Test Bank for Macroeconomics Theories and Policies, 10th Edition : Froyen

Test Bank for Macroeconomics Theories and

Policies, 10th Edition : Froyen

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 CHAPTER 6: KEYNESIAN SYSTEM (II): MONEY, INTEREST,
AND INCOME
Additional Questions

Essay Questions and/or Problems:

1. What is meant by a “liquidity trap?”
A liquidity trap is the assumption that one is on the horizontal portion of the demand for
money curve where the demand for money is assumed to be perfectly interest elastic.
2. What happens to inventories on all points that are below the IS curve? Are unplanned
inventories positive or negative? Explain.
Below the IS curve, for a given interest rate income is lower than equilibrium income. As a
result, unplanned inventories would be positive.
3. a. Define the LM curve. Define the IS curve.
The LM curve is the schedule depicting all levels of income and interest rates that produce
money market equilibrium. The IS curve is the product market equilibrium schedule and
portrays all combinations of R and Y for which the product market is in equilibrium.
b. Is the LM curve positively or negatively sloped? Is the IS curve positively or negatively
sloped?
The LM curve is positively sloped because an increase in income increases money demand
and leads to a higher equilibrium interest rate in the money market, since the transactions
demand for money varies positively with income with a fixed money supply. The IS curve
is negatively sloped because an increase in income increases savings, leading to a reduction
in interest rates.
c. When is the LM curve relatively steep? When is the IS curve relatively flat?
The LM curve is relatively steep when the interest elasticity of money demand is relatively
low and the income elasticity of money demand is high. The IS curve is relatively flat when
the interest elasticity of investment is relatively high.
4. List three changes in exogenous variables that would shift the IS curve to the right.
An increase in government spending, a decrease in taxes, an increase in investment, a
decrease in consumption or an increase in savings.
5. Keynes considered three motives for holding money. Which of these was similar to the
classical quantity theory of money demand? Which is unique to Keynesian theory?

52
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 KEYNESIAN SYSTEM (II): MONEY, INTEREST, AND INCOME 53

The transaction and precautionary motives are similar to the classical view that money is
solely a medium of exchange. The speculative motive was the most novel part of Keynes’
analysis of money demand. Keynes began with the question of why an individual would hold
any money above that needed for the transactions and precautionary motives when bonds pay
interest and money does not. Such an additional demand for money did exist, Keynes
believed, because of the uncertainty about future interest rates and the relationship between
changes in the interest rate and the market price of bonds. If interest rates were expected to
move in such a way as to cause capital losses on bonds, it was possible that these expected
losses would outweigh the interest earnings on bonds and cause an investor to hold money
instead. Those “speculating” on future changes in the interest rate would hold such money.
6. Suppose that the money supply in addition to money demand increases when the interest
rate increases. How do you think this change from the basic Keynesian money market
would affect the slope of the LM curve? Draw a graph to illustrate.
As a result of this, the money supply curve is upward sloping in the money market. This
means that for an increase in income and a shift in the money demand curve, interest rates
will not change as much. As a result, the LM curve is flatter than before.
7. If the central bank of an economy follows a policy of interest rate targeting, or maintaining
a fixed interest rate, then what will happen to the slope of the LM curve? Draw a graph to
illustrate.
The LM curve will be flat at the interest rate the central bank chooses to target, meaning that
income will have to make the full adjustment for any change in the IS curve.
8. If savings becomes more interest rate elastic, what happens to the slope of the IS curve.
Provide a graph to illustrate.
As savings becomes more responsive to changes in the interest rate, the savings curve
becomes flatter and any change in investment will lead to a smaller change in the interest
rate. As a result, the IS curve becomes flatter.

Additional Essay Questions and/or Problems:

9. Assume the following equations describe the goods market of an economy
C = 250 + .8(Y-T)
I = 100 - 50r
T = G = 100.
Calculate the IS curve for this economy. If G rises to 120, calculate the new IS curve for
this economy. How much and in what direction has the IS curve shifted?
The IS curve is Y = 1850 - 250r before and Y = 1950 - 250r after. The IS curve has shifted
up by 100 units.
10. Assume that following equations describe the money market of an economy
Ms = 1,000
Md = .2Y - 100r
Calculate the LM curve for this economy. Now assume that the money supply rises to
1,200. How much and in what direction has the LM curve shifted?
The LM curve is Y = 5,000 + 500r before and Y =6,000 + 500r after. The LM curve shifted
to the right by 1,000 units.

