Question 1

Suppose the investment demand function is given as the following algebraic function: I = 300 - 1000r where r is the interest rate. Calculate the amount of investment that would take place at an interest rate of ten percent. How much investment would there be if interest rates rose to fifteen percent?

Accepted Answer

The level of investment at a ten percent interest rate would be 300 - 1000(.10) = 200. If the interest rate rises to fifteen percent the level of investment will fall to 300 - 1000(.15) = 150.

Question 2

Discuss the two links between the goods market and the money market.

Accepted Answer

The first link exists because the demand for money depends on income. As aggregate output increases so does income. With the interest rate held constant this leads to an increase in money demand. The second link is between planned investment spending and the interest rate. In general, the higher the interest rate, the lower the level of planned investment and vice versa.

Question 3

Suppose investment becomes less responsive to (i.e., sensitive to) changes in the interest rate. What effect will this have on the effectiveness of fiscal policy? Specifically, what will happen to the output effects of a given change in government spending?

Accepted Answer

The effectiveness of fiscal policy will increase. The answer to this question is related to the crowding-out effects of fiscal policy. A fiscal expansion will cause an increase in Y and an increase in r. The higher r will cause a reduction in I partially offsetting the increase in G. If I does not fall as much, there will be less crowding-out and the increase in Y will be larger.

Question 4

Explain the two key links between the goods market and the money market.

Accepted Answer

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Question 5

Indicate the effect of each of the following policies on the variables: Y, C, S, r, I, Ms, and Md.
(a) The government reduces the personal income tax rates.
(b) Firms become more pessimistic about future sales.

Accepted Answer

The answer of Indicate the effect of each of the...

Question 6

Graphically illustrate the impact of a decrease and increase in the interest rate on aggregate expenditure. On your graph, illustrate the impact of an increase and decrease in the interest rate upon aggregate expenditure. Summarize the relationship among changes in the rate of interest (r), the change in planned investment spending (I), its impact on the aggregate expenditure function (AE), and the multiple effect on income (Y).

Accepted Answer

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Question 7

Explain why changes in the goods market may have side effects in the money market.

Accepted Answer

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Question 8

List four determinants of planned investment.

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Question 9

What action could the Fed take to reduce the crowding-out effect of an expansionary fiscal policy?

Accepted Answer

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Question 10

In addition to the rate of interest, what other conditions affect the level of planned investment? Explain how these factors affect planned investment spending.
(a) Expectations regarding business and overall economic conditions
(b) Capital utilization rates
(c) Relative labor and capital costs

Accepted Answer

The answer of In addition to the rate of interest,...

Question 11

Summarize the effects of an expansionary fiscal policy in the aggregate expenditure model. That is graphically illustrate the effects of an expansionary fiscal policy on the equilibrium level of output.

Accepted Answer

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Question 12

Explain the "crowding-out effect."

Accepted Answer

The answer of Explain the "crowding-out effect."...

Question 13

Explain what the aggregate demand curve is and the relationship between the price level and aggregate output.

Accepted Answer

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Question 14

Explain the role of expectations and "animal spirits" on investment decisions.

Accepted Answer

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Question 15

How much crowding out would be expected from an expansionary fiscal policy if investment was completely insensitive to the interest rate: that is independent of the interest rate? Explain your answer.

Accepted Answer

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Question 16

Assume the following graph for money supply and money demand. Explain the adjustment process that would take place in this money market if the interest rate is 12 percent. Make sure that your answer includes a discussion of what happens to money balances and bond prices.

Accepted Answer

The answer of Assume the following graph for money supply...

Question 17

Assume the Federal Reserve contracted the money supply in the face of high deficit spending on the part of Congress. Would this lessen or aggragavate the crowding out problem? Explain.

Accepted Answer

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Question 18

The textbook discusses the "crowding out effect". Can you think of any circumstances in which just the opposite effect could take place?

Accepted Answer

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Question 19

Draw the LM curve and explain its shape.

Accepted Answer

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Question 20

Describe the chain of events that are likely to unfold when the government reduces net taxes. Explain your answer in terms of its impact on aggregate output, the demand for money, the interest rate and planned investment.

Accepted Answer

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Exam 12: The Determination of Aggregate Output, the Price Level, and the Interest Rate