52
CHAPTER 6: KEYNESIAN SYSTEM (II): MONEY, INTEREST,
AND INCOME
Additional Questions
Essay Questions and/or Problems:
1. What is meant by a “liquidity trap?”
2. What happens to inventories on all points that are below the IS curve? Are unplanned
inventories positive or negative? Explain.
3. a. Define the LM curve. Define the IS curve.
b. Is the LM curve positively or negatively sloped? Is the IS curve positively or negatively
sloped?
c. When is the LM curve relatively steep? When is the IS curve relatively flat?
4. List three changes in exogenous variables that would shift the IS curve to the right.
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?
KEYNESIAN SYSTEM (II): MONEY, INTEREST, AND INCOME 53
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.
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.
8. If savings becomes more interest rate elastic, what happens to the slope of the IS curve.
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.
10. Assume that following equations describe the money market of an economy
Ms = 1,000
Md = .2Y – 100r
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?
12. What is the condition met by all points along the LM schedule? Demonstrate graphically
13. What factors determine the slope of the IS and LM schedules? Illustrate graphically.
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.
15. How would the shape of the IS curve change if:
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.
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.
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.
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.
56 CHAPTER 6
Multiple-Choice Questions:
1. In calculating the IS curve, _______ is taken as exogenous
2. If people increase their expected rate of interest, the speculative demand for money curve
will _____ and money supply will _____.
3. In the Keynesian money market, velocity is
4. If the consumption function is given by C = 100 + 0.75(Y-T), then an increase of 10 units
5. A decline in the money stock will
6. In the Keynesian theory, an exogenous decrease in the demand for money shifts
7. A fall in autonomous investment will shift the
8. An decrease in the velocity of money for given levels of income and the interest rate would
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
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
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
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.
13. The LM curve slopes upward because
14. Assume that the economy is presently in equilibrium. A decline in the interest rate
15. The IS curve slopes upward because
16. Along any IS curve
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
18. According to Keynes, the speculative demand for money pertains to money held in
anticipation of a(n)
19. According to the Keynesian model of the money market, the supply of money
20. In the Keynesian theory of money demand,
21. The money demand curve shifts to the right when
22. The intuition behind the slope of the LM curve is that
23. At any point on the LM curve
24. If Y>C+I+G but Md= Ms, then
25. A decrease in the price level, holding the nominal money supply constant, will shift the LM
curve
26. Panel (a) in Figure 6.1 depicts
27. Panel (b) in Figure 6.1 reflects
28. In the Keynesian model, everything else equal, a higher level of income
29. A shift in the LM curve to the left could be caused by
30. The IS curve represents
31. Which of the following factors cause the IS curve to shift?
32. Assuming that money demand is completely interest insensitive, the
33. In the IS-LM model, the two variables that are affected by the interest rate are
34. Points to the left of the LM schedule show that
35. If the current interest rate increases,
36. Points to the right of the IS schedule indicate that
37. In the Keynesian system, an increase in the money stock would
38. One of the most responsive components of investment to changes in interest rates are
39. If Md = 1,000 – 400r and Ms = 2,000, the MPC = .85, G=100, and T = 120, then the
equilibrium interest rate is
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,
41. According to Keynes, a shift in liquidity preference is
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
43. If the central bank follows a monetary policy in which it maintains a fixed interest rate,
then
44. If savings does not depend upon the interest rate, then
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
46. Keynes believed that the precautionary demand for money varied
KEYNESIAN SYSTEM (II): MONEY, INTEREST, AND INCOME 63
47. If Y=C+I+G but Md< Ms, then
48. In the classical model,
49. The IS curve becomes steeper when there is
50. The LM curve will become steeper when
51. If money demand is not responsive to changes in interest rates, then
52. A relatively steep money demand schedule reflects the assumption that the interest
elasticity of money demand is
53. Which of the following is true about the LM curve?
54. Where the IS and LM curves intersect:
55. If the money supply increases at the same time that taxes increase, then:
56. The IS curve will shift to the right if:
57. If the economy is in a liquidity trap, then: