1.

How does the IS-LM model developed in this chapter relate to the model of
aggregate demand developed in Chapter 9?

Solution:​
The IS-LM model explains the equilibrium in the goods and money markets, determining the
interest rate and national income. The aggregate demand (AD) curve in Chapter 9 shows the
relationship between the price level and output demanded. The IS-LM model helps derive
the AD curve: when the price level changes, it affects real money balances, shifting the LM
curve, which in turn changes equilibrium output and interest rates. Therefore, the IS-LM
framework provides the microeconomic foundation for the AD curve.

2. a. Explain in words how and why the multiplier a and the interest sensitivity of
aggregate demand affect the slope of the IS curve.

Solution:​
The multiplier a determines how strongly output responds to changes in autonomous
spending. A larger multiplier makes the IS curve flatter because a given change in the
interest rate leads to a larger change in output.​
The interest sensitivity of aggregate demand refers to how much investment (and therefore
output) responds to changes in the interest rate. Higher sensitivity also flattens the IS curve,
as small changes in interest rates cause large changes in investment and output.

b. Explain why the slope of the IS curve is a factor in determining the working of
monetary policy.

Solution:​
A flatter IS curve implies that changes in the interest rate (through monetary policy) lead to
larger changes in output. Thus, monetary policy is more effective when the IS curve is flat.
Conversely, if the IS curve is steep, changes in the interest rate will have little effect on
output, making monetary policy less potent.

3. Explain in words how and why the income and interest sensitivities of the demand
for real balances affect the slope of the LM curve.

Solution:​
The income sensitivity of money demand reflects how much money people demand when
income rises. Higher sensitivity steepens the LM curve, as more income leads to greater
money demand and hence higher interest rates.​
The interest sensitivity of money demand reflects how responsive money demand is to
interest rates. If money demand is very sensitive to interest rates, the LM curve is flatter,
since small changes in the interest rate cause large changes in money demand, requiring
smaller shifts in income to maintain equilibrium.
4. a. Why does a horizontal LM curve imply that fiscal policy has the same effects on
the economy as those derived in Chapter 9?

Solution:​
In Chapter 9, fiscal policy directly affects aggregate demand without crowding out private
investment through interest rate changes. A horizontal LM curve (perfectly elastic money
supply) implies the central bank accommodates any fiscal expansion by supplying money at
a constant interest rate. Thus, fiscal policy raises output without increasing interest rates,
just like in the basic aggregate demand model.

b. What is happening in this case in terms of Figure 10-3?

Solution:​
In Figure 10-3, a horizontal LM curve means the economy is in a liquidity trap. The interest
rate is so low that people prefer holding money over bonds. Fiscal expansion shifts the IS
curve rightward, increasing output with no change in interest rates.

c. Under what circumstances might the LM curve be horizontal?

Solution:​
The LM curve becomes horizontal in a liquidity trap, where nominal interest rates are near
zero. In such a scenario, monetary policy becomes ineffective because increases in the
money supply do not reduce interest rates further or stimulate investment.

5. It is possible that the interest rate might affect consumption spending. An increase
in the interest rate could, in principle, lead to increases in saving and therefore a
reduction in consumption, given the level of income. Suppose that consumption is, in
fact, reduced by an increase in the interest rate. How will the IS curve be affected?

Solution:​
If consumption becomes interest-sensitive, the IS curve becomes flatter. This is because a
change in the interest rate now affects not just investment but also consumption. Thus,
increases in interest rates cause larger reductions in aggregate demand, leading to a greater
fall in output.

6. Between January and December 1991, while the U.S. economy was falling deeper
into its recession, the interest rate on Treasury bills fell from 6.3 percent to 4.1
percent. Use the IS-LM model to explain this pattern of declining output and interest
rates. Which curve must have shifted? Can you think of a reason—historically valid or
simply imagined—that this shift might have occurred?

Solution:​
The IS curve must have shifted to the left, indicating a fall in aggregate demand. This leads
to lower output and, through equilibrium in the money market, a lower interest rate.​
Historically, this could have been due to declining consumer and business confidence after
the 1990 oil price shock, reduced investment, or fiscal contraction. Additionally, after the Gulf
War, uncertainty may have caused private spending to contract, shifting the IS curve left and
causing a recession despite falling interest rates.

