Demonstration Lecture 4: Suggested Solutions 1. True.

This question requires a detailed discussion of the interest rate effect in the process of deriving the AD curve from the IS-LM model. Note that up until this point in time e have assumed that the price level is constant and so an e!ogenous varia"le# hich is either determined outside of our model or pre-determined. $iven the initial assumption of a fi!ed or constant nominal mone% suppl%# a change in the price level is effectivel% changing the real mone% suppl% in the econom% at an% particular point in time. &ence the price level no changes from an e!ogenous varia"le to an endogenous varia"le# or one that is determined inside of the model. 'ith a fi!ed nominal mone% suppl%# and a constant price level for e!ample it means that our initial LM curve is dra n or constructed for a real mone% suppl% level. No ith a change in the price level# such as reduction in the price level# MSo()o to MSo()1# as demonstrated in *igure +.1,a- in the .roo/s manuscript# the real mone% suppl% has increased. As a result the LM curve ill shift to the right. This shift produces a ne com"ination of a lo er interest rate and a higher level of 0 or real $D). )lotting the various price levels against the various levels of related 0 or real $D)# e can derive the Aggregate Demand curve. Note that it is negativel% sloped# and sho s the relationship "et een aggregate e!penditure as determined "% the IS-LM frame or/# and the various price levels. The derivation can also "e sho n ith an increase in the price level. 1. True. The position of the AD curve is determined "% those autonomous factors hich impact upon either the positions of the IS or LM curves. In the case of a change in autonomous consumption e!penditure or 2o# it ill produce a shift to the right of the original IS curve# as is demonstrated in *igure +.+ ,a-. As this is a non-price factor that is changing# its resultant impact upon the AD curve ill not "e a movement along the curve "ut a shift of the curve per se. Note that in *igure +.+ ,"-# the shift in the AD curve produces an increase in 0 or real $D) "ut ith the maintenance of the original price level of )o. Students should also consider ho this change in autonomous e!penditure# 2o# ill lead to an increase in 0 or real $D) using the +3 degree line model approach. 4. True. An increase in the real mone% suppl% can come a"out from 1 sources# either a change in the nominal mone% suppl%# ith no change in the underl%ing price level# and(or a change in the price level ith no change in the nominal mone% suppl%. It is clear from previous or/ done on the ISLM model that an increase in the real mone% suppl% ill shift the LM curve to the left. .ut no students must differentiate "et een the 1 t%pes of change in the real mone% suppl%. If the increase in Ms() comes form a fall in the price level then this effectivel% translates to a movement along the AD curve. 5n the other hand if the increase in Ms() is due to am increase in the nominal mone% suppl% or Ms# then this translates to a right ard shift of the AD curve. Students should refer to *igures +.3 ,a-# and ,"- in the .roo/s manuscript to see the effect of the latter change in real mone% suppl%. +. True. The interest elasticit% is directl% related to the price elasticit% of the AD curve. Students should refer to Section +.1.3 in the .roo/s manuscript. It follo s that ith a relativel% elastic IS curve# and a normal LM curve# for e!ample # a change in the price level# such as a fall in price# ill shift the LM curve to the right. As a result of the latter# it is logical to e!pect a fairl% large increase in 0 or real $D). &ence one can conclude that a relativel% small fall in price ill lead to a large increase in 0. If students ere to plot thee outcomes along a price(0 set of a!es# this ould produce a relativel% elastic AD curve. &o ever one should also "e a are of the significance of the relative elasticit%(inelasticit% of the LM curve# and its impact upon the ultimate shape(slope of the AD curve. This relationship is addressed in the ans er to 6uestion 3. 3. True. 'hen the demand for mone% is interest elastic# it means that the total mone% demand curve is relativel% elastic. &ence a small change in the interest rate ill have a relativel% large impact upon the demand for mone% as opposed to other financial asset forms. In turn this corresponds to a relativel% elastic LM curve # as sho n in 2ase 1 in Section +.1.3 of the .roo/s manuscript. Assuming a given IS curve hich is neither highl% elastic nor inelastic in respect to interest rate variations# a change in the price level ill lead to an increase in real mone% suppl% if there is a reduction in price. The LM curve ill shift to the right "ut produce a relativel% small increase in 0 or real $D). In conclusion an average change in the price level ill produce a disproportionatel% small increase in 0 or real $D). In effect one is left ith a relativel% inelastic

AD curve. The rule that follo s is that a relativel% elastic LM curve leads to a relativel% inelastic AD curve and vice versa. 7. True. If the investment demand curve is totall% inelastic# it means that planned investment e!penditure is totall% insensitive to variations in the interest rate. It follo s that on the "asis of previous theoretical or/ done in this su"8ect that the associated IS curve is totall% inelastic.# as is demonstrated in *igure +.7 ,a- of the .roo/s manuscript. Assuming a conventional LM curve# then a fall in the price level ill move the LM curve out to the right. &o ever# given the vertical IS curve# this ill produce a reduction in the interest rate "ut no change in 0 or real $D). It therefore follo s that the resultant Ad curve ill also "e perfectl% price inelastic. In conclusion the change in the rate of interest generated "% the change in the real mone% suppl% ,due to the fall in the price level-# ill have no impact upon e!penditure and so no impact upon 0. Students should also attempt to see the effect of a totall% inelastic investment demand curve# hen placed in the conte!t of the +3 degree model. $iven the latter a change in i ill produce no change in Io# and so the Aggregate 9!penditure function remains constant. This effectivel% means that in the +3 degree model# there ould "e no change in A9 # and so 0e1 ould "e identical to 0e1.