Chapter 5

Macroeconomics, 8e (Blanchard)
Chapter 5: Goods and Financial Markets: The IS-LM Model
5.1 The Goods Market and the IS Relation
1) The IS curve represents

A) the single level of output where the goods market is in equilibrium.
B) the single level of output where financial markets are in equilibrium.
C) the combinations of output and the interest rate where the money market is in equilibrium.
D) the combinations of output and the interest rate where the goods market is in equilibrium.
E) none of these
Answer: D
Diff: 1
2) The IS curve will shift to the right when which of the following occurs?
A) an increase in the money supply
B) an increase in government spending
C) a reduction in the interest rate
D) all of these
E) none of these
Answer: B
Diff: 2
3) Which of the following occurs as the economy moves leftward along a given IS curve?
A) An increase in the interest rate causes investment spending to decrease.
B) An increase in the interest rate causes money demand to increase.
C) An increase in the interest rate causes a reduction in the money supply.
D) A reduction in government spending causes a reduction in demand for goods.
E) An increase in taxes causes a reduction in demand for goods.
Answer: A
Diff: 2
4) During 2008 in the United States, consumer confidence fell significantly. Which of the
following will occur as a result of this reduction in consumer confidence?
A) The LM curve will shift up.
B) The LM curve will shift down.
C) The IS curve will shift rightward.
D) The IS curve will shift leftward.
E) The IS curve will shift rightward, and the LM curve will shift up.
Answer: D
Diff: 2
1
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5) Suppose policy makers decide to reduce taxes. This fiscal policy action will cause which of
the following to occur?
A) The LM curve shifts and the economy moves along the IS curve.
B) The IS curve shifts and the economy moves along the LM curve.
C) Both the IS and LM curves shift.
D) Neither the IS nor the LM curve shifts.
E) Output will change causing a change in money demand and a shift of the LM curve.
Answer: B
Diff: 2
6) Suppose fiscal policy makers implement a policy to reduce the size of a budget deficit. Based
on the IS-LM model, we know with certainty that the following will occur as a result of this
fiscal policy action.
A) Investment spending will decrease.
B) Investment spending will increase.
C) There will be no change in investment spending.
D) Investment spending may increase, decrease, or not change.
E) none of these
Answer: D
Diff: 3
7) For this question, assume that investment spending depends only on the interest rate and no
longer depends on output. Given this information, a reduction in government spending
A) will cause investment to decrease.
B) will cause investment to increase.
C) may cause investment to increase or to decrease.
D) will have no effect on output.
E) will cause a reduction in output and have no effect on the interest rate.
Answer: B
Diff: 3
8) Suppose investment spending is not very sensitive to the interest rate. Given this information,
we
know that
A) the IS curve should be relatively flat.
B) the IS curve should be relatively steep.
C) the LM curve should be relatively flat.
D) the LM curve should be relatively steep.
E) neither the IS nor the LM curve will be affected.
Answer: B
Diff: 2
2
9) Explain the determinants of investment. Include in your answer an explanation of how a
change in each determinant affects investment.
Answer: Investment depends on the level of sales/output and on the interest rate. As output
changes, the demand for goods will change and firms will change investment so that their
capacity changes with the level of economic activity (and demand). I also depends on the interest
rate. As the interest rate rises, the cost of borrowing rises. Firms will cut back on investment as
borrowing costs rise.
Diff: 2
10) What is the IS relation? Explain why IS curve is downward sloping.

