Test Bank For Macroeconomics 2nd Edition Hubbard

Test Bank for Macroeconomics, 2nd Edition : Hubbard
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Macroeconomics, 2e (Hubbard / O'Brien / Rafferty)
Chapter 10 Explaining Aggregate Demand: The IS-MP Model
10.1 The IS Curve: The Relationship Between Real Interest Rates and Aggregate
Expenditure
1) Equilibrium in the goods market occurs where

A) real GDP equals nominal GDP.
B) aggregate expenditure equals autonomous consumption.
C) autonomous consumption equals induced consumption.
D) aggregate expenditure equals real GDP.
Answer: D
Diff: 1 Page Ref: 334
Topic: Equilibrium in the Goods Market
Objective: LO1: Explain how the IS curve represents the relationship between the real interest rate and aggregate
expenditure.
Special Feature: None - Recurring question
AACSB: Reflective Thinking Skills
Learning Outcome: Macro-12
2) Other things equal, if planned investment spending is greater than actual investment spending, then
aggregate expenditure will be ________ real GDP and inventories will ________.
A) greater than; rise
B) greater than; fall
C) less than; rise
D) less than; fall
Answer: B
expenditure.
3) Other things equal, if planned investment spending is less than actual investment spending, then
aggregate expenditure will be ________ real GDP and employment will ________.
A) greater than; increase
B) greater than; decrease
C) less than; increase
D) less than; decrease
Answer: D
expenditure.
1
Copyright © 2014 Pearson Education, Inc.
4) Which of the following best represents the consumption function?
A) consumption = autonomous consumption + (the marginal propensity to consume × disposable income)
B) consumption = disposable income - (autonomous consumption / the marginal propensity to consume)
C) consumption = disposable income × (1 / 1 - the marginal propensity to consume)
D) consumption = autonomous consumption + (the marginal propensity to consume × transfer payments)
/ disposable income
Answer: A
expenditure.
Figure 10.1
5) Refer to Figure 10.1. If the level of real GDP is initially Y2, spending is ________ production and there is
an unexpected ________ in inventories.
Answer: C
Diff: 2 Page Ref: 336-337
expenditure.
AACSB: Analytic Skills
2
6) Refer to Figure 10.1. If the level of real GDP is initially Y2, firms will ________ production until
equilibrium is reached at ________.
A) increase; Y2
B) decrease; Y2
C) increase; Y1
D) decrease; Y1
Answer: D
expenditure.
7) Refer to Figure 10.1. If the level of real GDP is initially Y3, spending is ________ production and there is
an unexpected ________ in inventories.
Answer: B
expenditure.
8) Refer to Figure 10.1. If the level of real GDP is initially Y3, firms will ________ production until
equilibrium is reached at ________.
A) increase; Y3
B) decrease; Y3
C) increase; Y1
D) decrease; Y1
Answer: C
expenditure.
3
9) If the MPC = 0.8, an increase in investment spending from $35 billion to $38 billion will increase real
GDP by
A) $3 billion.
B) $3.75 billion.
C) $15 billion.
D) $24 billion.
Answer: C
Topic: The Multiplier Effect
expenditure.
Figure 10.2
10) Refer to Figure 10.2. Assume the economy is initially at equilibrium at potential GDP of $250 billion. If
the MPC = 0.50 and the difference between AE1 and AE2 represents a $75 billion decrease in planned
investment spending, real GDP at Y2 will be equal to
A) $100 billion.
B) $125 billion.
C) $175 billion.
D) $212.5 billion.
Answer: A
expenditure.
4
11) Refer to Figure 10.2. Assume the economy is initially at equilibrium at potential GDP of $500 billion. If
the MPC = 0.80 , and real GDP falls to Y2 = $400 billion, the vertical distance between AE1 and AE2 must
be
A) $8 billion.
B) $20 billion.
C) $80 billion.
D) $100 billion.
Answer: B
expenditure.
12) Refer to Figure 10.2. If in this economy the MPC = 0.6, Y2 = $50 billion, and AE2 is $5 billion below
AE1, potential GDP is
A) $53 billion.
B) $55 billion.
C) $58.3 billion.
D) $62.5 billion.
Answer: D
expenditure.
13) If the MPC = 0.80, the government purchases multiplier is

