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Back to Subjects - Economics

Macroeconomics

Macroeconomics A) The IS curve slopes downward and to the right. B) The LM curve slopes upward and to the right. C) The slope of the LM curve depends on the interest sensitivity of money demand. An elastic money demand function caused the LM curve to be relatively flat. An inelastic money demand function caused the LM curve to be steep. D) The slope of the IS curve depends on the slope of the investment function. If investment is highly interest elastic, then the IS curve is relatively flat. If investment is not highly interest elastic, then the IS curve is very steep. E) The quantity of money and shifts in money demand at given levels of income and interest rates will shift the position of the LM curve. F) Government expenditures, tax increases, and autonomous investment expenditures shift the position of the IS curve. Transaction Demand – Money is a medium of exchange and individuals hold money for use in transactions. Money bridges the gap between the receipt of income and eventual expenditures. Precautionary Demand – Keynes believed that, in addition to the money people held for planned transactions, more money was held for unexpected expenditures that were at times necessary. Money would be held for emergencies, to pay unexpected medical bills or repair bills of various types. Speculative Demand – Money held by those speculating on future changes in the interest rate and the relationship the interest rate had with the level of bond prices. Md = Co + (C1 x Y) + (C2 x R) , C1 * 0 , C2 * 0 A rise in income increases money demand, a rise in the interest rate leads to a fill in money demand. C = Parameter (Holds no economic value) Transaction Demand - Dependent positively on the level of income. Precautionary Demand - Keynes believed that the amount of money held for this purpose depends positively on income. The interest rate might be a factor if people tended to economize on the amount of money held for the precautionary motive as interest rates rose. Speculative Demand - The money also held by those speculating on future changes in the relationship with the interest rate and the level of bond prices. If interest rates were expected to move in such a way as to cause capital losses on bonds, money would be held by those individuals. The speculative demand for money was negatively related to the interest rate. 2. A) Decrease in government spending: Y decrease because Y = C + I + G (If G goes up so must Y.) The decrease in government spending shifts the IS schedule out to the left to a position IS1. The equilibrium level of income decreases. The equilibrium level of the interest rate also decreases. Lower interest rate serves to increase investment (I), thereby leading to increase in y. Money supply goes up, output goes up, and interest rates go down. b) Autonomous increase in investment spending: I increases because Y = C + I + G (If I goes up so must Y.) The autonomous increase in investment spending shifts the IS schedule to the right from ISo to IS1. Income increases from Y0 to Y1. The interest rate increases from Ro to R1. Income increases because investment demand at the initial interest rate from Io to I’1. As income increases, consumption spending increases. The interest rate increase is also a result from the income increase. The increase in income causes money demand to go up and interest rates to increase. The increase in money stock shifts the LM schedule to the right, LM to LM1. As a result, the interest rate falls from Ro to R1 and income rises from Yo to Y1. The increase in money stock creates an excess supply of money, which causes the interest rate to fall. As the interest rate falls, investment demand is increased, and this increase causes income to rise with an increase in consumption demand due to the change in income. 3. Possible reasons why the money wage does not adjust proportionately with the price level in the short-run Keynesian model. a. Workers were interested in both their absolute and relative wage rates. Absolute wage rate means the wage rate that actually effects me and relative wage rate meaning the wage rate of others in relation to mine. b. Unionized sectors of the economy that utilized labor contracts, sometime lasting 2 to 3 years. c. Even in the absence of formal labor contracts, informal agreements between workers and firms may have existed. 4. Increase in the money stock with price level & money wage are assumed to be variable. a. An increase in the money stock is shown to shift the LM schedule to the right & the aggregate demand schedule to the right. Price level increased from Po to P1. Output increased from Yo to Y1. In the IS-LM model, output & employment rose and interest rates fell from R0 to R1. When price level is allowed to vary, the increase in output will be less than when the price level in fixed output rises to Y1 instead of Y’1. The reason is that the increase in the price level reduces the real money stock & the reduction partially effects of the increase in the nominal quantity of money. The interest rate falls only to R1, not R’1. This policy has smaller effect on investment & output. 5. Friedman’s theory of money demand differed from that of Keynesians in that Keynesian theory emphasized money as a determinant of the level of economic activity. But, “velocity” was not constant and it was determined within the system. Friedman viewed demand as stable. Friedman doesn’t segment money demand into transactions demand, speculation demand, and precautionary demand. Friedman includes separate returns for different asset classes. Md = K (Rb, Rc, Rd) P x Y P x Y = nominal income K = increase in the velocity of money Also, K is not constant, but depends on asset returns or alternatives to holding money. For Friedman, an increase in the return on any of the assets caused money demand to decline. The assumption that is required in order to be considered the strong form of the Quantity Theory of Money is assuming that the variable in “K” (i.e. Rb, Re, Rd) have little effect on money demand. This makes velocity nearly constant. Ms = Md = K (constant) x p x y. The strong form extends the Quantity Theory of Money from a theory of money demand to one of nominal income. This also asserts the economic importance of money and therefore monetary policy. 6. Monetarists view fiscal policy as ineffective. Effect of an increase in Government Expenditures – Reflects monetarist view that fiscal policy was ineffective because “Y” changes little. Monetary Policy/Increase in Money Supply – Monetarist and Keynesians believed that changes in the money supply (Ms) could have significant effects on nominal income. Macroeconomic Equilibrium with short run & long run supply curves. Long run has higher prices only. Short run has higher prices & output. Output increases from Y* to Y1, employment goes up, unemployment goes down, prices go up. Phillips Curve – negative relationship between unemployment & inflation. Ultimately, the monetarist policy implication is that attempts to lower employment below its “natural rate” will only be successful in the short run. Over the long term, these policies will be inflationary. In the short run, we can exceed the natural rate because workers are fooled into supplying more labor than the correct real wage would bear. However, excess demand for labor will force wages higher in the long run. Thus, monetary policy is effective in the short run, but not in the long run. 9. “Natural rate of unemployment” – An equilibrium level of output and a following level of unemployment determined by the supply of factors of production, technology, and institutions of the economy. Changes in aggregate demand mainly caused by changes in the supply of money causes temporary movements of the economy away from the natural rate. The monetarist policy implications is that attempts to lower unemployment below its natural rate will only be successful in the short run. Over the long term, these policies will be inflationary. 10. Rational Expectations Hypothesis – Neo-classicalist economists believe that agents form rational expectations and that they make systematic forecast errors. Expectations are formed on the basis of all available information concerning the variable being predicted. Individuals then use the available information to understand how variables relate to each other. The central tenant of new classical economics is that the stabilization of real variables such as output and employment cannot be achieved by aggregate demand management. The values of real variables in both the short and long term are insensitive to systemic aggregate demand management policies. (Policy Ineffectiveness Postulate) In relation to the labor supply, individuals will account for any expected policy actions and they understand how these aggregate demand policies affect the price level. As a result, anticipated and unanticipated policy changes can have very different effects, like unanticipated changes having short run ramifications. Neo-classical economists believe that output & employment are unaffected by systematic and predictable changes in monetary and fiscal policy. In conclusion, neo-classical economists do not believe that there is any meaningful role for macroeconomic stabilization policy. Bibliography:

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