Answer: The IS relation shows the combinations of the interest rate and the level of output that
are consistent with equilibrium in the goods market. An increase in the interest rate leads to a
decline in output. Consequently, the IS curve is downward sloping.
Diff: 2
11) Graphically derive the IS curve from the goods market equilibrium.
Answer: Suppose the initial equilibrium in the goods market is at point A with interest rate i.
Suppose now that the interest rate increases from its initial value i to a higher value i'. The
increase in the interest rate decreases investment. The decrease in investment leads to a decrease
in output. Now the new equilibrium point is at A', with a higher value of i and lower value of Y.
After we plot the combinations of i and Y when the goods market is in equilibrium, we can
connect these two points (A and A') to get a downward sloping IS curve.
Diff: 2
5.2 Financial Markets and the LM Relation
1) For each interest rate, the LM curve illustrates the level of output where
A) the goods market is in equilibrium.
B) inventory investment equals zero.
C) money supply equals money demand.
D) all of these
E) none of these
Answer: C
Diff: 2
2) The LM curve shifts down (or, equivalently, to the right) when which of the following occurs?
A) an increase in taxes
B) an increase in output
C) an open market sale of bonds by the central bank
D) an increase in consumer confidence
E) none of these
Answer: E
Diff: 2
3
3) Which of the following statements is consistent with a given (i.e., fixed) LM curve?
A) A reduction in the interest rate causes investment spending to increase.
B) A reduction in the interest rate causes money demand to decrease.
C) A reduction in the interest rate causes an increase in the money supply.
D) An increase in output causes an increase in demand for goods.
E) An increase in output causes an increase in money demand.
Answer: E
Diff: 2
4) In late 2007 and early 2008, the U.S. Federal Reserve pursued expansionary monetary policy.
Which of the following will occur as a result of this monetary policy action?
A) The LM curve shifts down.
B) The LM curve shifts up.
C) The IS curve shifts rightward as the interest rate falls.
D) The IS curve shifts leftward as the interest rate increases.
E) none of these
Answer: A
Diff: 2
5) Suppose the demand for money is not very sensitive to the interest rate. Given this
information, we know that
A) the IS curve should be relatively flat.
B) the IS curve should be relatively steep.
C) the LM curve should be relatively flat.
D) the LM curve should be relatively steep.
E) neither the IS nor the LM curve will be affected.
Answer: D
Diff: 3
6) Which of the following is the definition for the real supply of money?
A) The stock of money measured in terms of goods, not dollars.
B) The stock of high powered money only.
C) The real value of currency in circulation only.
D) The actual quantity of money, rather than the officially reported quantity.
E) The ratio of the real GDP to the nominal money supply.
Answer: A
Diff: 1
7) First, define the LM curve. Second, explain why it has its particular shape.
Answer: The LM curve illustrates the combinations of the interest rate and level of output that
maintain financial market equilibrium. The curve is upward sloping because as income increases,
money demand will rise. This increase in money demand will cause an excess demand for money
and an excess supply of bonds. Bond prices will fall and the interest rate will increase until
equilibrium is restored.
Diff: 2
4
5.3 Putting the IS and the LM Relations Together
1) Suppose the economy is currently operating on both the LM curve and the IS curve. Which of
the following is true for this economy?
A) Production equals demand.
B) The quantity supplied of bonds equals the quantity demanded of bonds.
C) The money supply equals money demand.
D) Financial markets are in equilibrium.
E) all of these
Answer: E
Diff: 1
2) Suppose the economy is operating on the LM curve but not on the IS curve. Given this
information, we know that
A) the goods market is in equilibrium and the money market is not in equilibrium.
B) the money market and bond markets are in equilibrium and the goods market is not in
equilibrium.
C) the money market and goods market are in equilibrium and the bond market is not in
equilibrium.
D) the money, bond and goods markets are all in equilibrium.
E) neither the money, bond, nor goods markets are in equilibrium.
Answer: B
Diff: 2
3) Suppose the current level of output and the interest rate are such that the economy is operating
on neither the IS nor LM curve. Which of the following is true for this economy?
A) Production does not equal demand.
B) The money supply does not equal money demand.
C) The quantity supplied of bonds does not equal the quantity demanded of bonds.
D) Financial markets are not in equilibrium.
E) all of these
Answer: E
Diff: 2
4) An increase in the money supply will cause an increase in which of the following variables?
A) output
B) investment
C) consumption
D) all of these
E) none of these
Answer: D
Diff: 2
5
5) Suppose there is an increase in consumer confidence. Which of the following represents the
complete list of variables that must increase in response to this increase in consumer confidence?
A) consumption
B) consumption and investment
C) consumption, investment and output
D) consumption and output
E) consumption, output and the interest rate
Answer: E
Diff: 2
6) Suppose there is a fiscal contraction. Which of the following is a complete list of the variables
that must decrease?
A) consumption
B) consumption and investment
C) consumption and output
D) consumption, output and the interest rate
E) consumption, output and investment
Answer: C
Diff: 2
7) We know with certainty that a tax increase must cause which of the following?
A) an increase in investment
B) a reduction in investment
C) no change in investment
D) none of these
Answer: D
Diff: 2
8) A fiscal contraction will tend to cause which of the following to occur?

