CHAPTER 1: IS-LM MODEL

PART 1: T/F
1. Government increases spending and it leads to flatter IS curve.
FALSE
We have IS function
−(1−MPC ) C + I+G−MPC . T
r= Y+
b b
In which:
b: measures the sensitivity of investment to a change in interest rate
C : autonomous expenditure of household
I : autonomous investment of firms
T : autonomous tax or lump sum tax
G : autonomous government spending
MPC : marginal propensity to consumption
According to the function, government spending is exogenous factor, which means the
slope of IS curve is not affected by it. Therefore, if government increases spending, IS
curve will shift rightward and the slope of it remains unchanged.
 the statement is false

A B
r
IS1
IS0

YA Y
YB

2. Government increases tax and it leads to steeper IS curve.

FALSE
We have IS function
−(1−MPC ) C + I+G−MPC . T
r= Y+
b b
In which:
b: measures the sensitivity of investment to a change in interest rate
C : autonomous expenditure of household
I : autonomous investment of firms
T : autonomous tax or lump sum tax
G : autonomous government spending
MPC : marginal propensity to consumption
According to the function, tax is exogenous factor, which means the slope of IS curve is
not affected by it. Therefore, if government increases tax, the IS curve will shift leftward
and the slope of it remains unchanged.
 the statement is false.

B
A
r
IS1 IS0

Y
YB YA
3. According to IS-LM model, fiscal policy is neutral in the long run.
FALSE
 In case of expansionary fiscal policy:
 r
LM1

LM0

C
rC

B
rA A

IS1
IS0
Y
YA

(1). When expansionary policy is applied IS shifts rightward from IS0 to IS1
(2). In short-run new equilibrium moves from A to B . Compare A to B, we have: r
increases, Y increases
(3). In the long-run, as the new output in greater than potential output (Y B> YA);
therefore, price will increase, which shifts the LM to the left (LM 0 to LM1). The new
equilibrium is now point C.
Compare A to C, we have: r increases, Y remains unchanged.
 Expansionary fiscal policy changes interest rate in the long-run.
 In the case of contractionary fiscal policy

r
LM0

A LM1
rA

rC
C
IS0

IS1
Y
YA
(1). When contractionary policy is applied IS shifts leftward from IS0 to IS1 .
(2). In short-run, new equilibrium moves from A to B . Compare A to B, we have: r
decreases, Y decreases
(3). In the long-run, as the new output in smaller than potential output (YB< YA);
therefore, price will decrease, which shifts the LM to the right (LM0 to LM1). The new
equilibrium is now point C.
Compare A to C, we have: r decreases, Y remains unchanged.
 Contractionary fiscal policy changes interest rate in the long-run.
In conclusion, fiscal policy is non-neutral in the long run as it changes the interest rate.
 the statement is false.
4. According to IS-LM model, monetary policy is neutral in the long run.
TRUE
 In the case of expansionary monetary policy:

r
LM0

A LM1
rA

rB B

IS0

YA YB
(1). When expansionary monetary policy is applied LM shifts rightward from LM0 to
LM1.
(2). In short-run, new equilibrium moves from A to B . Compare A to B, we have: r
decreases, Y increases
(3). In the long-run, as the new output in greater than potential output (Y B> YA);
therefore, price will increase, which shifts the LM to the left (LM 1 to LM0). The new
equilibrium is now point A. Then we have: r remains unchanged, Y remains unchanged.
 Expansionary monetary policy does not change interest rate in the long-run.
 In the case of contractionary monetary policy:
r

LM1

B LM0
rB

rA
A

IS0

YB YA

(1). When contractionary monetary policy is applied LM shifts leftward from LM0 to
LM1
(2). In short-run, new equilibrium moves from A to B . Compare A to B, we have: r
increases, Y decreases
(3). In the long-run, as the new output is smaller than potential output (YB< YA);
therefore, price will decrease, which shifts the LM to the right (LM1 to LM0). The new
equilibrium is now point A. Then we have: r remains unchanged, Y remains unchanged.
 Contractionary monetary policy does not change interest rate in the long-run.
In conclusion, monetary policy is neutral in the long run as it does not change the interest
rate.
 The statement is true

5. According to IS-LM model, when government implements expansionary fiscal policy,

both output and interest rate increase in the long-run.
FALSE r
LM1

LM0

C
rC

B
rA A

IS1
IS0
Y
YA

(1). When expansionary policy is applied IS shifts rightward from IS0 to IS1.
(2). In short-run, new equilibrium moves from A to B. Compare A to B, we have: r
increases, Y increases
(3). In the long-run, as the new output in greater than potential output (Y B> YA);
therefore, price will increase, which shifts the LM to the left (LM 0 to LM1). The new
equilibrium is now point C. Compare A to C, we have: r increases, Y remains unchanged.
Therefore, expansionary fiscal policy only changes interest rate in the long run
 The statement is false

6. According to IS-LM model, when government implements contractionary fiscal

policy, both output and interest rate are unchanged in the long run.
FALSE
contractionary fiscal policy
r
LM0

A LM1
rA

rC
C
IS0

IS1
Y
YA

(1). when contractionary policy is applied IS shifts leftward from IS0 to IS1
(2). In short-run, new equilibrium moves from A to B . Compare A to B, we have:
r decreases, Y decreases
(3). In the long-run, as the new output in smaller than potential output (YB< YA);
therefore, price will decrease, which shifts the LM to the right (LM0 to LM1). The
new equilibrium is now point C. Compare A to C, we have: r decreases, Y remains
unchanged.
 Contractionary fiscal policy changes interest rate in the long-run.
 the statement is false