1. The following equations describe an economy:

(P1) C = 0.8(1 - t) * Y​
(P2) t = 0.25​
(P3) I = 900 - 50i​
(P4) G = 800​
(P5) L = 0.25Y - 62.5i​
(P6) M/P = 500

a. What is the equation that describes the IS curve?

Solution:​
The IS curve represents equilibrium in the goods market:​
Y=C+I+G

Using given values:

●​ t = 0.25 → Disposable income = 0.75Y

●​ C = 0.8 × 0.75Y = 0.6Y
●​ I = 900 - 50i
●​ G = 800

So,​
Y = 0.6Y + (900 - 50i) + 800​
→ Y - 0.6Y = 1700 - 50i​
→ 0.4Y = 1700 - 50i​
→ IS curve: Y = 4250 - 125i

b. What is the general definition of the IS curve?

Solution:​
The IS curve represents combinations of interest rates (i) and output (Y) where the goods
market is in equilibrium(i.e., where planned spending equals actual output).

c. What is the equation that describes the LM curve?

Solution:​
The LM curve represents equilibrium in the money market:​
M/P = L(i, Y)
Given:​
M/P = 500​
L = 0.25Y - 62.5i

Set them equal:​

500 = 0.25Y - 62.5i​
→ LM curve: Y = 2000 + 250i

d. What is the general definition of the LM curve?

Solution:​
The LM curve represents combinations of interest rates (i) and output (Y) where the
money market is in equilibrium, i.e., where money demand equals money supply.

e. What are the equilibrium levels of income and the interest rate?

Solution:​
Equilibrium: IS = LM​
From earlier:​
IS: Y = 4250 - 125i​
LM: Y = 2000 + 250i

Set them equal:​

4250 - 125i = 2000 + 250i​
→ 2250 = 375i​
→ i = 6%

Substitute into IS:​

Y = 4250 - 125×6 = 4250 - 750 = 3500

Equilibrium:​
i = 6%, Y = 3500

2. Continue with the same equations:

a. What is the value of a which corresponds to the simple multiplier (with taxes) of
Chapter 9?

Solution:​
Multiplier a = 1 / (1 - MPC × (1 - t))​
MPC = 0.8, t = 0.25​
→ a = 1 / (1 - 0.8×0.75) = 1 / (1 - 0.6) = 2.5
b. By how much does an increase in government spending of ΔG increase the level of
income in this model (IS-LM)?

Solution:​
In IS-LM, the fiscal multiplier is smaller due to crowding out.​
From IS: Y = 4250 - 125i​
ΔY/ΔG = 1 / (1 - 0.6) = 2.5 (same initial effect as above)​
But equilibrium is where IS and LM intersect. Solve using total differentiation or approximate:

New IS after ΔG:​

Let’s say G increases by 100:​
New IS becomes:​
Y = 0.6Y + 900 - 50i + 900​
→ 0.4Y = 1800 - 50i → Y = 4500 - 125i​
New IS intersects LM (Y = 2000 + 250i)​
4500 - 125i = 2000 + 250i​
→ 2500 = 375i → i = 6.67​
→ Y = 2000 + 250×6.67 ≈ 3667

So, ΔY ≈ 3667 - 3500 = 167​

Hence, multiplier = 1.67 (vs 2.5 in simple model)

c. By how much does a change in government spending of ΔG affect the equilibrium

interest rate?

Solution:​
Before: i = 6%, After: i ≈ 6.67%​
So, Δi = 0.67%

d. Explain the difference between your answers to parts (a) and (b).

Solution:​
In (a), the simple multiplier ignores interest rate changes (no crowding out). In (b), IS-LM
includes the money market, so rising interest rates partially offset fiscal expansion by
reducing investment—resulting in a lower multiplier.

3.

a. How does an increase in the tax rate affect the IS curve?

Solution:​
Higher taxes reduce disposable income → lower consumption → IS curve shifts leftward
(output falls at each interest rate).
b. How does the increase affect the equilibrium level of income?

Solution:​
Lower consumption reduces aggregate demand → equilibrium income falls.

c. How does the increase affect the equilibrium interest rate?

Solution:​
Lower demand → IS shifts left → intersection with LM occurs at a lower interest rate.

4.

a. Show that a given change in the money stock has a larger effect on output the less
interest-sensitive is the demand for money.