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54 CHAPTER 6

11. Explain the relationship between the rate of interest and the demand for money within the
Keynesian theory of money demand. How does this differ from the classical quantity theory
of money demand?
In the Keynesian model, an increase in the interest rate increases the opportunity cost of
holding money, reducing money demand. In the quantity theory, money demand (both
velocity and the marginal propensity to hold money) are constant and not affected by
changes in interest rates.
12. What is the condition met by all points along the LM schedule? Demonstrate graphically
the derivation of the LM schedule and explain the properties of the schedule. What is the
condition met by all points along the IS schedule. Demonstrate graphically the derivation of
the IS schedule and explain the properties of the schedule.
13. What factors determine the slope of the IS and LM schedules? Illustrate graphically.
See text.
14. Compare and contrast the effects of an increase in the money supply on interest rates
within the Keynesian and Classical model. Provide graphs to illustrate. Discuss why the
results differ between these models.
In the Keynesian model, an increase in the money supply reduces interest rates in the
money market. This is because money is primarily an asset, and the interest rate is the
opportunity cost of holding money. Because the price level is fixed, any increase in the
money supply does not affect prices. In the classical model, prices are not fixed and will
rise as the money supply rises. Interest rates will rise after an increase in the money supply
because of an increase in the price level and inflation.
15. How would the shape of the IS curve change if:
a. the MPC gets bigger.
b. Investment becomes more elastic.
As the MPC gets bigger and as investment becomes more elastic, the IS curve gets flatter.
16. Assume that the government passes a deficit-financed tax cut. If the central bank would like
to keep interest rates constant, what monetary policy should they follow? Provide an IS/LM
graph to illustrate.
The deficit-financed tax cut would shift the IS curve to the right. In order to prevent the
interest rate from rising, the central bank should increase the money supply and shift the
LM to the right.
17. Suppose that there is an unexpected increase in the demand for money at every level of
interest rates and income. What happens to equilibrium interest rates and income as a
result? Provide an IS/LM curve to illustrate.
The LM curve shifts to the left, equilibrium interest rates increase and income falls.

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 KEYNESIAN SYSTEM (II): MONEY, INTEREST, AND INCOME 55

18. Household consumption likely depends upon accumulated wealth and not just current
income as it does in the basic Keynesian model examined in this chapter. How would the
IS/LM model respond to a decline in housing prices, such as what occurred in the US
during the 2008 global financial crisis, if consumption was a function of wealth. Provide a
graph to illustrate.
A decline in wealth would reduce consumption demand, shifting the IS curve down and
reducing equilibrium interest rates and income.

Additional Question From the Appendix

1. Given the following information
G =100
T =0
S = - 50+0.25Y
Md =80 - 20r + 0.2Y
Ms = 188
a. find the equilibrium values of Y and r.
b. if MS is increased to 210, find the new equilibrium values of Y and r.
2. Given the following information
G = 300
T = 200
C = 220 + .6 (Y-T)
I = 100 – 4r
Md = .75Y – 6r
Ms = 735
a. Derive the IS and LM curves. Calculate the equilibrium values of Y and r.
b. Suppose that G is reduced until the budget deficit is eliminated. Calculate the new
equilibrium values of Y and r. Explain the intuition of what happened, providing an
IS/LM graph to illustrate.

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56 CHAPTER 6

Multiple-Choice Questions:
1. In calculating the IS curve, _______ is taken as exogenous
a. the interest rate.
b. aggregate income.
c. the price level.*
d. planned investment.
e. a and d.
2. If people increase their expected rate of interest, the speculative demand for money curve
will _____ and money supply will _____.
a. shift downward, remain unchanged.*
b. shift upward; remain unchanged.
c. not be affected; shifts upward.
d. not be affected; not be affected.
3. In the Keynesian money market, velocity is
a. negatively related to the interest rate.
b. independent of the interest rate.
c. positively related to the interest rate.*
d. is positively related to the money supply.
e. is not related to the interest rate but income.
4. If the consumption function is given by C = 100 + 0.75(Y-T), then an increase of 10 units
in taxes will cause the IS schedule to shift to the right by
a. -30 units.*
b. -10 units.
c. 30 units.
d. 40 units.
5. A decline in the money stock will
a. shift the LM schedule to the right.*
b. shift the LM schedule to the left.
c. not have any effect on the LM schedule.
d. shift the IS schedule downward and to the right.
6. In the Keynesian theory, an exogenous decrease in the demand for money shifts
a. the LM curve to the right.
b. the LM curve to the left.*
c. the IS curve to the right.
d. the IS curve to the left.
e. neither the IS or LM curves.
7. A fall in autonomous investment will shift the
a. IS curve to the right toward higher interest rates and output.
b. LM curve to the right towards lower interest rates and higher output.
c. IS curve to the left towards higher interest rates and output.
d. None of the above*

