in autonomous consumption, investment, government
spending, or taxes? Explain. How will income change if the interest rate falls?

7. What is the expenditure multiplier? Why is it useful?

8. Explain why investment is negatively related to the interest rate.

9. Derive the IS curve graphically and explain intuitively why the IS curve
slopes downward.

10. Show graphically and explain intuitively how the slope of the IS curve
changes when the responsiveness of investment to the interest rate (|I_{i}|)
increases. When is investment more sensitive to changes in the interest rate, at
full employment or in a recession? Explain.

11. What factors cause the IS curve to shift? In what direction do they shift
the IS curve? Show the shifts graphically using 45 degree line and IS curve
diagrams.

12. Show graphically and explain intuitively how an increase in (a) the money
supply, and (b) government spending affects income and the interest rate in the
IS-LM model.

13. Use the IS-LM model to examine how the relative effectiveness of monetary
and fiscal policy changes as investment becomes less sensitive to the interest
rate. Explain the result intuitively.

14. Use the IS-LM model to examine how the relative effectiveness of monetary
and fiscal policy changes as money demand becomes less sensitive to the interest
rate. Explain the result intuitively.