A) 2.
B) 4.
C) 5.
D) 8.
Answer: C
Topic: The Government Purchases and Tax Multipliers
expenditure.
5
14) If the MPC = 0.80, the tax multiplier is
A) -2.
B) -4.
C) -5.
D) -8.
Answer: B
expenditure.
15) If the MPC = 0.75, a decrease in government spending from $875 billion to $840 billion will decrease
real GDP by
A) $26.25 billion.
B) $35 billion.
C) $46.67 billion.
D) $140 billion.
Answer: D
expenditure.
16) If the MPC = 0.75, a decrease in personal taxes from $100 billion to $80 billion will increase real GDP
by
A) $20 billion.
B) $40 billion.
C) $60 billion.
D) $80 billion.
Answer: C
expenditure.
6
Table 10.1
Consumption C = $1.0 + 0.80YD

Investment = $1.5
Government purchases = $2.2
Net exports = −$0.1
Taxes = $0
Government transfer payments = $0
(all values are in billions of dollars)
17) Refer to Table 10.1. The value of the government purchases multiplier in this economy is
A) 0.2.
B) 0.8.
C) 4.
D) 5.
Answer: D
expenditure.
Special Feature: Solved Problem 10.1: Calculating Equilibrium Real GDP
18) Refer to Table 10.1. The value of the tax multiplier in this economy is
A) 0.
B) -2.
C) -4.
D) -5.
Answer: C
expenditure.
7
19) Refer to Table 10.1. Equilibrium real GDP for this economy is equal to
A) $5.75 billion.
B) $12 billion.
C) $23 billion.
D) $46 billion.
Answer: C
expenditure.
20) Refer to Table 10.1. Suppose that all of the information given in the Table remains the same except
that taxes increase by $1.0 billion and transfers increase by $1.5 billion. Equilibrium real GDP for this
economy is equal to
A) $6.25 billion.
B) $17 billion.
C) $25 billion.
D) $47 billion.
Answer: C
expenditure.
that taxes increase by $1.0 billion and transfers increase by $1.5 billion. If potential GDP equals $30
billion, by how much would government purchases have to change for equilibrium GDP to equal
potential GDP?
A) $1 billion
B) $1.25 billion
C) $1.5 billion
D) $5 billion
Answer: A
expenditure.
8
that taxes increase by $1.0 billion and transfers increase by $1.5 billion. If potential GDP equals $30
billion, by how much more would taxes have to change for equilibrium GDP to equal potential GDP?
A) $1 billion
B) $1.25 billion
C) $1.5 billion
D) $5 billion
Answer: B
expenditure.
23) Changes in the real interest rate affect all of the following components of aggregate expenditure except
A) consumption.
B) investment.
C) government purchases.
D) net exports.
Answer: C
Topic: Constructing the IS Curve
expenditure.
24) The IS curve shows the combinations of ________ and ________ where the goods market is in
equilibrium.
A) aggregate expenditure; real GDP
B) the real interest rate; real GDP
C) potential GDP; aggregate expenditure
D) the nominal interest rate; the quantity of money
Answer: B
expenditure.
9
Figure 10.3
Panel (a) Panel (b)
25) Refer to Figure 10.3. An increase in the real interest rate, with no other changes that affect aggregate
expenditure, is best represented by ________ in panel (a) and ________ in panel (b).
A) a shift from AE2 to AE3; a shift from IS1 to IS2
B) a shift from AE3 to AE2; a shift from IS2 to IS1
C) a shift from AE2 to AE1; a movement from point B to point A
D) a shift from AE3 to AE1; a movement from point C to point A
Answer: C
Topic: Shifts of the IS Curve
expenditure.
26) Refer to Figure 10.3. A decrease in the real interest rate, with no other changes that affect aggregate
expenditure, is best represented by ________ in panel (a) and ________ in panel (b).
C) a shift from AE1 to AE2; a movement from point A to point B
D) a shift from AE1 to AE3; a movement from point A to point C
Answer: C
expenditure.
10
27) Refer to Figure 10.3. A positive demand shock with no change in the real interest rate is best
represented by ________ in panel (a) and ________ in panel (b).
Answer: B
expenditure.
28) Refer to Figure 10.3. A negative demand shock with no change in the real interest rate is best
represented by ________ in panel (a) and ________ in panel (b).
Answer: A
expenditure.
29) Refer to Figure 10.3. A negative demand shock accompanied by an increase in the real interest rate is
best represented by ________ in panel (a) and ________ in panel (b).
A) a shift from AE3 to AE2; a movement from point C to point B
Answer: D
expenditure.
11
30) Refer to Figure 10.3. A positive demand shock accompanied by a decrease in the real interest rate is
best represented by ________ in panel (a) and ________ in panel (b).
A) a shift from AE2 to AE3; a movement from point B to point C
Answer: D
expenditure.
31) Other things equal, when the real interest rate rises, C, I and NX ________ and real GDP will ________
relative to potential GDP.
A) decrease; decrease
B) decrease; increase
C) increase; increase
D) increase; decrease
Answer: A
Topic: The IS Curve and the Output Gap
expenditure.
32) Other things equal, when the real interest rate falls, C, I and NX ________ and the output gap will
________.
A) decrease; decrease
B) decrease; increase
C) increase; increase
D) increase; decrease
Answer: C
Topic: The IS Curve and the Output Gap
expenditure.
12
33) Suppose the economy is initially in equilibrium at potential GDP = $100 billion and investment
increases by $8 billion. If the MPC in this economy is 0.8, what will happen to real GDP? Draw an
aggregate expenditure graph showing this change in investment and real GDP.
Answer: If the MPC = 0.8, the multiplier is (1 / 1-0.8) = 5. When investment increases by $8 billion, real
GDP will increase by $8 billion × 5 = $40 billion.
The increase in investment will shift the AE curve up by $8 billion, from AE1 to AE2. Real GDP will
increase by $40 billion, from YP = $100 billion to Y2 = $140 billion.