Solution:​
From the LM equation: M/P = L(Y, i)​
If money demand is less sensitive to interest rates (low |dL/di|), then a given increase in
M/P shifts LM more horizontally, leading to a larger rise in output for the same fall in
interest rates.

b. How does the response of the interest rate to a change in the money stock depend
on the interest sensitivity of money demand?

Solution:​
If money demand is highly interest-sensitive, LM is flat → interest rate changes little.​
If it’s not sensitive, LM is steep → interest rate changes a lot for a given ΔM.

5. Discuss, using the IS-LM model, what happens to interest rates as

prices change along a given AD schedule.

Solution:​
As prices fall, real balances (M/P) increase, shifting the LM curve rightward.​
This leads to lower interest rates and higher output along the AD curve.

6. Show, using IS and LM curves, why money has no effect on output in

the classical supply case.
Solution:​
In the classical case, output is determined by supply-side factors (full employment output).​
Even if LM shifts (change in M), the vertical AS means output stays fixed, only interest
rates change.

7. Suppose there is a decline in the demand for money. At each output level
and interest rate the public now wants to hold lower real balances.

a. In the Keynesian case, what happens to equilibrium output and to prices if money
demand falls?

Solution:​
LM shifts right → interest rate falls, output increases, prices constant (short run,
Keynesian fix-price assumption).

b. In the classical case, what is the effect on output and on prices?

Solution:​
LM shifts right → interest rate falls → no change in output (fixed at full employment), but
prices rise due to increase in AD.

Question:

By the end of this chapter, you learned that increases in interest rates reduce aggregate
demand. Is this true in practice? Let's examine how interest rates relate to the growth rate of
the U.S. economy.​

Instructions:

1.​ Go to FRED.​FRED+10FRED+10FRED+10
2.​ Download data for the following two variables:​
○​ Real Gross Domestic Product (GDP), Annual Percentage Changes:
Under "Gross Domestic Product (GDP) and Components," select the series
"A191RL1A225NBEA." Click on "Download Data," and choose "Percent
Change from Year Ago."​FRED+3FRED+3FRED+3
○​ Bank Prime Loan Rate: Under "Interest Rates," select the series "MPRIME."
Download the monthly data and transform these observations into annual
data using the average function in Excel.​
3.​ Use Excel to plot these two series on the same graph.​

Solution:

To analyze the relationship between interest rates and economic growth, follow these steps:​

1.​ Access and Download Data:

○​ Real GDP Growth Rate:
 ■​ Navigate to the Real Gross Domestic Product (A191RL1A225NBEA)
series on FRED.
■​ Click on "Download Data" and select the option for "Percent Change
from Year Ago" to obtain annual percentage changes.
○​ Bank Prime Loan Rate:
■​ Navigate to the Bank Prime Loan Rate (MPRIME) series on FRED.
■​ Download the monthly data.
■​ In Excel, calculate the annual average of the monthly prime rates to
align with the annual GDP growth data.
2.​ Plot the Data:
○​ In Excel, create a line graph plotting both the Real GDP Growth Rate and the
Bank Prime Loan Rate over the same time period.​
○​ Ensure both series are clearly labeled, and consider using dual axes if the
scales differ significantly.​FRED+1FRED+1
3.​ Analyze the Graph:
○​ Observe the trends and relationship between the two variables.​
○​ Typically, economic theory suggests that higher interest rates may lead to
lower economic growth due to increased borrowing costs, while lower interest
rates may stimulate growth.​
○​ Look for periods where changes in the Bank Prime Loan Rate correspond
with changes in the Real GDP Growth Rate.​

Findings:

Upon examining the graph, you may notice that in several instances, increases in the Bank
Prime Loan Rate are followed by a slowdown in GDP growth, and decreases in the prime
rate are followed by accelerated growth. This inverse relationship aligns with the theoretical
expectation that higher interest rates can dampen economic activity by making borrowing
more expensive, thereby reducing investment and consumption. Conversely, lower interest
rates can encourage borrowing and investment, stimulating economic growth.​

Conclusion:

The empirical data generally support the notion that increases in interest rates are
associated with reductions in aggregate demand and economic growth. However, it's
important to consider that this relationship can be influenced by various factors, including
monetary policy decisions, inflation expectations, and external economic shocks. Therefore,
while the observed inverse relationship provides evidence consistent with economic theory, it
is essential to analyze these trends within the broader context of the economic environment.​