7. According to IS-LM model, when Central bank implements expansionary monetary

policy, both output and interest rate are unchanged in the long-run.
TRUE
 r
LM0

A LM1
rA

rB B

IS0

YA YB
(1). when expansionary monetary policy is applied LM shifts rightward from
LM0 to LM1
(2). In short-run, new equilibrium moves from A to B. Compare A to B, we have: r
decreases, Y increases
(3). In the long-run, as the new output in greater than potential output (Y B> YA);
therefore, price will increase, which shifts the LM to the left (LM 1 to LM0). The
new equilibrium is now point A. Then we have: r remains unchanged, Y remains
unchanged.
 Expansionary monetary policy does not change interest rate and output in the long-
run.
 the statement is true

8. According to IS-LM model, when government implements contractionary monetary

policy, both output and interest rate decrease in the long-run.
FALSE
r

LM1

B LM0
rB

rA
A

IS0
 YB YA

Contractionary monetary policy:

(1). When contractionary monetary policy is applied LM shifts leftward from LM0 to
LM1
(2). In short-run, new equilibrium moves from A to B . Compare A to B, we have: r
increases, Y decreases
(3). In the long-run, as the new output is smaller than potential output (YB< YA);
therefore, price will decrease, which shifts the LM to the right (LM1 to LM0). The new
equilibrium is now point A. Then we have: r remains unchanged, Y remains unchanged.
 Contractionary monetary policy does not change interest rate and output in the long-
run.
 the statement is false.

9. Government increases spending and Central bank decreases reserve rate requirement
then output definitely rises.
Assume that the economy is initially at the potential output (Y0)
(1) When the Central Bank decreases the discount rate (expansionary monetary policy
is applied):  LM curve shifts rightward (from LM0 to LM1).
The government increases spending (expansionary fiscal policy is applied): IS curve
shifts rightward (from IS0 to IS1).
(2) In the short run: after the shifts of 2 curves, the equilibrium of the economy moves
from A to B. Compare B to A: Y increases while r is ambiguous as it depends on
the magnitude of the shifts in 2 curves.
Since the new output is greater than potential one (Y1>Y0) then price level (P) increases.
IS shifts by a IS shifts by a IS shifts by the
greater distance smaller distance same distance as
than LM than LM LM
r r r LM2
LM2 LM2
LM0 LM0
C LM0
LM1
C LM1
r2 LM1
r1
C
r2
r1 B
r0 A B
A A r0
r0
B
IS1 r1
IS1
IS0 IS0 IS1
IS0
0 0 Y1 Y 0
Y0 Y1 Y Y0 Y0 Y1 Y

(3). In the long run: Since the new output is greater than potential one (Y 1>Y0) then price
level (P) increases. Increase of P shifts LM to the left from LM 1 to LM2 (as output in the
long run will come back to the potential output). The new equilibrium of the economy
moves from B to C. Compare C to A, we have r increases, Y remains unchanged.
Conclusion: In the long run, when central bank decreases discount rate and government
increases spending, r (interest rate) increases while Y (output) remains unchanged.
⇨ The statement is false in the long run

10. Government increases spending and Central bank sells government bonds then
interest rate definitely rises.
⇨ The statement is true in the long-run (Giống câu 9)

11. Government increases tax and Central bank buys government bonds then output
definitely decreases.
Assume that the economy is initially at the potential output (Y0)
 (1) When the Central Bank buys government bonds (expansionary monetary policy is
applied):  LM curve shifts rightward (from LM0 to LM1).
The government increases tax (contractionary fiscal policy is applied): IS curve
shifts leftward (from IS0 to IS1).
(2) In the short run: after the shifts of 2 curves, the equilibrium of the economy moves
from A to B. Compare B to A: r decreases while Y is ambiguous as it depends on
the magnitude of the shifts in 2 curves.
IS shifts by a greater IS shifts by a smaller IS shifts by the same
distance than LM distance than LM distance as LM
r r r Y1

LM0
LM1 LM0
LM0 LM1
LM1
LM2
A
r0 r0 A
r0 A

B r2 C
r1
IS0 IS0
r2 C r1 B r1 B
IS0
IS1 IS1 IS1

0 Y1 Y0 0 Y 0
Y Y0 Y1 Y0 Y

(3) Case 1: Since the new output is smaller than potential one (Y 0>Y1) then price level
(P) decreases.
In the long run: Decrease of P shifts LM to the right from LM 1 to LM2 (as output
in the long run will come back to the potential output). The new equilibrim of the
economy moves from B to C. Compare C to A, we have r decreases, Y remains
unchanged.
The same pattern is applied for case 2 and 3
Conclusion: In the long run, when central bank decreases discount rate and government
increases spending, r decreases and Y is unchanged.
 The statement is false
12. Government increases tax and Central bank raises discount rate then interest rate
definitely decreases. (contrac+contrac long run)
.
Assume that the economy is initially at the potential output (Y0)
(1) When the Central Bank raises the discount rate (contractionary monetary policy is
applied):  LM curve shifts leftward (from LM0 to LM1).
The government increases tax (contractionary fiscal policy is applied): IS curve shifts
leftward (from IS0 to IS1).
(2) In the short run: after the shifts of 2 curves, the equilibrium of the economy moves
from A to B. Compare B to A: Y decreases while r is ambiguous as it depends on
the magnitude of the shifts in 2 curves.
Since the new output is smaller than potential one (Y0>Y1) then price level (P) decreases.
IS shifts by a IS shifts by a IS shifts by the
greater distance smaller distance same distance as
than LM than LM LM
r r r