expenditure.
13
34) Suppose that the marginal propensity to consume is 0.75.
a. If the government decreases spending by $500 billion, what is the change in output?
b. If the government decreases taxes by $500 billion, what is the change in output?
c. If the government decreases transfer payments by $500 billion, what is the change in output?
d. If the government decreases spending by $500 billion and at the same time decreases taxes by $500
billion, what is the change in output?
Answer:
If the MPC = 0.75, the autonomous expenditure multiplier = 1 / (1 - 0.75) = 4.
If the MPC = 0.75, the tax multiplier = -0.75 / (1 - 0.75) = -3.
If the MPC = 0.75, the transfer payment multiplier = 0.75 / (1 - 0.75) = 3.
a. If the government decreases spending by $500 billion, output will decrease by $500 billion × 4 = $2
trillion.
b. If taxes are decreased by $500 billion, output will increase by -$500 billion × -3 = +$1.5 trillion.
c. If transfer payments are decreased by $500 billion, output will decrease by $500 billion × 3 = $1.5
trillion.
d. If the government decreases spending by $500 billion at the same time as decreasing taxes by $500
billion, output will change by (-$500 billion × 4) + (-$500 billion × -3) = -$500 billion )a decrease of $500
billion), the same amount as the initial decrease in government spending.
expenditure.
35) For each of the following changes, identify whether there will be a shift in the IS curve or a movement
along the IS curve. In each case identify the direction of the movement or shift.
a. The real interest rate decreases.
b. The government decreases tax rates.
c. Government spending decreases.
d. Investors become optimistic about future profitability.
Answer:
a. A decrease in the real interest rate causes a movement down the IS curve.
b. A decreases in taxes will shift the IS curve to the right.
c. A decrease in government spending will shift the IS curve to the left.
d. More optimistic investors will cause the IS curve to shift to the right.
expenditure.
14
36) Explain how an increase in the real interest rate, with no changes to other factors that affect aggregate
expenditure, impacts aggregate expenditure and how this interest rate increase is shown on the IS curve.
How would this change if there was a negative demand shock with no change in the real interest rate?
Show both situations using graphs for aggregate expenditure and the IS curve.
Answer: An increase in the real interest rate with no changes to other factors that affect aggregate
expenditure will shift the aggregate expenditure curve down from AE1 to AE2, decreasing real output
from Y1 to Y2. This is represented by a movement up the IS1 curve from point A to point B.
A negative demand shock with no change in the real interest rate will also shift the aggregate expenditure
curve down from AE1 to AE2, decreasing real output from Y1 to Y2. With no change in the real interest
rate, a negative demand shock will shift the IS curve to the left from IS1 to IS2.