A) a reduction in the interest rate and a reduction in investment
B) a reduction in the interest rate and an upward shift in the LM curve
C) a reduction in the interest rate and an ambiguous effect on investment
D) no change in output if the Fed simultaneously pursues contractionary monetary policy
Answer: C
Diff: 2
9) An increase in the money supply must cause which of the following?

A) a leftward shift in the IS curve
B) a reduction in the interest rate and ambiguous effects on investment
C) an increase in investment and a rightward shift in the IS curve
D) no change in the interest rate if investment is independent of the interest rate
E) no change in output if investment is independent of the interest rate
Answer: E
Diff: 1
6
10) An increase in consumer confidence will tend to cause which of the following to occur?
A) a rightward shift in the IS curve
B) a leftward shift in the IS curve
C) an upward shift in the LM curve
D) a downward shift in the LM curve
Answer: A
Diff: 1
11) Assume that investment does not depend on the interest rate. A reduction in government
spending will cause which of the following for this economy?
A) no change in the interest rate
B) no change in output
C) no change in investment
D) an increase in investment
E) none of these
Answer: E
Diff: 3
12) Assume that investment does not depend on the interest rate. A reduction in the money
supply will cause which of the following for this economy?
A) no change in the interest rate
B) no change in output
C) a reduction in investment
D) an increase in investment
Answer: B
Diff: 3
13) For this question, assume that investment spending depends only on output and no longer
depends on the interest rate. Given this information, an increase in the money supply
C) will cause a reduction in the interest rate.
D) will have no effect on output or the interest rate.
E) will cause an increase in output and have no effect on the interest rate.
Answer: C
Diff: 3
14) A reduction in consumer confidence will likely have which of the following effects?
Answer: B
Diff: 2
7
15) An increase in the reserve deposit ratio, θ, will most likely have which of the following
effects?
Answer: C
Diff: 2
16) A Fed purchase of securities will most likely have which of the following effects?
Answer: D
Diff: 2
17) A reduction in the aggregate price level, P, will most likely have which of the following
effects?
Answer: D
Diff: 2
18) An increase in the aggregate price level, P, will most likely have which of the following
effects?
Answer: C
Diff: 2
19) The IS curve will not shift when which of the following occurs?
A) a reduction in government spending
B) a reduction in the interest rate
C) a reduction in consumer confidence
D) all of these
E) none of these
Answer: B
Diff: 1
8
20) Which of the following best defines the IS curve?
A) the combinations of i and Y that maintain equilibrium in the goods market
B) illustrates the effects of changes in i on investment
C) illustrates the effects of changes in i on desired money holdings by individuals
D) the combinations of i and Y that maintain equilibrium in financial markets
Answer: A
Diff: 1
21) Which of the following best defines the LM curve?