IS0 LM1 LM1 C LM1 LM0

LM0 LM0
IS0
IS0 LM2
LM2
IS1 LM2 IS1
IS1
r0 A
r1 B
B A
r1 B r0
r0 A

r2 r1 C
r2 C C

0 0 Y1 Y 0
Y1 Y0 Y Y0 Y1 Y0 Y

(3) In the long run: Decrease of P shifts LM to the right from LM 1 to LM2 (as output
in the long run will come back to the potential output). The new equilibrium of the
economy moves from B to C. Compare C to A, we have r decreases, Y remains
unchanged.
Conclusion: In the long run, when central bank raises discount rate and
government increases tax, r (interest rate) decreases while Y (output) remains
unchanged.
 ⇨ The statement is true in the long-run

13. In IS-LM model, if expenditure multiplier is big, investment is sensitive to interest

rate and money demand is insensitive to income but sensitive to interest rate then
monetary policy is more effective than fiscal policy.
+) We have IS function:
−1 C + I +G−MPC . T
.Y+
r = b. 1 b
1−MPC
In which:
b: measures the sensitivity of investment to a change in interest rate
C : autonomous expenditure of households
I : autonomous investment of firms
G :autonomous government spending
T : autonomous tax
MPC: marginal propensity to consumption
1
: expenditure multiplier
1−MPC
- If expenditure multiplier is big MPC is big
- Investment is sensitive to interest rate b is big
Then IS slope is small IS curve is flat
+ We have LM function:
k M
: r = .Y−
h P.h
In which:
k: measures the sensitivity of money demand to a change in income
h: measures the sensitivity of money demand to a change in interest rate
If money demand is insensitive to income => k is small
If money demand is insensitive to income k is small
14. In IS-LM model, if expenditure multiplier is small, investment is insensitive to
interest rate and money demand is insensitive to income but sensitive to interest rate then
fiscal policy is more effective than monetary policy.
−1 C + I +G−MPC . T
.Y+
+) We have IS function: r = b . 1 b
1−MPC
In which:
b: measures the sensitivity of investment to a change in interest rate
C : autonomous expenditure of households
I : autonomous investment of firms
G :autonomous government spending
T : autonomous tax
MPC: marginal propensity to consumption
1
: expenditure multiplier
1−MPC
If expenditure multiplier is small => MPC is small
Investment is insensitive to interest rate => b is small
⇨ IS’s slope is big => IS curve is steep
k M
+) We have LM function: r = .Y−
h P.h
In which:
k: measures the sensitivity of money demand to a change in income
h: measures the sensitivity of money demand to a change in interest rate
If money demand is insensitive to income => k is small
Money demand sensitive to interest rate => h is big
⇨ LM’s slope is small => LM curve is flat
 r IS1 r LM0
IS0 IS LM1
LM

r2 r2

r1 r1

Y1 Y2 Y Y1 Y2 Y

Expansionary fiscal policy: Y Expansionary monetary policy: Y

increases significantly increases slightly

Exercise 1: Consider a closed economy that is characterized by the following equations

in the short-run:
C = 200 + 0,75(Y-T); T = 100; I = 225 – 25r; G = 75
M = 1000; P = 2; MDr = Y – 100r
a) Find the equations for IS curve and LM curve. Calculate equilibrium r and Y
of the economy.
 IS function:
−( 1−MPC ) C + I+G−MPC . T
r= Y+
b b
−( 1−0.75 ) 200+ 225+75−0.75 × 100
⇔ r= Y+
25 25

⇔ r=−0.01 Y +17 (1)

 LM function
k M
r= Y−
h Ph
⇔ ( LM ) r=0.01Y −5 (2)

 From (1) and (2), we have equilibrium point

{ r 0=6( %)
Y 0=1100(units)
 b) Assume that G increases by 50 units. Calculate new equilibrium r and Y of
the economy. How does the IS curve shift? Calculate the degree of crowding-
out effect in this case.
 G increases by 50 units we have new IS function:
( IS 1 ) : r=−0.01 Y +19 (3)
 From (2) and (3) we have new equilibrium point

{ r 1 =7(% )
Y 1=1200(units)

 IS curve shifts upward by 2 units

 Calculate the degree of crowding out effect
- Replace r0 into IS (1) function:  Y1’= 1300
 the degree of crowding-out effect= 1300-1200=100
c) Assume that M increases by 200 units. Calculate new equilibrium r and Y of
the economy. How does the LM curve shift?
- New LM equation
LM(1) : r =0.01Y −6 (4)
- From (1) and (4), we have new equilibrium point

{r 2=5.5
Y 2=1150

 LM shifts downward by 1 unit.

d) Assume that P is double. Calculate new equilibrium r and Y of the economy.
- New LM equation
LM(2) : r =0.01Y −2.5 (5)
- From (1) and (5) , we have new equilibrium point

{ r 3=7.25
Y 3=975

e) Find the equation of AD curve.

 10
From (1) and (2): 0.01 Y − =−0.01 Y +17
P
 We have AD function
500
(AD): Y = +850
P

Exercise 2: Consider a closed economy that is characterized by the following equations

in the short-run:
C = 40 + 0,8(Y-T); T = 100; I = 100 – 20r; G = 200
M = 1200; P = 2; MDr = 2Y – 50r
a. Find the equations for IS curve and LM curve. Calculate equilibrium r and Y of
the economy.
−( 1−MPC ) C + I +G−MPC . T
 IS function: r = Y+
b b
⇔( IS ) :r =−0.01 Y +13 (1)
k M
 LM function: r= Y−
h Ph

⇔ (LM): r =0.04 Y −12 (2)

 From (1) and (2), we have equilibrium equation:

{r=−0.01Y ⇔{
+13 r =8( %)
0
r =0.04 Y −12 Y =500(units)
0

b.  Find the value of G so that Y = 600. How does the IS curve shift? Calculate the
degree of crowding-out effect in this case.
 Replace Y1=600 into the LM function (2)  r = 12
 Replace r1=12, Y=600 into (IS) function (1)
40+100+G−0.8× 100
 12=−0.01× 600+
20
⇔ G= 300
 we have new IS function (IS1) :r =−0.01Y + 18 (3)
 The IS curve shifts upward by 5 units.
 Replace r 0 into (IS1) function, we have Y1’=1000
 The degree of crowding-out effect= Y1’- Y1= 1000-600=400

c. In the condition of question (b), if Government wants to keep the interest rate
remains unchanged, how should the monetary policy be implemented? How does
the LM curve shift? 
 Replace r 0 into (IS1) function, we have Y1’=1000
M1
 Denote M1 as the nominal money supply, we have MDr =MS r ⇔ 2 Y −50=
P
⇔ M 1=3200
 ∆ M =M 1−M =3200−1200=2000
 Central should implement expansionary monetary policy by increasing the money
supply by 2000 units so as to keep the interest rate remain unchanged.
In this case, we have new LM function (LM1): ¿ 0.04 Y −32
 the LM curve will shift downward by 20 units.
d.  Given money multiplier = 4, what should Central bank do in order to implement
monetary policy in question (c) by using open market operation?
We have: ∆ M =mM × ∆ B  ∆ B=2000: 4=500
 Central bank should buy Government bonds which worth 500 units.
e. Find the equation of AD curve.
24
- We have LM function: r =0.04 Y − (*)
P
24
- From (1) and (*), we have: 0.04 Y − =¿−0.01Y +13
P
480
AD function: (AD): Y = +260
P
Exercise 5: Consider a closed economy that is characterized by the following equations
in the short-run:
C = 100 + 0,8(Y - T); I = 200 - 10r; G = 120; T = 50 + 0,25Y
MB = 200; MD = Y – 25r; P = 1
 a. Find the equations for IS and LM curve given equilibrium output of the economy
is 800. 
−( 1−MPC ) C + I+G−MPC . T
 We have IS function: r = Y+
b b
−( 1−0.8 ) 100+200+120−0.8(50+0.25 Y )
⇔ r= Y+
10 10
⇔ (IS): r =−0.04 Y +38 (1)
 Replace Y=800 into IS function  r=6
 Replace r=6 into MD function M=650
 We have LM function (LM): r =0.04 Y −26 (2)
b. Government increases spending by 4 units. Find the change in equilibrium income and
interest rate. Calculate the degree of crowding-out effect in this case.
Gnew = 124
−( 1−0.8 ) 100+200+124−0.8(50+0.25 Y )
 New IS function: (IS1)r = Y+
10 10
⇔ (IS1): r =−0.04 Y +38.4 (3)
 From (2) and (3) we have new equilibrium point

{ r 1=6.2(% )
Y 1=805(units)
'
 Replace r=6 into (IS1) function, we have Y 1=810
 The degree of crowding-out effect= 810-805=5

c. If Government decreases lump-sum tax by 4 units instead of the increase in

government spending as above, how about the impact of this action on income in
comparison with the case of question (b)?
* New IS function (IS2): r =−0.04 Y +38.32 (4)
 From (2) and (4) we have new equilibrium point

{ r 2=6.16(%)
Y 2=804 (units)
As Y 2 <Y 1  The impact of decreasing lump sum tax is smaller than increasing
government spending.
d. Given money multiplier = 2, what is the response of Central bank using open market
operation in order to keep interest rate to be stable after the policy in question (b)?
'
 Replace r=6 into (IS1) function, we have Y 1=810
 Denote M1 as the nominal money supply, we have MDr =MS r ⇔ M 1=660
 ∆ M =M 1−M =660−650=10
 ∆ M =mM × ∆ B  ∆ B=10:2=5
 Central Bank should buy government bonds which worth 5 units

CHAP 1:
Ex 1: C=200 + 0.75(Y-T); I=225 – 25r; G = 75; T = 100; M = 1000; P = 2; MD = Y-
100r
a. Find the equilibrium value of r and Y
b. G=? so that Y = 1500
−( 1−MPC ) C + I +G−MPC . T
a. IS function: r = Y+
b b
−( 1−0.75 ) 200+225+75−0.75 ×100
⇔ r= Y+
25 25
⇔(IS): r =−0.01Y + 17 (1)
k M
 LM function: r = h Y − Ph
⇔ r =0.01Y −5 (2)
 From (1) and (2), we have equilibrium equation:

{r=−0.01Y ⇔{
+17 r =6( %)0
r=0.01 Y −5 Y =1100(units)
0

b. Replace Y=1500 into LM function (2) , we have

r =0.01× 1500−5=10
 Replace Y=1500 and r=10 into IS function:
−( 1−0.75 ) 200+225+G−0.75× 100
We have: r = Y+
25 25
⇔ G= 275
Ex 2: C = 60 + 0.8(Y-T); T = 100; G = 500; I = 300 – 20r; M = 1080; P = 2; MD = Y –
40r
a. Find the equilibrium value of r and Y
−( 1−MPC ) C + I+G−MPC . T
IS function: r = Y+
b b
−( 1−0.8 ) 60+500+300−0.8 ×100
⇔ r= Y+
20 20
⇔(IS): r =−0.01Y + 39 (1)
k M
 LM function: r = h Y − Ph
⇔ r =0.025 Y −13.5 (2)
 From (1) and (2), we have equilibrium equation:

{r=0.025 ⇔{
r=−0.01Y +39 r =24(%)
0
Y −13.5 Y =1500(units)
0

b. M=? so that Y = 1500

* Replace Y=1500 into LM function (2) , we have: r =−0.01× 15+39

Ex 3: C = 200 + 0.75(Y-T); T =100; G = 75; I = 225 – 25r; M = 1000; MD = Y-100r

a. Find the equation of AD
−( 1−MPC ) C + I +G−MPC . T
a. IS function: r = Y+
b b
−( 1−0.75 ) 200+225+75−0.75 ×100
⇔ r= Y+
25 25
⇔(IS): r =−0.01Y + 17 (1)
k M
 LM function: r = h Y − Ph
10
⇔ r =0.01Y − (2)
P
10
 From (1) & (2), we have: −0.01 Y +17=0.01Y − P
500
⇔ Y= +850 (AD)
P

b. Find the equilibrium price in the long run if the natural level of output is 1000
Replace Y=1000 into (AD) function
 500 10
1000= +850 → P=
P 3
Ex 4: C = 40 + 0.8(Y-T); T = 100; I = 100-20r; G = 200; M = 1200; P = 2; MD = 2Y –
50r
a. Find the output and interest rate at equilibrium
−( 1−MPC ) C + I +G−MPC . T
a. IS function: r = Y+
b b
−( 1−0.8 ) 40+100+ 200−0.8 × 100
⇔ r= Y+
20 20
⇔(IS): r =−0.01Y + 13 (1)
k M
 LM function: r = h Y − Ph
⇔ r =0.04 Y −12 (2)
 From (1) and (2), we have equilibrium equation:

{r=−0.01Y ⇔{
+13 r =8( %)
0
r =0.04 Y −12 Y =500(units)
0

b. If G = 300 find the new equilibrium

−( 1−0.8 ) 40+100+ 300−0.8 ×100
* G=300, then we have new IS function: r = Y+
20 20
⇔ r =−0.01Y + 18 (3)
 * From (3) and (2), we have equilibrium equation:

{r=−0.01Y ⇔{
+18 r =12(%)
1
r =0.04 Y −12 Y =600(units)
1

c. Estimate the degree of crowding-out effect

* Replace r=8 into the new IS function, we have Y '1=1000

 The degree of crowding-out effect= Y '1−Y 1 =1000−600=400

 CHAP 2: MUNDELL-FLEMING MODEL AND AD
1. According to Mundell-Fleming model with flexible foreign exchange economy, fiscal
policy is effective in changing output.
For example, in the case of expansionary
fiscal policy.
r LM
(1). Expansionary fiscal policy IS shifts IS1
rightward from IS0 to IS1. Equilibrium
IS0
moves from A to B. B
(2). B is above BP line interest rate
increase (r>r*) that leads to appreciation
A
of domestic currency, inducing massive r* BP
capital inflows. Therefore, net export
decreases.
Then, IS curve shifts leftward from IS1 0 Y0 Y1 Y
to IS2 until the equilibrium is at r*.
 Equilibrium of the economy moves
from B to A.
(3). Y is unchanged, r remains unchanged,
e increases, NX decreases.

The same pattern is applied with contractionary fiscal policy

As we can see, fiscal policy does not change output, therefore it is ineffective
 the statement is false
2. According to Mundell-Fleming model with flexible foreign exchange economy,
monetary policy is ineffective in changing output.
 For example, in the case of expansionary
monetary policy.
(1)LM curve shifts to the right from LM0
to LM1. Equilibrium moves from A to
B.
(2) B lies below BP, interest rate decrease
(r<r*), that leads to depreciation of
domestic currency inducing massive
capital outflows. Therefore, net export
increases.
Then, IS curve shifts rightward from
IS0 to IS1 until the equilibrium is at r*.
Equilibrium of the economy moves
from B to C.
(3). r remains unchanged, Y increases, e
decreases, NX increases.
The same pattern is applied with contractionary monetary policy.
 The statement is false
 3. According to Mundell-Fleming model with fixed foreign exchange economy,
fiscal policy is ineffective in changing output.
For example, in case of expansionary fiscal LM0
r
policy adoption: IS1 LM1
(1) IS curve shifts to the right from IS0 to IS0
IS1. Equilibrium moves from A to B. B
(2) B lies above BP, interest rate increases
A
(r>r*) that leads to appreciation of r* C BP
domestic currency, inducing massive
capital inflows that leads to
appreciation of domestic currency. 0 Y0 Y1 Y2 Y
Therefore, central bank will increase
money supply to maintain fixed
exchange.
Then, LM curve shifts rightward from
LM0 to LM1 until the equilibrium is at
r*. Equilibrium of the economy moves
from B to C.
(3) r remains unchanged, e is unchanged,
NX is unchanged, Y increases.
Same pattern is applied for contractionary fiscal policy
⇨ The statement is false.

4. According to Mundell-Fleming model with fixed foreign exchange economy,

monetary policy is effective in changing output.
For example, in case of expansionary
monetary policy adoption:
(1) LM curve shifts to the right from LM0
to LM1. Equilibrium moves from A to
B.
(2) B lies above BP, interest rate increases
(r<r*), inducing massive capital
outflows that leads to depreciation of
domestic currency. Therefore, central
bank will decrease money supply to
maintain fixed exchange.
Then, LM curve shifts leftward from
LM1 to LM0 until the equilibrium is at
r*. Equilibrium of the economy moves
from B to A.
(3) r, Y, e, NX remain unchanged.
Same pattern is applied for contractionary monetary policy
⇨ The statement is false.

5. According to Mundell-Fleming model, trade policy is effective in changing output

in a small, open, perfect capital mobility economy with flexible exchange system.
Like expansionary fiscal policy in flexible

LM0
r
IS1
IS0

B
A
r* BP

0 Y0 Y1 Y
 6. According to Mundell-Fleming model, trade policy is ineffective in changing
output in a small, open, perfect capital mobility economy with fixed exchange system.
Like expansionary fiscal policy in fixed
LM0
r
IS1 LM1
IS0
B

A C
r* BP

7. In Mundell-Fleming model with flexible exchange rate system, monetary policy is

0more effective Y
Y2 trade policy.
Y0 Y1 than

 In case of trade policy in flexible exchange rate system

(1) IS curve shifts to the right from IS0 LM0
r
to IS1. Equilibrium moves from A to IS1
B. IS0

(2) B lies above BP, interest rate

B
increases (r>r*), inducing massive A
BP
r*
capital inflows that leads to
appreciation of domestic currency.
Therefore, net export decreases. 0 Y0 Y1 Y

Then, IS curve shifts rightward from IS1

to IS0 until the equilibrium is at r*.
Equilibrium of the economy moves from
B to A.
(3) r, Y, NX remain unchanged, e
increases
 In case of expansionary monetary policy in flexible exchange rate system
(1) LM curve shifts to the right from LM0
to LM1. Equilibrium moves from A to B.
(2) B lies below BP, interest rate decrease
(r<r*), inducing massive capital
outflows that leads to depreciation of
domestic currency. Therefore, net export
increases.
Then, IS curve shifts rightward from
IS0 to IS1 until the equilibrium is at
r*. Equilibrium of the economy
moves from B to C.
(3) r remains unchanged, Y increases, e
decreases, NX increases.
+) The same pattern is applied for
contractionary monetary policy

 In case of contractionary monetary policy in flexible exchange rate system

LM1
r

IS1 IS0
LM0
B

r* C A BP

0 Y2 Y1 Y0 Y
(1) LM curve shifts to the left from LM0 to LM1. Equilibrium moves from A to B.
(2) B lies above BP, interest rate increase (r>r*) that leads to appreciation of domestic
currency, inducing massive capital inflows. Therefore, net export decreases.
Then, IS curve shifts leftward from IS0 to IS1 until the equilibrium is at r*.
Equilibrium of the economy moves from B to C.
(3) r remains unchanged, Y decreases, e increases, NX decreases.

⇨ In Mundell – Fleming model with flexible exchange rate system, monetary policy
is more effective than traded policy in changing output
⇨ The statement is true

8. In Mundell-Fleming model with fixed exchange rate system, monetary policy is

more effective than trade policy.
 In the case of trade policy in fixed exchange rate system
(1) IS curve shifts to the right from IS0
to IS1. Equilibrium moves from A to
B.
(2) B lies above BP, interest rate
increases (r>r*), inducing massive
capital inflows that leads to
appreciation of domestic currency.
Therefore, central bank will increase
the money supply to maintain fixed
exchange.
Then, LM curve shifts rightward from
LM0 to LM1 until the equilibrium is at
r*. Equilibrium of the economy moves
 from B to C.
(3) r and e remain unchanged, Y and
NX increase
 In the case of expansionary monetary
policy in fixed
(1)LM curve shifts to the right from LM0 LM0
r
to LM1. Equilibrium moves from A to LM1
B. IS0
(2) B lies below BP, interest rate decreases
(r<r*), inducing massive capital
outflows that leads to depreciation of A
r* BP
domestic currency. Therefore, central
bank will decrease money supply to B
maintain fixed exchange. 0 Y0 Y1 Y
Then, LM curve shifts leftward from
LM1 to LM0 until the equilibrium is
at r*. Equilibrium of the economy
moves from B to A.
(3) r, Y, e, NX remain unchanged.
The same pattern is applied with contractionary monetary policy in fixed exchange rate

LM1
r LM0

IS0
B

A
r* BP

0 Y1 Y0 Y
(1). LM curve shifts leftward from LM0 to LM1. The new equilibrium moves from A to
B
(2). B lies above BP line, interest rate increases (r>r*) that leads to domestic currency
appreciation, inducing massive capital inflow. Therefore, central bank will increase
money supply to maintain fixed exchange rate.
Then, LM curve will shifts rightward from LM1 to LM0 until it reaches r* again.
Equilibrium moves from B to A
(3). Y, r, e, nx remain unchanged.
9. In Mundell-Fleming model with floating exchange rate system, if the IS curve is
steeper than LM curve then fiscal policy is more effective than monetary policy.
10. In Mundell-Fleming model with fixed exchange rate system, if the LM curve is
steeper than IS curve then monetary policy is more effective than fiscal policy.
CHAPTER 3: AGGREGATE SUPPLY AND PHILLIPS CURVE

1. According to sticky price model, proportion of flexible price firms increases then
AS curve becomes flatter.
(1−s) . α e (1−s). α
We have AS function: P = .Y +[P − .Y ]
s s
In which:
1-s: proportion of flexible price firms
s: proportion of fixed price firm
α : measures the sensitivity of price to the difference in real income and expected
income
Y: real income
Y : expected income

P : expected price level

e

AS proportion of flexible price firms increases  1-s increases ⇔ s decreases

the slope of AS curve is bigger AS curve becomes steeper.
 the statement is false
 P AS P
AS

Y Y

AS curve when there are many AS curve when there are many
flexible price firms in the market. fixed price firms in the market.

2. According to sticky price model, proportion of sticky price firms increases then
AS curve becomes steeper.
3. According to Phillips curve model, an increase in the oil price in the short run will
lead to the downward shift of the economy to a lower Phillips curve.
- A rise in the price of oil would lead to higher petrol prices and higher transport
costs. - All firms would see some rise in costs. As the most important commodity,
higher oil prices often lead to cost-push inflation => SRAS shifts upward or
leftward.