expenditure.
15
10.2 The Monetary Policy Curve: The Relationship Between the Central Bank's Target
Interest Rate and Output
1) Which of the following equations best represents the long-term real interest rate? The long-term real
interest rate =
A) the short-term real interest rate + the term structure effect + the default-risk premium + the expected
rate of inflation
B) the short-term nominal interest rate + the term structure effect + the default-risk premium - the
expected rate of inflation
C) the long-term nominal interest rate + the term structure effect + the default-risk premium - the
D) the short-term nominal interest rate - the term structure effect - the default-risk premium + the
Answer: B
Topic: The Link Between the Short-Term Nominal Interest Rate and Long-Term Real Interest Rate
Objective: LO2: Use the monetary policy, MP, curve to show how the interest rate set by the central bank helps to
determine output.
2) The Fed has control over the long-term real interest rate provided that three variables remain
unchanged. These three variables include all of the following except
A) the expected rate of inflation.
B) the default premium.
C) term structure effects.
D) the short-term real interest rate.
Answer: D
determine output.
16
3) If the short-term nominal interest rate is 3.4%, the term structure effect is 1.2%, the default-risk
premium is 1.4%, and the expected rate of inflation is 2.7%, the long-term real interest rate will be
A) -1.9%.
B) 0.5%.
C) 3.3%.
D) 8.7%.
Answer: C
determine output.
4) If the long-term real interest rate is 5.1%, the term structure effect is 2.0%, the default-risk premium is
1.7%, and the expected rate of inflation is 3.3%, the short-term nominal interest rate will be
A) -1.9%.
B) 4.7%.
C) 5.5%.
D) 12.1%.
Answer: B
determine output.
5) Assume the long-term nominal interest rate is 7% and the expected inflation rate is 3%. If the Fed
increases the money supply and as a result, the expected inflation rate increases to 5%, then based on the
Fisher effect, the long-term real interest rate will
A) remain at 4%.
B) increase to 6%.
C) fall to 3%.
D) increase to 9%.
Answer: A
determine output.
17
6) Assume the long-term real interest rate is 4% and the expected inflation rate is 5%. If the Fed decreases
the money supply and as a result, the expected inflation rate decreases to 2%, then based on the Fisher
effect, the long-term real interest rate will ________ and the long-term nominal interest rate will ________.
A) fall to 4%; rise to 7%
B) remain at 4%; fall to 6%
C) fall to 1%; fall to 6%
D) fall to 6%; remain at -1%
Answer: B
determine output.
Figure 10.4
7) Refer to Figure 10.4. Suppose the economy's equilibrium starts out with an output gap of 1, and real
GDP increases so the output gap increases to 2. If the Fed keeps the money supply constant, money
demand will ________ and the nominal interest rate will ________.
A) increase; increase
B) increase; decrease
C) increase; remain constant
D) remain constant; remain constant
Answer: A
Topic: Deriving the MP Curve Using the Money Market Model
determine output.
18
GDP increases so the output gap increases to 2. If the Fed wants to keep the interest rate at the target,
the money demand curve will ________ and the money supply curve will ________.
A) shift from MD1 to MD2; shift from MS1 to MS2
B) shift from MD2 to MD1; shift from MS2 to MS1
C) remain at MD1; remain at MS1
D) remain at MD2; remain at MS2
Answer: A
determine output.
GDP increases so the output gap increases to 2. If the Fed acts to keep the short-term nominal interest
rate at the target and the term structure effect, the default-risk premium, and the expected inflation rate
remain constant, then the long-term nominal interest rate will
A) increase.
B) decrease.
C) remain constant.
D) be indeterminant, since the Fed has no control over long-term rates.
Answer: C
determine output.
19
Figure 10.5
10) Refer to Figure 10.5. A shift from MP1 to MP2 will occur if
A) the Fed decreases its target for the short-term nominal interest rate.
B) the term structure effect increases.
C) the default-risk premium decreases.
D) the expected inflation rate increases.
Answer: B
Topic: Shifts of the MP Curve
determine output.
A) investors decrease the short-term interest they expect in the future.
B) investors decrease the term premium they require on long-term bonds.
C) the default-risk premium decreases.
D) the expected inflation rate decreases.
Answer: D
determine output.
20
A) investors increase the short-term interest they expect in the future.
B) investors increase the term premium they require on long-term bonds.
C) the Fed decreases its target for the short-term nominal interest rate.
D) the expected inflation rate decreases.
Answer: C
determine output.
A) the term structure effect increases.
B) the default-risk premium decreases.
C) investors increase the short-term interest they expect in the future.
D) the Fed increases its target for the short-term nominal interest rate.
Answer: B
determine output.
21
Figure 10.6
14) Refer to Figure 10.6. Suppose the economy is originally in equilibrium at point A in the above figure.
Explain what happens to the money supply and money demand if real GDP increases and increases the
output gap if the Fed wants to keep the nominal interest rate at its target, and show these changes on the
money market graph. Use the new money market graph to derive an MP curve.
Answer: The increase in real GDP will increase the demand for money, shifting the MD curve to the
right. If the Fed wants to maintain its target interest rate, it will increase the money supply, shifting the
MS curve to the right, so MS2 and MD2 intersect at the target interest rate. The MP curve will be
horizontal since the real rate of interest will not change, with the economy moving from the original
output gap 1 to the new output gap 2.