A) the combinations of i and Y that maintain equilibrium in the goods market
B) illustrates the effects of changes in i on investment
C) illustrates the effects of changes in i on desired money holdings by individuals
D) the combinations of i and Y that maintain equilibrium in financial markets
Answer: D
Diff: 1
22) Based on our understanding of the IS-LM model that takes into account dynamics, we know
that a reduction in the money supply will cause
A) an immediate drop in Y and immediate increase in i.
B) an immediate increase in i and no initial change in Y.
C) a gradual increase in i and gradual reduction in Y.
D) none of these
Answer: B
Diff: 2
that a reduction in government spending will cause
A) an immediate drop in Y and immediate increase in i.
B) an immediate reduction in i and no initial change in Y.
C) a gradual reduction in i and gradual reduction in Y.
D) a gradual reduction in i and an immediate reduction in Y.
Answer: C
Diff: 2
that an
increase in the money supply will cause
A) an immediate increase in i and no initial change in Y.
B) an immediate decrease in i and no initial change in Y.
C) a gradual decrease in i and gradual increase in Y.
D) none of these
Answer: B
Diff: 2
9
that an
increase in government spending will cause
A) a gradual increase in i and gradual increase in Y.
B) an immediate increase in Y and immediate drop in i.
C) an immediate increase in i and no initial change in Y.
D) a gradual increase in i and an immediate increase in Y.
Answer: A
Diff: 2
26) An increase in government spending will likely have which of the following effects?
Answer: A
Diff: 2
27) A reduction in the reserve deposit ratio, θ, will most likely have which of the following
effects?
Answer: D
Diff: 2
28) If government spending and taxes increase by the same amount,

A) the IS curve does not shift
B) the IS curve shift leftward
C) the IS curve shifts rightward
D) the LM curve shifts downward
Answer: C
Diff: 2
29) If government spending and taxes decrease by the same amount,