P SRAS1
SRAS0
P1
B 1 B

P0 A 0 A

AD SRPC1
SRPC0

Y1 Y0 Y u0 u1 u

- SRAS shifts leftward P increases and Y decreases inflation increases and

unemployment increases. That leads to the rightward or upward shift in SRPC.
 the statement is false
 4. According to Phillips curve model, in the short run, government implements
demand stimulus policy will lead to the upward shift of the economy to a higher
Phillips curve.
When government implements demand stimulus AD shifts rightward  P increases
and Y increases inflation increases and unemployment decreases
That leads to the movement up along the Phillips curve.
 the statement is false

P
SRAS0
P1 B
A
P0
AD1
AD0

Y0 Y1 y

πP SRAS1
SRAS0
P
π1 1 B
A

AD

Y0 Y1

5. According to Phillips curve model, in the short run, government implements

contractionary fiscal policy will lead to the upward move to the left of the
economy along a Phillips curve.
When the government implements contractionary fiscal policy  IS curve will
shift leftward the AD curve will shift leftward
  P decreases, Y decreases
 inflation decreases, u increases
That will lead to the movement down along SRPC curve
 the statement is false

SRAS

A
A
P0 B

P1 B
SRPC
AD0
AD1 Y
U
YA
UA UB

6. According to Phillips curve model, in the short run, expansionary fiscal policy will
lead to the upward move to the left of the economy along a Phillips curve. 
7. According to Phillips curve model, a rise in expected inflation rate in the short run
will lead to the downward shift of the economy to a lower Phillips curve.
We have Phillip function
π=−βu+(π ¿ ¿ e + β . un + v)¿
e
π=π −β ( u−u n ) +v
 In which :
π : real inflation rate

π : expected inflation rate

e

u: real unemployment rate

un : natural unemployment rate
u−un: cyclical unemployment rate
β : measures the sensitivity of real inflation rate to a change in cyclical
unemployment
v : supply shock
As we can see in the function, expected inflation rate is exogenous factor. When
there is a rise in the expected inflation rate, the SRPC will shifts rightward or
upward
 the statement is false

8. According to Phillips curve model, a decrease of natural rate of unemployment in

the short run will lead to the downward move to the right of the economy along a
Phillips curve.
 CHAP 4: CONSUMPTION
I. Keynes
Consumption function: C=C+ MPC . Y d
In which:
C: consumption
C : autonomous consumption
MPC: marginal propensity to consumption
Y d : Disposable income
C C
Average propensity to consume: APC= Y = Y + MPC
d

1. Keynes’s conjecture
- 0<MPC<1
- APC decreases as Y increase:
- Y is the primary determination of consumption
2. Stagnation
- to Keynes, Y increases APC decreases APS increases saving increases
investment increases capital increases output increases. Y increases while MPC
decreases Surplus in goods stagnation
3. 2 shortcomings
(1). Short-run : APC decreases as Y increases ( consumption curve straight line , start
from vertical intersection)
Long- run: APC remain unchanged, ( consumption curve straight line, upward sloping,
start from origin)
(2). Keynes only sees the importance of Y, other factors should be appeared
II. IRVING FISHER & INTER-TEMPORAL CHOICE
1. Assumptions
(1). A person lives in 2 period lives
1st: Y1, C1
2nd: Y2, C2
(2). Consume all Y on 2nd period
2. Budget constraint
- Period 1: S1=Y1-C1
- Period 2: C2= Y2+ S1(1+r)
* C2+ (1+r)C1=Y2+ (1+r)Y1
C2 Y2
 C 1+ =Y 1 +
1+r 1+ r
 budget constraint: C 2=−( 1+r ) C1 + [ Y 2 +(1+ r)Y 1 ]

{r ↑ → C1 max ↓ ,C 2 max ↑→ BC steeper

r ↓ →C 1 max ↑, C 2max ↓ → BC flatter

- Y1/ Y2 increase BC shifts outward

- Y1/Y2 decreases BC shifts inward
3. Optimal consumption : MPC= 1+r
4. Effects
a. Income effect:
- Y1/ Y2 increase BC shifts outward C1, C2 increase
- Y1/Y2 decreases BC shifts inward C1, C2 decrease
b. substitution effect, relative price
r C1 C2
 Ambiguous 
S1>0 (saving)
 ambiguous 
  Ambiguous
S1<0 (borrowing)
  ambiguous
IE: S với r cùng dấu thì Y2 tăng => C1, C2 tăng SE: r tăng thì C2 tăng, C1 giảm

III. FRANCO & LIFE-CYCLE HYPOTHESIS

 1. Assumption:
- consumers spend the same amount of money annually until they die
2. Franco’s consumption function
W + R+Y 1 R
C= = W+ Y
T T T
In which :
W: wealth
R: remaining years of work
T: remaining years of life
Y: annual average income till retirement
Or αW + βY
In which:
1
α= = MPC (w)
T
R
β= = MPC (y)
T
W
- APC=α +β
Y
+ Short-run : Y  APC 
+ Long-run: Y  APC remains unchanged ( as W also increases)
NOTE:
- When consumer is old, consumption is more sensitive to wealth (α old>αyoung ¿
- When consumer is young, consumption is more sensitive to income
( βold < βyoung ¿
IV. MILTON FRIED MAN & PERMANENT Y
1. Assumption
- Total income :
Y= YP + YT
In which :
YP: permanent income= average income
YT: transitory income
2. Friedman’s consumption function
C=α .Y P
P
α .Y
APC=
Y P +Y T
+ Short-run : Y  APC  (come from YT)
+ Long-run: Y  APC remains unchanged (come from Yt)
3. Tax policy
- Short-run: only affects Yt
 C unchanged
- Long-run: affects Yp
 consumption changes

