11Chapter-Mankiw

# 11Chapter-Mankiw - CHAPTER 11 Aggregate Demand II Questions...

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Questions for Review 1. The aggregate demand curve represents the negative relationship between the price level and the level of national income. In Chapter 9, we looked at a simplified theory of aggregate demand based on the quantity theory. In this chapter, we explore how the IS–LM model provides a more complete theory of aggregate demand. We can see why the aggregate demand curve slopes downward by considering what happens in the IS LM model when the price level changes. As Figure 11–1(A) illustrates, for a given money supply, an increase in the price level from P 1 to P 2 shifts the LM curve upward because real balances decline; this reduces income from Y 1 to Y 2 . The aggregate demand curve in Figure 11–1(B) summarizes this relationship between the price level and income that results from the IS LM model. 91 LM ( P = P 2 ) Y 2 Y 2 Y 1 P 2 P 1 LM ( P = P 1 ) Y 1 A. The IS LM Model B. The Aggregate Demand Curve r Interest rate B A IS Income, output Income, output P Price level AD Figure 11–1 CHAPTER 11 Aggregate Demand II

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2. The tax multiplier in the Keynesian-cross model tells us that, for any given interest rate, the tax increase causes income to fall by T × [ – MPC /(1 – MPC )]. This IS curve shifts to the left by this amount, as in Figure 11–2. The equilibrium of the economy moves from point A to point B. The tax increase reduces the interest rate from r 1 to r 2 and reduces national income from Y 1 to Y 2 . Consumption falls because disposable income falls; investment rises because the interest rate falls. Note that the decrease in income in the IS LM model is smaller than in the Keynesian cross, because the IS LM model takes into account the fact that investment rises when the interest rate falls. 3. Given a fixed price level, a decrease in the nominal money supply decreases real money balances. The theory of liquidity preference shows that, for any given level of income, a decrease in real money balances leads to a higher interest rate. Thus, the LM curve shifts upward, as in Figure 11–3. The equilibrium moves from point A to point B. The decrease in the money supply reduces income and raises the interest rate. Consumption falls because disposable income falls, whereas investment falls because the interest rate rises. LM A B Y Income, output Interest rate r T × 1 – MPC Y 1 Y 2 r 1 r 2 IS 2 IS 1 – MPC 92 Answers to Textbook Questions and Problems Figure 11–2 B A IS Y Income, output r Y 1 LM 2 1 r 2 r 1 Y 2 Figure 11–3
4. Falling prices can either increase or decrease equilibrium income. There are two ways in which falling prices can increase income. First, an increase in real money balances shifts the LM curve downward, thereby increasing income. Second, the IS curve shifts to the right because of the Pigou effect: real money balances are part of household wealth, so an increase in real money balances makes consumers feel wealthier and buy more. This shifts the IS curve to the right, also increasing income.

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## This note was uploaded on 02/22/2012 for the course ECON 602 taught by Professor Smith during the Spring '12 term at FSU.

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11Chapter-Mankiw - CHAPTER 11 Aggregate Demand II Questions...

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