A) the IS curve does not shift.
B) the IS curve shift leftward.
C) the IS curve shifts rightward.
D) the LM curve shifts downward.
Answer: B
Diff: 2
10
30) Which of the following triggered the U.S. recession of 2001?
A) decline in investment demand
B) decline in consumption demand
C) increase in budget deficit
D) increase in trade deficit
Answer: A
Diff: 2
31) The IS curve will shift to the left when which of the following occurs?
A) a reduction in the money supply
B) a reduction in government spending
C) an increase in the interest rate
D) all of these
E) none of these
Answer: B
Diff: 2
32) Which of the following occurs as the economy moves rightward along a given IS curve?
A) A reduction in the interest rate causes investment spending to decrease.
B) A reduction in the interest rate causes money demand to increase.
C) A reduction in the interest rate causes a reduction in the money supply.
D) An increase in government spending causes a reduction in demand for goods.
E) A reduction in taxes causes a reduction in demand for goods.
Answer: A
Diff: 2
33) When the central bank pursues contractionary monetary policy, we that this policy will result
in an increase in the interest rate, a reduction in investment, a reduction in demand, and a lower
level of equilibrium output. Explain what happens to the position of the IS curve as the central
bank pursues contractionary monetary policy.
Answer: Changes in the interest rate do cause changes in investment, demand, and output.
However, they do not cause shifts of the IS curve. Changes in the interest rate cause movements
along the IS curve.
Diff: 2
34) A fiscal expansion (e.g. a tax cut) will result in an increase in income, an increase in money
demand, and an increase in the equilibrium interest rate in financial markets. Explain what
happens to the position of the LM curve as policy makers pursue expansionary fiscal policy.
Answer: The fiscal expansion will cause an increase in output. However, changes in Y only
cause movements along the LM curve. The effects of changes in Y on the interest rate are
embedded in the shape of the LM curve.
Diff: 2
11
35) Explain in detail what effect a Fed sale of bonds will have on: (1) the LM curve; and (2) the
IS curve.
Answer: A Fed sale of bonds will cause a reduction in H and a reduction in the money supply.
This will cause an excess demand for money and the interest rate must increase to restore money
market equilibrium. The LM curve will shift up as a result of this to reflect the now higher
interest rate. The IS curve does not shift as a result of this. We would simply observe a
movement along the IS curve.
Diff: 2
36) Explain in detail what effect a reduction in government spending will have on: (1) the LM
curve; and (2) the IS curve.
Answer: A reduction in taxes will cause an increase in disposable income and an increase in
consumption. The rise in C will cause an increase in demand and the equilibrium level of output
in the goods market will be higher. This is reflected in a rightward shift in the IS curve. Goods
market events such as this will not cause a shift in the LM curve (only a movement along it).
Diff: 2
37) Based on your understanding of the IS-LM model, graphically illustrate and explain what
effect a reduction in consumer confidence will have on output, the interest rate, and investment.
Answer: A reduction in consumer confidence will cause a reduction in consumption and,
therefore, a reduction in demand and a leftward shift in the IS curve. As Y decreases, money
demand will decrease causing the interest rate to fall. The effects on I are ambiguous. The lower
Y will cause I to fall while the lower interest rate will cause I to increase.
Diff: 2
38) Based on your understanding of the IS-LM model, graphically illustrate and explain what
effect a monetary expansion will have on output, the interest rate, and investment.
Answer: An increase in M will cause the LM curve to shift down and the interest rate to fall. As
the interest rate falls, firms will increase investment causing an increase in demand and
subsequent increase in output. So, the interest rate will fall and Y will rise. I will be higher due to
the rise in Y and drop in the interest rate.
Diff: 2
39) Increases in the budget deficit are believed to cause reductions in investment. Based on your
understanding of the IS-LM model, will a fiscal policy action that causes a reduction in the
budget deficit cause an increase in investment? Explain.
Answer: A policy that causes a reduction in the budget deficit will have an ambiguous effect on
investment. Output will fall which will tend to depress I. However, the interest rate will also fall
which will tend to increase I. I could increase, decrease, or remain unchanged.
Diff: 2
12
40) Explain in detail what effect a Fed purchase of bonds will have on: (1) the LM curve; and (2)
the IS curve.
Answer: A Fed purchase of bonds will cause an increase in H and an increase in the money
supply. This will cause an excess supply of money and the interest rate must decline to restore
money market equilibrium. The LM curve will shift down as a result of this to reflect the now
lower interest rate. The IS curve does not shift as a result of this. We would simply observe a
movement along the IS curve.
Diff: 2
41) Explain in detail what effect an increase in government spending will have on: (1) the LM
curve; and (2) the IS curve.
Answer: An increase in government spending will cause an increase in demand and the
equilibrium level of output in the goods market will be higher. This is reflected in a rightward
shift in the IS curve. Goods market events such as this will not cause a shift in the LM curve
(only a movement along it).
Diff: 2
5.4 Using a Policy Mix
1) Suppose there is a simultaneous fiscal expansion and monetary expansion. We know with
certainty that
A) output will increase.
B) output will decrease.
C) the interest rate will increase.
D) the interest rate will decrease.
E) both output and the interest rate will increase.
Answer: A
Diff: 2
2) Suppose there is a simultaneous fiscal expansion and monetary contraction. We know with
certainty that
A) output will increase.
B) output will decrease.
C) the interest rate will increase.
D) the interest rate will decrease.
E) both output and the interest rate will increase.
Answer: C
Diff: 2
13
3) For this question, assume that investment spending depends only on output and no longer
depends on the interest rate. Given this information, an increase in government spending
E) will cause an increase in output and have no effect on the interest rate.
Answer: B
Diff: 3
4) A reasonable dynamic assumption for the IS-LM model is that

