Chapter 9 Mishkin (9)

Macreconomics: Policy and Practice (Mishkin) Chapter 9 The IS Curve 9.1 Planned Expenditure 1) There are no questions for this section. Answer: 9.2 The Components of Expenditure 1) Total aggregate demand includes ________. A) planned investment spending B) consumption expenditures C) net exports D) all of the above E) none of the above Answer: D Topic: 9.1 The Components of Expenditure 2) The consumption function shows how ________. A) the marginal propensity to consume varies with disposable income B) income varies as a result of changes in consumption C) consumption depends on the decision to save D) all of the above E) none of the above Answer: E Topic: 9.1 The Components of Expenditure 3) Consumption expenditures decrease when ________. A) the real interest rate falls B) disposable income increases C) autonomous consumption increases D) all of the above E) none of the above Answer: E Topic: 9.1 The Components of Expenditure AACSB: Reflective Thinking 4) If disposable income falls, consumption expenditure falls ________. A) by an amount that depends on the real interest rate B) so that planned expenditure remains constant C) by an amount smaller than the decrease in disposable income D) all of the above E) none of the above Answer: C Topic: 9.1 The Components of Expenditure AACSB: Reflective Thinking 1 Copyright © 2012 Pearson Education, Inc.

5) Total planned expenditure (equals total output) is 14,000 when autonomous consumption expenditure is 450. When autonomous consumption expenditure falls to 400, total planned expenditure (equals total output) is 13,800. The marginal propensity to consume is ________. A) 0.89 B) 0.75 C) 0.99 D) 0.44 E) 0.03 Answer: B Topic: 9.1 The Components of Expenditure AACSB: Analytical Skills 6) Total planned expenditure (equals income) is 13,500, autonomous consumption expenditure is 600, the marginal propensity to consume is 0.8, government purchases are 2,700, taxes are 2,500 and planned investment spending is 2,900. Net exports is ________. A) 3,840 B) negative 1,500 C) negative 1,380 D) negative 1,340 E) 2,100 Answer: B Topic: 9.1 The Components of Expenditure AACSB: Analytical Skills 7) Consumption expenditure is 15,000, government purchases are 5,000, planned investment spending is 4,000 and net exports are 1,500. If total output is 25,000, then unplanned inventory investment is ________. A) negative 500 B) 2,500 C) 3,500 D) 4,000 E) negative 450 Answer: A Topic: 9.1 The Components of Expenditure AACSB: Analytical Skills 8) An increase in the real interest rate will cause an increase in ________. A) saving B) planned investment C) net exports D) all of the above E) none of the above Answer: A Topic: 9.1 The Components of Expenditure

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9) An decrease in the real interest rate will cause an increase in ________. A) consumption B) planned investment C) net exports D) all of the above E) none of the above Answer: D Topic: 9.1 The Components of Expenditure 10) When firms spend more on additional holdings of raw materials, parts and finished goods ________. A) they are increasing their fixed investment B) they are increasing their inventory investment C) they are increasing their private consumption D) all of the above E) none of the above Answer: B Topic: 9.1 The Components of Expenditure 11) Fixed investment is typically ________. A) smaller than inventory investment B) calculated as the change in holdings of raw materials and finished goods C) planned spending on equipment, structures, and new residential housing D) all of the above E) none of the above Answer: C Topic: 9.1 The Components of Expenditure 12) Planned investment spending ________. A) is equal to planned fix investment spending plus the amount of inventory investment planned by firms B) is closely related to the real interest rate C) is heavily influenced by expectations about the future D) all of the above E) none of the above Answer: D Topic: 9.1 The Components of Expenditure 13) Planned investment spending ________. A) is equal to planned fixed investment spending plus government investment B) is unrelated to the real interest rate C) is heavily influenced by expectations about the future D) all of the above E) none of the above Answer: C Topic: 9.1 The Components of Expenditure 3 Copyright © 2012 Pearson Education, Inc.