determine output.
22
15) Assuming everything else constant, what effect will each of the following have on the long-term real
interest rate?
a. The expected inflation rate decreases.
b. The default-risk premium increases.
c. Investors expect future short-term interest rates to fall.
Answer:
a. Assuming the short-term nominal interest rate does not change, the long-term real interest rate will
decrease.
b. The long-term real interest rate will increase.
c. The long-term real interest rate will decrease.
determine output.
16) List five factors that will cause the MP curve to shift. Explain what needs to happen to each of these
factors to cause the MP curve to shift upward and to shift downward.
Answer:
1. The Fed changes the target for the nominal short-term interest rate. If the Fed increases the target, the
MP curve shifts up, and if the Fed decreases the target, the MP curve shifts down.
2. Investors change the short-term interest they expect in the future. If investors increase the short-term
interest they expect, the MP curve shifts up, and if investors decrease the short-term interest they expect,
the MP curve shifts down.
3. Investors change the term premium they require on long-term bonds. If investors increase the term
premium, the MP curve shifts up, and if investors decrease the term premium, the MP curve shifts down.
4. The default-risk premium changes. If the default-risk premium increases, the MP curve shifts up, and if
the default-risk premium decreases, the MP curve shifts down.
5. The expected inflation rate changes. If the expected inflation rate decreases, the MP curve shifts up, and
if the expected inflation rate increases, the MP curve shifts down.
determine output.
23
10.3 Equilibrium in the IS-MP Model
1) The housing market crash that accompanied the 2007-2009 recession has had severe negative effects on
the U.S. economy. Since December 2008, the target federal funds rate has been 0.0-0.25%. When the Fed
keeps the real interest rate constant, an economic shock such as the housing market crash would cause
the ________, and the output gap would ________.
A) MP curve to shift up; increase
B) MP curve to shift down; decrease
C) IS curve to shift to the left; decrease
D) IS curve to shift to the right; increase
Answer: C
Topic: Demand Shocks and Fluctuations in Output
Objective: LO3: Use the IS-MP model to understand why real GDP fluctuates.
2) The housing market crash that accompanied the 2007-2009 recession has had severe negative effects on
the U.S. economy. Since December 2008, the target federal funds rate has been 0.0-0.25%. Assuming the
Fed keeps the real interest rate constant, a recovery in the housing market would cause the ________, and
the output gap would ________.
A) MP curve to shift up; become less negative
B) MP curve to shift down; become more negative
C) IS curve to shift to the left; become more negative
D) IS curve to shift to the right; become less negative
Answer: D
3) Assume the economy is initially in equilibrium where potential GDP equals real GDP. If the economy
experiences a ________ demand shock and the Fed does not change its target short-term nominal interest
rate, the IS curve shifts to the left and real GDP will be ________ potential GDP.
A) positive; greater than
B) positive; less than
C) negative; greater than
D) negative; less than
Answer: D
Special Feature: Chapter Opener: Fear of Falling (into a Recession)
24
4) Holding other factors constant, a decline in incomes of Europeans will result in a ________ curve in the
United States, reducing real GDP relative to potential GDP.
A) leftward shift of the IS
B) rightward shift of the IS
C) upward shift of the MP
D) downward shift of the MP
Answer: A
Special Feature: Making the Connection: Will the European Financial Crisis Cause a Recession in the United States?
5) Assume the economy is initially in equilibrium where potential GDP is greater than real GDP. If the
expected inflation rate, the term structure effect, and the default-risk premium are constant, a decrease in
the Fed's target short-term nominal interest rate will ________ the MP curve and the output gap will
become ________.
A) shift up; smaller
B) shift up; larger
C) shift down; smaller
D) shift down; larger
Answer: C
Topic: Monetary Policy and Fluctuations in Real GDP