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 KEYNESIAN SYSTEM (II): MONEY, INTEREST, AND INCOME 57

8. An decrease in the velocity of money for given levels of income and the interest rate would
shift the a. LM curve up.*
b. IS curve up.
b. IS curve down.
c. LM curve down.
9. If the consumption function is given by C = 200 + 0.6YD, then an increase in taxes of 50
units will cause the IS schedule to
a. shift to the right by 75 units..
b. shift to the left by 50 units.
c. shift to the left by 75 units.*
d. shift to the left by 125.
10. If the money demand function is given by Md = 10 + 0.2Y − 10r then a 10-unit increase in
the quantity of money will cause the LM schedule to shifts to
a. to the right by 10 units.
b. the right by 50 units.*
c. to the left by 40 units.
d. to the left by 50 units.
e. to the right by 40 units.
11. If the MPC is 0.6, then a 50-unit rise in taxes and a 50-unit rise in government spending
will shift the IS curve
a. to the right by 50 units.*
b. to the right by 75 units.
c. to the left by 125 units.
d. to the left by 75 units.
12. According to Keynes' theory of money demand, a low interest rate increases the likelihood
of a capital ________ and ______ the interest elasticity of money demand.
a. gain on bonds; reduces.
b. gain on money; increases.
c. loss on bonds; reduces.*
d. loss on money; increases.
e. none of the above.
13. The LM curve slopes upward because
a. as income rises, savings rise, increasing output.
b. as interest rates rise, the money supply rises, increasing output.
c. as interest rates rise, planned investment must fall, increasing output.
d. as income increases, money demand rises, which increases interest rates.*
e. none of the above.
14. Assume that the economy is presently in equilibrium. A decline in the interest rate
a. increases planned investment, aggregate demand, and equilibrium income.*
b. increases unplanned investment, reducing aggregate demand and equilibrium income.
c. increases unplanned investment, increasing aggregate demand and equilibrium income.
d. increases money demand, the money supply, aggregate demand, and equilibrium
income.

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58 CHAPTER 6

15. The IS curve slopes upward because

a. as income rises, savings rise and consumption falls, decreasing output.*
b. as interest rates rise, the money supply rises, increasing output.
c. as interest rates rise, planned investment must fall, increasing output.
d. as income increases, money demand rises, which increases interest rates.
16. Along any IS curve
a. both government spending and expectations are fixed.*
b. government spending and the price level may vary.
c. consumption and the price level are fixed.
d. both government spending and tax rates may vary.
e. all of the above
17. Assume that you purchased a $1,000 perpetual bond that pays a market interest rate of 5
percent. If you attempted to sell this bond today subsequent to an increased market rate of
interest of 7.5 percent, then you
a. could only sell this bond at a capital loss.*
b. could sell this bond at a capital gain.
c. would not be able to sell this bond.
d. could exchange your bond yielding 5 percent for a bond yielding 7.5 percent on an even
exchange basis.
18. According to Keynes, the speculative demand for money pertains to money held in
anticipation of a(n)
a. increase in bond prices.
b. decrease in bond prices.
c. rise in interest rates.
d. fall in interest rates.
e. both b and c*
19. According to the Keynesian model of the money market, the supply of money
a. depends on the interest rate.
b. is chosen by the central bank.*
c. varies with the price level.
d. varies with income.
20. In the Keynesian theory of money demand,
a. the velocity of money is constant.
b. the marginal propensity to hold money is constant.
c. money is held in part because it is an asset.*
d. interest rates are fixed.
e. none of the above.
21. The money demand curve shifts to the right when
a. there is an increase in the riskiness of interest-bearing assets.
b. there is a decrease in the interest rate.
c. income decreases.
d. income increases.
e. both a and d.*

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 KEYNESIAN SYSTEM (II): MONEY, INTEREST, AND INCOME 59

22. The intuition behind the slope of the LM curve is that

a. as the interest rate increases, the money supply increases and income increases.
b. as the interest rate increases, investment and income decreases.
c. as income increases, money demand increases which increases interest rates.*
d. as income increases, money demand decreases which decreases interest rates.
e. none of the above.
23. At any point on the LM curve
a. there is labor market equilibrium.
b. money supply equals money demand.*
c. equilibrium output equals potential output.
d. both commodity and money market are necessary for equilibrium.
e. both b and c.
24. If Y>C+I+G but Md= Ms, then
a. interest rates must rise and output must fall.
b. both interest rates and output must fall.*
c. interest rates must fall and output must rise.
d. both interest rates and output must rise.
e. none of the above.
25. A decrease in the price level, holding the nominal money supply constant, will shift the LM
curve
a. upward and to the right.*
b. downward and to the left.
c. downward and to the right.
d. upward and to the left.

26. Panel (a) in Figure 6.1 depicts

a. low interest elasticity of money demand.*
b. high interest elasticity of money demand.
c. no interest elasticity of money demand, which is the same as Panel (b).
d. None of the above

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60 CHAPTER 6

27. Panel (b) in Figure 6.1 reflects

a. low interest elasticity of money demand.
b. money demand to be highly interest elastic.*
c. money demand to be completely interest insensitive.
d. None of the above
28. In the Keynesian model, everything else equal, a higher level of income
a. increases money demand and reduces the interest rate.
b. increases money demand and increases the interest rate.
c. increases savings and decreases the interest rate.
d. increases investment and has no effect on the interest rate.
e. both b and c.*
29. A shift in the LM curve to the left could be caused by
a. an increase in the price level.
b. a decrease in the money supply.
c. an increase in the precautionary demand for money.
d. all of the above.*
e. none of the above.
30. The IS curve represents
a. equilibrium in the money market.
b. all outcomes where Y=C+I+G in a closed economy.
c. equilibrium in the labor market.
b. all points where there is no excess demand or excess supply.*
31. Which of the following factors cause the IS curve to shift?
a. A change the money supply.
b. A change in the level of taxes
c. An autonomous investment change that shifts the investment function
d. Both b and c*
e. All of the above
32. Assuming that money demand is completely interest insensitive, the
a. LM schedule will be horizontal.
b. LM schedule will be vertical.*
c. IS schedule is vertical.
d. IS schedule is horizontal.
33. In the IS-LM model, the two variables that are affected by the interest rate are
a. money supply and money demand.
b. money supply and investment spending.
c. money demand and consumption.
d. money demand and investment spending.*
e. none of the above.
34. Points to the left of the LM schedule show that
a. the amount of money supplied exceeds the amount of money demanded.*
b. saving plus taxes will exceed investment plus government purchases.
c. the amount of money demanded exceeds the amount of money supplied.
d. investment plus government purchases will exceed saving plus taxes.

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 KEYNESIAN SYSTEM (II): MONEY, INTEREST, AND INCOME 61

35. If the current interest rate increases,

a. the money demand curve shifts downward and the money supply curve remains
unchanged.
b. the money demand curve shifts upward and the money supply curve remains
unchanged.
c. there is a movement along the money demand curve and the money supply curve
increases.
d. there is a movement along the money demand curve and the money supply curve
remains unchanged.*
36. Points to the right of the IS schedule indicate that
a. investment plus government spending will exceed saving plus taxes.
b. the amount of money supplied exceeds the amount of money demanded.
c. saving plus taxes will exceed investment plus government spending.*
d. the amount of money demanded exceeds the amount of money supplied.
37. In the Keynesian system, an increase in the money stock would
a. increase the interest rate, which, in turn, would increase aggregate demand and income.
b. decrease the interest rate, which, in turn, would decrease aggregate demand and income.
c. decrease the interest rate, which, in turn, would increase aggregate demand and
income.*
d. decrease the interest rate but would have no effect on aggregate demand and income.
38. One of the most responsive components of investment to changes in interest rates are
a. equipment.
b. inventories.
c. automobile purchases.
d. residential housing.*
e. none of the above.
39. If Md = 1,000 – 400r and Ms = 2,000, the MPC = .85, G=100, and T = 120, then the
equilibrium interest rate is
a. 2.5*
b. 5
c. 10
d. 20
e. not enough information was given.
40. Assume that you purchased a $1,000 perpetual bond and the interest rate on that bond
declined from 5 percent to 2 percent. Thus,
a. the bond price increased by $1,500.
b. you could sell this bond at a capital gain.
c. if this was anticipated, the speculative demand for money fell.
d. All of the above*
e. None of the above

