Answer Key: Chapters 58, 14
CHAPTER 5
Quick Check
1.
a.
True.
b.
True.
c.
False.
d.
False.
The balanced budget multiplier is positive (it equals one), so the IS curve shifts
right.
e.
False.
f.
Uncertain.
An increase in government spending leads to an increase in output (which
tends to increase investment), but also to an increase in the interest rate (which tends to
reduce investment).
g.
True.
2.
a.
Y
=[1/(1
c
1
)][
c
0

c
1
T
+
I
+
G
]
The multiplier is 1/(1
c
1
).
b.
Y
=[1/(1
c
1

b
1
)][
c
0

c
1
T
+
b
0

b
2
i
+
G
]
The multiplier is 1/(1
c
1

b
1
).
Since the multiplier is larger than the multiplier in part (a),
the effect of a change in autonomous spending is bigger than in part (a).
An increase in
autonomous spending now leads to an increase in investment as well as consumption.
c.
Substituting for the interest rate in the answer to part (b),
Y
=[1/(1
c
1

b
1
+
b
2
d
1
/
d
2
)][
c
0

c
1
T
+
b
0
+(
b
2
/
d
2
)(
M
/
P
)+
G
].
The multiplier is 1/(1
c
1

b
1
+
b
2
d
1
/
d
2
).
d.
The multiplier is greater (less) than the multiplier in part (a) if (
b
1

b
2
d
1
/
d
2
) is greater (less)
than zero.
The multiplier as measured in part (c) measures the marginal effect of an
increase in autonomous spending on
equilibrium
output.
As such, the multiplier is the
sum of two effects:
a direct effect of output on demand and an indirect effect of output
on demand via the interest rate.
The direct effect is equivalent to the horizontal shift of
the
IS
curve.
The indirect effect depends on the slope of the
LM
curve (since the
equilibrium moves along the
LM
curve in response to a shift of the
IS
curve) and the
effect of the interest rate on investment demand.
The direct effect is captured by the sum
c
1
+
b
1
, which measures the marginal effect of an
increase in output on the sum of consumption and investment demand.
As this sum
increases, the multiplier gets larger.
The indirect effect is captured by the expression
b
2
d
1
/
d
2
and tends to reduce the size of the
multiplier.
The ratio
d
1
/
d
2
is the slope of the
LM
curve, and the parameter
b
2
measures
the marginal effect of an increase in the interest rate on investment.
Note that the slope
of the LM curve becomes larger as money demand becomes more sensitive to income
(i.e., as
d
1
increases) and becomes smaller as money demand becomes more sensitive to
the interest rate (i.e., as
d
2
increases).
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a.
The
IS
curve shifts left.
Output and the interest rate fall.
The effect on investment is
ambiguous because the output and interest rate effects work in opposite directions: the
fall in output tends to
reduce investment, but the fall in the interest rate tends to
increase it.
b.
From the answer to 2(c),
Y
=[1/(1
c
1

b
1
+
b
2
d
1
/
d
2
)][
c
0

c
1
T
+
b
0
+(
b
2
/
d
2
)(
M
/
P
)+
G
].
c
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 Spring '10
 tack
 Inflation, Monetary Policy

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