1.  Life cycle hypothesis of Franco Modigliani could explain the decline of APC in
the long-run when income rises.
1 R
In life cycle hypothesis: C = .W + .Y = α .W + β . Y
T T
α .W
⇨ APC = +β
Y
In which:
T: remaining years of living
R: remaining years of working
W: wealth
Y: annual income until retirement
1 R
In the long run, α ( ) and β ( )change insignificantly
T T
When income rises, wealth will also increasesby the same ratio. Therefore, APC is
constant in the long-run.
⇨ The statement is false.
 2.  Life cycle hypothesis of Franco Modigliani could explain why APC is stable in
the long-run when income rises.
(like ex1) the statement is true

3.  Permanent income hypothesis of Milton Friedman could explain the decline of

APC in the long-run when income rises.
In Milton’s permanent income
- Total income :
Y= YP + YT
In which :
YP: permanent income= average income
YT: transitory income
- Friedman’s consumption function
C=α .Y P
P
α .Y
APC= P T
Y +Y
- In the short-run, change in income frequently come from Y T => when income
rises, APC will decrease.
- In the long-run, change in income frequently come from Y P => when income rises,
APC is constant
=> Statement is false

4.  Permanent income hypothesis of Milton Friedman could explain why APC is

stable in the long-run when income rises.
 CHAPTER 5: SOLOW MODEL
1. Production function Y = A K α L1−α
- Production function/ labor: y= A k α
2. Saving function: sav=sy (0< s<1),
 raising s have positive impact on economy (in short-run)
3. Investment function: i=sav=sy (0< s< 1)
4. Consumption function: c= y−sav =( 1−s ) f (k )
5. Depreciation: dep=δk (0< δ <1)
 raising depreciation have negative impact on economy (in short-run)
6. Steady state: dep=i⇔ ∆ k=0 → k ¿
7. Golden rule: k ¿ that max c ⇔ c: f ( k ¿ ) −δ × k ¿ max ⇔ MP K =δ
8. Population growth:
- Golden rule: MP K =δ+ n
 population growth has negative impact on economy (in short-run)
9. Technological advance
- Golden rule: MP K =δ+ n+ g
 Technological advance in long-run

Variables Symbol Steady-state growth

Capital/ effective labor K 0
k=
¿
Output/ effective labor Y 0
y=
¿
Capital/real labor K g
=kE
L
Output/real labor Y g
= yE
L
Total capital K=kLE n+ g
Total output Y = yLE n+ g
 Tech.adv has positive impact in long-run
 Tech.adv is the ONLY source to affect economic growth in the long-run
`
PART 2: TRUE OR FALSE, EXPLAIN?
1. According to Solow model, if depreciation rate increases then output per person
and investment per person at the steady state will increase.
False.
- When depreciation rate increases δ increases the slope of depreciation line
becomes steeper, which leads to the decrease in y, i.

2. According to Solow model, if depreciation rate decreases then consumption per

person at the steady state will decrease.
False
- When depreciation rate increases δ decreases the slope of depreciation line
becomes flatter, which leads to the increase in y, i. Therefore, consumption will
increase as well.
3. According to Solow model, if population growth rate increases then consumption
per person at the steady state will decrease.True
- When population growth rate increases δ +n decreases the slope of depreciation
line becomes steeper, which leads to the decrease in y, i. Therefore, consumption
will decrease as well.
4. According to Solow model, if population growth rate decreases then output per
person and investment per person will decrease. False
5.  According to Solow model, if saving rate increases then consumption per person
at the steady state will increase.
6.  According to Solow model, if saving rate decreases then consumption per person
at the steady state will increase.False
7. Production function y = 2k2/3 has golden rule saving rate equals to 66,67%.True
8. According to Solow model, technological advance can maintain economic growth
at the steady state.

PART 3: CALCULATING EXERCISES

Ex5: Given production function Y = 2K1/2L1/2. Saving rate = 40%, depreciation rate =
20%, population growth rate = 5%/year.
a) Calculate the value of k*, y*, i*, c*.
- production/ labor function: y=2k 0.5
- saving function: i=sav=0.4 y
- depreciation function: dep=( 0.2+0.05 ) k =0.25 k
* At steady state: i=dep ⇔ 0.4 y =0.25 k ⇔ 0.4 × 2 k 0.5=0.25 k ⇔ k* = 10.24
 y*= 6.4 , i*= 2.56, c*=3.84
b) Find the value of saving rate so that c* = 4.
- denote x is the value of saving rate (0<x<1)
- c*=4 ⇔ y*-sav*=4 ⇔ y=2k ¿0.5 −¿
Solve:

Ex6: Given production function Y = 3K1/2L1/2. Saving rate = 20%, depreciation rate =
10%, population growth rate = 5%/year.
a) Calculate the value of k*, y*, i*, c*.

b) Find the value of saving rate so that c* = 6.

Ex7: Given production function Y = 9K1/4(EL)3/4. Saving rate = 45%, depreciation rate
= 5%/year, population growth rate = 3%/year, technological advance grows by
7%/year.
 a. Calculate the value of k*, y*, i*, c*.
b. Calculate k*gold and sgold.
CHAP 5:
Ex 1: The economy has the production function as follow Y = K L . Find k* given that
1/2 1/2

s=30%; =10%; n=5%.

Ex 2: The economy has the production function as follow y=k1/2 and =0,1 (n=0). Find saving
rate (s) so that achieving k* of the golden rule? In general, demonstrate that if the
production function is y = A.k then saving rate (s) for the Golden Rule is α.

LM1
LM2

B LM0
rB
C

rC

rA
A
IS1

IS0
Y
YB YA