CHAPTER 10
MONEY, INTEREST, AND INCOME
Answers
to
Problems
in
the
Textbook
:
Conceptual Problems:
1.
The model in Chapter 9 assumed that both the price level and the interest rate were fixed. But the IS-
LM model lets the interest rate fluctuate and determines the combination of output demanded and the
interest rate for a fixed price level. It should be noted that while the upward-sloping AD-curve in
Chapter 9 (the [C+I+G+NX]-line in the Keynesian cross diagram) assumed that interest rates and
prices were fixed, the
downward-sloping AD-curve that is derived at the end of Chapter 10 from the
IS-LM model lets the price level fluctuate and describes all combinations of the price level and the
level of output demanded at which the goods and money sector simultaneously are in equilibrium.
2.a. If the expenditure multiplier (
α
) becomes larger, the increase in equilibrium income caused by a unit
change in intended spending also becomes larger. Assume investment spending increases due to a
change in the interest rate. If the multiplier
α
becomes larger, any increase in spending will cause a
larger increase in equilibrium income. This means that the IS-curve will become flatter as the size of
the expenditure multiplier becomes larger.
If aggregate demand becomes more sensitive to interest rates, any change in the interest rate
causes the [C+I+G+NX]-line to shift up by a larger amount and, given a certain size of the
expenditure multiplier
α
, this will increase equilibrium income by a larger amount. As a result, the
IS-curve will become flatter.
2.b. Monetary policy changes affect interest rates and this leads to a change in intended spending, which
is reflected in a change in income. In 2.a. it was explained that a steep IS-curve means either that the
multiplier
α
is small or that desired spending is not very interest sensitive.
Therefore, an increase in
money supply will reduce interest rates.
However, this does not result in a large increase in
aggregate demand if spending is very interest insensitive.
Similarly, if the multiplier is small, then
any change in spending will not affect output significantly. Therefore, the steeper the IS-curve, the
weaker the effect of monetary policy changes on equilibrium output.
3.
Assume that money supply is fixed.
Any increase in income will increase money demand and the
resulting excess demand for money will drive the interest rate up.
This, in turn, will reduce the
quantity of money balances demanded to bring the money sector back to equilibrium. But if money
demand is very interest insensitive, then a larger increase in the interest rate is needed to reach a new
equilibrium in the money sector. As a result, the LM-curve becomes steeper.
Along the LM-curve, an increase in the interest rate is always associated with an increase in
income. This means that an increase in money demand (due to an increase in income) has to be offset
by a decrease in the quantity of money demanded (due to an increase in the interest rate) to keep the
money sector in equilibrium. But if money demand becomes more income sensitive, a smaller change
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