6) Assume the economy is initially in equilibrium where potential GDP is less than real GDP. If the
expected inflation rate, the term structure effect, and the default-risk premium are constant, ________ in
the Fed's target short-term nominal interest rate will shift up the MP curve which will result in real GDP
________.
A) an increase; falling
B) an increase; rising
C) a decrease; falling
D) a decrease; rising
Answer: B
25
7) Assume the economy is initially in equilibrium where potential GDP equals real GDP. If the expected
inflation rate, the term structure effect, and the default-risk premium are constant and the Fed wants to
lower the inflation rate, the Fed could ________ the target short-term nominal interest rate, which will
result in real GDP being ________ potential GDP.
A) increase; greater than
B) increase; less than
C) decrease; greater than
D) decrease; less than
Answer: B
8) Assume the economy is initially in equilibrium where potential GDP equals real GDP. If the expected
inflation rate, the term structure effect, and the default-risk premium are constant and the Fed wants to
________ the inflation rate, the Fed could lower the target short-term nominal interest rate, which will
result in an output gap which is ________.
A) raise; greater than zero
B) raise; less than zero
C) lower; greater than zero
D) lower; less than zero
Answer: C
9) Assume the economy is initially in equilibrium where potential GDP equals real GDP. If the economy
experiences a positive demand shock, increasing consumer optimism, and the Fed does not change its
target short-term nominal interest rate, the ________ shifts to the right and the output gap will be
________.
A) IS curve; positive
B) IS curve; negative
C) MP curve; positive
D) MP curve; negative
Answer: A
Special Feature: Key Issue and Question: What Explains the Business Cycle?
26
Figure 10.7
10) Refer to Figure 10.7. A movement from point B to point D could be caused by
A) an increase in the target interest rate.
B) an increase in consumer confidence.
C) an increase in the term structure effect.
D) a decrease in the expected rate of inflation.
Answer: B
Diff: 2 Page Ref: 355, 359
11) Refer to Figure 10.7. A movement from point A to point B could be caused by
A) a negative demand shock.
B) a decrease in the term premium investors expect in the future.
C) an increase in the default-risk premium.
D) an increase in the expected rate of inflation.
Answer: C
27
12) Refer to Figure 10.7. A movement from point C to point A could be caused by
A) a negative demand shock.
B) a decrease in the term premium investors expect in the future.
C) a decrease in the default-risk premium.
D) a decrease in the expected rate of inflation.
Answer: A
13) Refer to Figure 10.7. A movement from point D to point C could be caused by
A) a positive demand shock.
B) an increase in the term premium investors expect in the future.
C) an increase in the term structure effect.
D) an increase in the expected rate of inflation.
Answer: D
14) Refer to Figure 10.7. A movement from point A to point D could be caused by
A) a positive demand shock accompanied by an increase in the default-risk premium.
B) a decrease in consumer confidence accompanied by a decrease in the expected rate of inflation.
C) a negative demand shock accompanied by an increase in the target interest rate.
D) an increase in consumer confidence accompanied by a decrease in the term premium investors expect
in the future.
Answer: A
28
15) Refer to Figure 10.7. A movement from point C to point B could be caused by
A) an increase in consumer confidence accompanied by a decrease in the target interest rate.
B) a decrease in consumer confidence accompanied by an increase in the expected rate of inflation.
C) a negative demand shock accompanied by an increase in the term structure effect.
D) a positive demand shock accompanied by a decrease in the default-risk premium.
Answer: C
16) Assume the economy is in a recession and the Federal government decides to cut personal income tax
rates. All else equal, the cut in tax rates should
A) shift the IS curve to the right and move the output gap closer to zero.
B) shift the IS curve to the left and move the output gap farther away from zero.
C) shift up the MP curve and move the output gap closer to zero.
D) shift up the MP curve and move the output gap farther away from zero.
Answer: A
Special Feature: Solved Problem 10.3: Using the IS-MP Model to Analyze the 2001 Tax Cut
17) Assume the economy is in a recession and the Federal government decides to cut personal income tax
rates. All else equal, the cut in tax rates should
A) increase consumption expenditures and cause real GDP to increase relative to potential GDP.
B) increase the nominal interest rate and cause potential GDP to increase relative to real GDP.
C) decrease the real interest rate and decrease expectations of inflation.
D) increase the target interest rate and cause real GDP to fall relative to potential GDP.
Answer: A
29
18) The aggregate demand curve is all of the equilibrium combinations of
A) the IS curve and the MP curve.
B) the output gap and the price level.
C) the price level and the real interest rate.
D) the real interest rate and the output gap.
Answer: B
Topic: IS-MP and Aggregate Demand
19) An increase in the price level causes a ________ the IS curve and a ________ the aggregate demand
curve.
A) movement up along; movement down along
B) shift to the right of; movement down along
C) movement down along; movement down along
D) shift to the left of; movement up along
Answer: C
20) A decrease in the price level causes a ________ the IS curve and a ________ the aggregate demand
curve.
A) movement up along; movement up along
B) shift to the right of; movement up along
D) shift to the left of; movement down along
Answer: A
30
21) A negative demand shock causes a ________ the IS curve and a ________ the aggregate demand
curve.
A) movement up along; shift to the left of
B) shift to the right of; movement up along
D) shift to the left; shift to the left of
Answer: A
22) A positive demand shock causes a ________ the IS curve and a ________ the aggregate demand curve.
A) movement up along; shift to the right of
B) shift to the right of; movement down along
D) shift to the right; shift to the right of
Answer: D
23) Expansionary monetary policy causes a ________ the MP curve and a ________ the aggregate demand
curve.
A) movement to the right along; shift to the right of
B) downward shift of; shift to the right of
C) movement to the left along; movement down along
D) upward shift of; shift to the right of
Answer: B
31
24) Contractionary monetary policy causes a ________ the MP curve and a ________ the aggregate
demand curve.
A) movement to the right along; shift to the right of
B) downward shift of; shift to the right of
C) movement to the left along; movement up along
D) upward shift of; shift to the left of
Answer: D
25) Using the IS-MP model, explain what happens to output and the real interest rate when the IS curve
shifts to the right and when it shifts to the left, and when the MP curve shifts up and when it shifts down?
Answer: All else equal, when the IS curve shifts to the right, output increases and the real interest rate
does not change, and when the IS curve shifts to the left, output decreases and the real interest rate does
not change.
All else equal, when the MP curve shifts up, output decreases and the real interest rate increases, and
when the MP curve shifts down, output increases and the real interest rate decreases.
32
26) Suppose that the economy is experiencing inflation and is above full employment, and the federal
government implements an income tax increase as a corrective action. Use the IS-MP model to analyze
the effect the tax increase should have on real GDP and the output gap. Show any shifts in the IS curve
and the MP curve, and identify the old and new equilibrium values of the output gap.
Answer: Since the economy is originally above full employment, real GDP is greater than potential GDP,
so the output gap is positive. The higher income tax rate will decrease disposable income, thereby
decreasing consumption expenditures. Therefore, aggregate expenditures should now be lower for any
given real interest rate. This will shift the IS curve to the left, from IS1 to IS2, moving short-run
equilibrium from point A to point B and decreasing real GDP relative to potential GDP, so the output gap
changes from 1, which is greater than zero, to 2, which will be less than 1.

27) Explain how the AD curve can be derived from the IS-MP model.
Answer: The aggregate demand curve (AD) is all of the equilibrium combinations of the output gap and
the price level. Consider the effect of an increase in the price level on the IS curve. In the money market,
an increase in the price level causes the demand for money curve to shift to the right, increasing the
equilibrium interest rate. A higher interest rate leads to a decline in aggregate expenditure, which causes
a movement up along the IS curve, resulting in a lower level of real GDP relative to potential GDP. The
increase in the price level causes a movement along the IS curve. If we kept varying the price level and
tracing the effects on the IS curve, we would have plotted all the points on the aggregate demand curve.
33
10.4 Appendix: IS-LM: An Alternative Short-Run Macroeconomic Model
1) The IS-MP model assumes the Fed targets ________, and the IS-LM model assumes the Fed targets the
________.
A) the expected inflation rate; the unemployment rate
B) short-term nominal interest rates; the money supply
C) the output gap; the long-term real interest rate
D) short-term real interest rates; the expected inflation rate
Answer: B
Topic: Asset Market Equilibrium
Objective: LO4: Use the IS-LM model to illustrate macroeconomic equilibrium.
2) The market for money is in equilibrium

A) only if the non-money asset market is in equilibrium.
B) whenever the economy is at potential GDP.
C) when the cyclical unemployment rate is zero.
D) the Fed achieves its target for the expected inflation rate.
Answer: A
Topic: Asset Market Equilibrium
34
Figure 10.8
3) Refer to Figure 10.8. Other things equal, a decrease in the nominal money supply would best be
represented by
A) a movement from point A to point C.
B) a movement from point A to point D.
C) a shift from LM1 to LM2.
D) a shift from LM2 to LM1.
Answer: D
Topic: Shifting the LM Curve
4) Refer to Figure 10.8. Other things equal, an increase in the price level would best be represented by
Answer: D
35
5) Refer to Figure 10.8. Other things equal, an increase in expected inflation would best be represented by
Answer: C
6) Refer to Figure 10.8. Other things equal, a decrease in the nominal interest rate on money would best be
represented by
Answer: C
7) Refer to Figure 10.8. Other things equal, an increase in the demand for money and the accompanying
change in the real interest rate would best be represented by
Answer: A
36
8) Suppose the economy is initially in short-run equilibrium and the Fed decreases the nominal money
supply. If the price level remains constant, real GDP will ________ relative to potential GDP and the real
interest rate will ________.
C) decrease; increase
D) decrease; decrease
Answer: C
Topic: Equilibrium in the IS-LM Model
9) If the economy is initially in short-run equilibrium and then experiences a positive demand shock, real
GDP will ________ relative to potential GDP and the real interest rate will ________.
C) decrease; increase
D) decrease; decrease
Answer: A
37
Figure 10.9
10) Refer to Figure 10.9. Other things equal, a positive demand shock is best represented as a change in
equilibrium from
A) point A to point B.
B) point A to point D.
C) point C to point B.
D) point C to point D.
Answer: A
11) Refer to Figure 10.9. Other things equal, a negative demand shock is best represented as a change in
equilibrium from
Answer: D
38
12) Refer to Figure 10.9. Other things equal, an increase in the nominal money supply by the Fed is best
represented as a change in equilibrium from
Answer: B
Special Feature: Solved Problem 10A.1: Monetary Policy During the Great Depression
13) Refer to Figure 10.9. Other things equal, a decrease in the nominal money supply by the Fed is best
represented as a change in equilibrium from
Answer: C
Special Feature: Solved Problem 10A.1: Monetary Policy During the Great Depression
39
14) Assume that the economy is initially in equilibrium and the Fed keeps the nominal money supply
constant. Construct a money market graph and an LM curve and use them to explain what happens if the
economy experiences a negative demand shock.
Answer: With a negative demand shock, households and firms make fewer purchases, so real GDP
decreases relative to potential GDP (the output gap decreases from 1 to 2) and the money demand
curve shifts to the left, from MD1 to MD2. Since the Fed is keeping the nominal money stock constant, the
money supply curve does not change and the equilibrium real interest rate decreases from r1 to r2. The
economy's equilibrium is now at point B in both figures.

40
Test Bank for Macroeconomics, 2nd Edition : Hubbard
15) Assume that the economy is initially in equilibrium and the Fed decreases the nominal money supply.
Construct a money market graph and an LM curve and use them to explain what happens if the Fed
decreases the nominal money supply when the price level and output remain constant.
Answer: When the Fed decreases the nominal money stock, the money supply curve shifts to the left
from MS1 to MS2. As a result, the equilibrium real interest rate increases from r1 to r2 since the price level
remains constant. If output remains constant at , a decrease in the equilibrium real interest rate will
move equilibrium to point B, so the LM curve has shifted to the left from LM1 to LM2.

41
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1) Equilibrium in the goods market occurs where

13) If the MPC = 0.80, the government purchases multiplier is

Consumption C = $1.0 + 0.80YD

(all values are in billions of dollars)

Panel (a) Panel (b)

Diff: 2 Page Ref: 338-339

Diff: 2 Page Ref: 343-344

Diff: 2 Page Ref: 350-351

Diff: 2 Page Ref: 360-361

2) The market for money is in equilibrium

Diff: 2 Page Ref: 374-375

Diff: 2 Page Ref: 373-375

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