A) the economy is always on both the IS and LM curves.
B) the economy is always on the IS curve, but moves only slowly to the LM curve.
C) the economy is always on the LM curve, but moves only slowly to the IS curve.
D) the money market is quick to adjust, but the bond market adjusts more slowly.
E) adjustment to the new IS-LM equilibrium is instantaneous after an LM shift, but not after an
IS shift.
Answer: C
Diff: 2
5) Under the reasonable dynamic assumptions discussed in the text, a monetary contraction
should result in
A) an immediate rise in the interest rate, and no further interest rate changes.
B) an immediate rise in the interest rate, and then a fall in the interest rate over time.
C) an immediate rise in the interest rate, and then a further rise over time.
D) a very gradual but steady rise in the interest rate to its new equilibrium level.
E) no change in the interest rate initially, and then a sudden rise to its new equilibrium value.
Answer: B
Diff: 2
6) For this question, assume that investment spending depends only on the interest rate and no
longer depends on output. Given this information, a reduction in the money supply
E) will cause a reduction in output and have no effect on the interest rate.
Answer: A
Diff: 3
14
7) Suppose there is a Fed purchase of bonds and simultaneous tax cut. We know with certainty
that this combination of policies must cause
A) an increase in the interest rate (i).
B) a reduction in i.
C) an increase in output (Y).
D) a reduction in Y.
Answer: C
Diff: 2
8) Suppose there is a simultaneous Fed sale of bonds and increase in consumer confidence. We
know with certainty that these two simultaneous events will cause
Answer: A
Diff: 2
9) Suppose there is a simultaneous central bank purchase of bonds and increase in taxes. We
know with certainty that this combination of policies must cause
Answer: B
Diff: 2
10) Suppose there is a simultaneous central bank sale of bonds and tax increase. We know with
certainty that this combination of policies must cause
Answer: D
Diff: 2
11) First, briefly explain what is meant by the policy mix. Second, explain what effect different
policy mixes might have on the level of output, investment, and the interest rate.
Answer: The policy mix refers to the possible combinations of monetary (exp. or contr.) and
fiscal (exp. or contr.) that can be simultaneously implemented. There are a number of different
answers that could be given to the latter part of the question. The effects on output, the interest
rate, and investment will depend on the type of mix.
Diff: 2
15
12) Use the IS-LM model to answer this question. Suppose there is a simultaneous increase in
government spending and reduction in the money supply. Explain what effect this particular
policy mix will have on output and the interest rate. Based on your analysis, do we know with
certainty what effect this policy mix will have on investment? Explain.
Answer: In this case, the LM curve shifts up and the IS curve shifts to the right. The interest
rate will clearly be higher. The effects on output depend on the relative magnitude of the two
policies. The effects on I are also ambiguous. If output falls, I will be lower. However, it is
possible that output will rise here which creates the ambiguity.
Diff: 2
taxes and reduction in the money supply. Explain what effect this particular policy mix will have
on output and the interest rate. Based on your analysis, do we know with certainty what effect
this policy mix will have on investment? Explain.
Answer: In this case, the LM curve shifts up and the IS curve shifts to the left. In this case,
output will clearly fall. What happens to the interest rate depends on the relative magnitude of
the two policies. The effects on I are again ambiguous.
Diff: 2
government spending and increase in the money supply. Explain what effect this particular
policy mix will have on output and the interest rate. Based on your analysis, do we know with
certainty what effect this policy mix will have on investment? Explain.
Answer: In this case, the LM curve shifts down and the IS curve shifts to the right. The output
will clearly be higher. The effects on interest rate depend on the relative magnitude of the two
policies. The effects on I are also ambiguous. If interest rate falls, I will be higher. However, it is
possible that interest rate will rise here which creates the ambiguity.
Diff: 2
5.5 How does the IS-LM Model Fit the Facts?
1) Empirically it takes nearly ________ years for monetary policy to have its full effect on
output.
A) 2
B) 1
C) 3
D) 4
Answer: A
Diff: 1
16
2) The largest decrease in retail sales from an increase in federal funds rate occurs after
______quarters.
A) 5
B) 1
C) 2
D) 4
Answer: A
Diff: 1
3) The largest decrease in output from an increase in federal funds rate occurs after
______quarters.
A) 8
B) 7
C) 5
D) 3
Answer: A
Diff: 1
17

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Chapter 5

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Macroeconomics, 8e (Blanchard)

Chapter 5: Goods and Financial Markets: The IS-LM Model

5.1 The Goods Market and the IS Relation

1) The IS curve represents

10) What is the IS relation? Explain why IS curve is downward sloping.

5.2 Financial Markets and the LM Relation

8) A fiscal contraction will tend to cause which of the following to occur?

9) An increase in the money supply must cause which of the following?

21) Which of the following best defines the LM curve?

28) If government spending and taxes increase by the same amount,

29) If government spending and taxes decrease by the same amount,

5.4 Using a Policy Mix

4) A reasonable dynamic assumption for the IS-LM model is that

5.5 How does the IS-LM Model Fit the Facts?

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