Macroeconomics I

Practice #3

Due on October 28th, 2015

All students: 10:00am class slot

1. First, define the LM curve. Second, explain why it has its particular shape.

2. Based on your understanding of the IS-LM model, graphically illustrate and explain what

effect a reduction in consumer confidence will have on output, the interest rate, and

investment.

3. Use the IS-LM model to answer this question. Suppose there is a simultaneous increase in

taxes and reduction in the money supply. Explain what effect this particular policy mix will

have on output and the interest rate. Based on your analysis, do we know with certainty

what effect this policy mix will have on investment? Explain.

4. Explain in detail what effect a Fed purchase of bonds will have on: (1) the LM curve; and

(2) the IS curve.

5. Give answers to odd-numbered questions available in Set5.pdf

6. One IS-LM economy is characterized by the following set of equations

C=50 + 0.6YD ; I=48+0.2Y-500i ; G=200; T=180

H=500 ; c=4/9 ; θ=0.1 ; (M/P)d=100+1.2Y-1000i; P=1

a. Derive the IS relation and the LM relation.

b. Solve for the equilibrium real output and the interest rate. Show the IS-LM

equilibrium in a diagram. Verify that both the goods market and the money market

are in equilibrium.

c. Now suppose that central bank money falls by 10% due to open market sales of

bonds. Find the new IS-LM equilibrium and do a graphical display. Discuss the effects

of the monetary contraction on Y, i, C, and I.

d. Set H back to its initial value, and suppose that there is a deflationary episode and the

price level falls by 10%. Find the new IS-LM equilibrium and do a graphical display.

Discuss the effects of the decrease in prices on Y, i, C, and I.