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62 CHAPTER 6

41. According to Keynes, a shift in liquidity preference is

a. a shift in the money demand schedule drawn against the interest rate as the level of
income changes.
b. a change in the amount of money demanded for given levels of the interest rate and
income.
c. a shift in individuals’ portfolios away from bonds and toward holding an increased
amount of money for given levels of the interest rate and income.
d. Either a or c
e. all of the above*
42. If Md = 2,600 – 200r, the MPC = .75, G=100, and T = 100. If the central bank wants the
interest rate to be r=2, then the money supply must be
a. 5.
b. 400
c. 300
d. 3,000*
e. not enough information was given.
43. If the central bank follows a monetary policy in which it maintains a fixed interest rate,
then
a. the LM curve will get steeper.
b. the IS curve will get steeper.
c. the LM curve will become vertical.
d. the LM curve will become horizontal.*
e. none of the above.
44. If savings does not depend upon the interest rate, then
a. the IS curve is vertical.
b. the IS curve is horizontal.
c. the LM curve is horizontal.
d. the IS curve is still downward sloping.*
e. none of the above.
45. With respect to the Keynesian liquidity trap, at very low levels of income, equilibrium in
the money market occurs at points along the flat portion of the money demand schedule
where
a. the elasticity of money demand is extremely high.*
b. money demand is associated with a low interest elasticity.
c. money demand is completely interest inelastic.
d. None of the above
46. Keynes believed that the precautionary demand for money varied
a. negatively with income.
b. positively with income.
c. negatively with the interest rate.
d. positively with the interest rate.
e. Both b and c *

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 KEYNESIAN SYSTEM (II): MONEY, INTEREST, AND INCOME 63

47. If Y=C+I+G but Md< Ms, then

a. interest rates must rise and output must fall.
b. both interest rates and output must fall.
c. interest rates must fall and output must rise.*
d. both interest rates and output must rise.
e. none of the above.
48. In the classical model,
a. both fiscal and monetary policy will have larger impacts on income.
b. neither fiscal nor monetary policy can influence output.*
c. monetary policy cannot influence output.
d. fiscal policy cannot influence output.
e. none of the above.
49. The IS curve becomes steeper when there is
a. a higher marginal propensity to save.
b. a smaller parameter measuring the interest sensitivity of investment.
c. a lower marginal propensity to save.
d. Both a and b*
e. Both b and c
50. The LM curve will become steeper when
a. there is a larger money demand increase per unit increase in income.
b. money demand is less sensitive to the interest rate.
c. money demand is more sensitive to the interest rate.
d. Both a and b*
e. Both a and c
51. If money demand is not responsive to changes in interest rates, then
a. the LM curve is vertical.*
b. the IS curve determines equilibrium output.
c. the LM curve will become horizontal.
d. the LM curve will become vertical.
e. a and b.
52. A relatively steep money demand schedule reflects the assumption that the interest
elasticity of money demand is
a. low (in absolute value).*
b. high (in absolute value).
c. zero.
d. indefinite.
53. Which of the following is true about the LM curve?
a. Along the LM curve, actual expenditure is equal to planned expenditure.
b. The LM curve slopes upward and is consistent with a given level of income.
c. The LM cuve slopes upward for a given level of the money supply.*
d. The LM curve is horizontal in the classical model.
e. none of the above.

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Test Bank for Macroeconomics Theories and Policies, 10th Edition : Froyen

64 CHAPTER 6

54. Where the IS and LM curves intersect:

a. actual expenditure is equal to planned expenditure.
b. output equals aggregate demand.
c. savings plus taxes equals investment plus government spending.
d. all of the above.
55. If the money supply increases at the same time that taxes increase, then:
a. interest rates will definitely increase.
b. interest rates will definitely decrease.*
c. income will definitely increase.
d. income will definitely decrease.
56. The IS curve will shift to the right if:
a. the government deficit decreases.
b. consumer confidence decreases.
c. the MPC decreases.
d. taxes decrease.*
e. the money supply increases.
57. If the economy is in a liquidity trap, then:
a. fiscal policy can still stimulate the economy through lower interest rates.
b. monetary policy cannot stimulate the economy by lowering interest rates.*
c. the precautionary demand for money is falling.
d. all of the above.

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