14) Investment spending ________. A) is comprised of fixed and inventory investment B) is negatively related to the real interest rate C) is heavily influenced by what Keynes coined as "animal spirits" D) all of the above E) none of the above Answer: D Topic: 9.1 The Components of Expenditure 15) When the U.S. real interest rate falls ________. A) U.S. dollar assets earn a higher return relative to foreign assets B) it makes U.S. exports more expensive in foreign currencies C) imports will decrease D) all of the above E) none of the above Answer: C Topic: 9.1 The Components of Expenditure AACSB: Reflective Thinking 16) When the U.S. real interest rate rises ________. A) U.S. dollar assets earn a lower return relative to foreign assets B) makes U.S. exports more expensive in foreign currencies C) imports will decrease D) all of the above E) none of the above Answer: B Topic: 9.1 The Components of Expenditure AACSB: Reflective Thinking 17) When the U.S. real interest rate rises ________. A) U.S. dollar assets earn a higher return relative to foreign assets B) makes U.S. exports cheaper in foreign currencies C) imports will decrease D) all of the above E) none of the above Answer: A Topic: 9.1 The Components of Expenditure AACSB: Reflective Thinking

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18) Net exports ________. A) are heavily determined by foreign demand for domestic goods B) are heavily determined by domestic demand for domestic goods C) are independent of domestic interest rate fluctuations D) all of the above E) none of the above Answer: A Topic: 9.1 The Components of Expenditure AACSB: Reflective Thinking 19) Planned expenditures ________. A) are directly affected by government purchases B) increase when there is a reduction in taxes C) decrease when disposable income decreases D) all of the above E) none of the above Answer: D Topic: 9.1 The Components of Expenditure AACSB: Reflective Thinking 20) What is the meaning of "animal spirits"? How do these relate to planned investment spending and to unplanned investment spending? Answer: Animal spirits are emotional waves of optimism and pessimism. They influence autonomous investment, changing the amount of planned investment at any real interest rate. They impact unplanned investment, as well, since each firm's planned investment expenditures are, typically, purchases from other firms. A sudden change from optimism to pessimism will leave businesses with unsold inventory, an increase in inventory investment. Unplanned negative inventory investment results from a change from pessimism to optimism. Topic: 9.1 The Components of Expenditure 21) The investment function implies that current output does not influence investment. Does that make sense? Answer: Yes. Planned investment relies mostly on business expectations of future economic activity. Fluctuations in current activity affect investment as unplanned inventory changes and, perhaps, as an updating of expectations, causing a change in autonomous investment. Topic: 9.1 The Components of Expenditure AACSB: Reflective Thinking

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22) Acme Brands invested $5 million in 2010 on new equipment, spent $750 thousand to increase its inventory of intermediate components, and added $25 thousand to its inventory of finished goods. At year's end, the components inventory is found to be $200 thousand above its beginning-of-the- year level, and finished goods inventory is up $30 thousand over its starting level. Calculate planned investment, unplanned investment, and actual (total) investment. Answer: Planned investment is $5 million plus $750 thousand plus $25 thousand equals $5.775 million. Unplanned investment is $200 thousand minus $750 thousand plus $30 thousand minus $25 thousand equals negative $545 thousand. Actual investment is $5 million plus $200 thousand plus $30 thousand equals $5.23 million (equals $5.775 million minus $545 thousand). Topic: 9.1 The Components of Expenditure AACSB: Analytical Skills 9.3 Goods Market Equilibrium 1) The IS curve ________. A) shows the relationship between aggregate output and the real interest rate when the goods market is in equilibrium B) tells us that increases in autonomous consumption, investment, government purchases, or net exports raise output for any real interest rate C) tells us that a decrease in taxes leads to increases in output for any given real interest rate D) all of the above E) none of the above Answer: D Topic: 9.2 Goods Market Equilibrium AACSB: Reflective Thinking 2) In the IS curve ________. A) an increase in the interest rate constitutes an upward movement along the curve B) an increase in aggregate consumption constitutes a downward movement along the curve C) an increase in taxes constitutes a rightward shift of the curve D) all of the above E) none of the above Answer: A Topic: 9.2 Goods Market Equilibrium AACSB: Reflective Thinking 3) The IS curve ________. A) traces out the points at which the goods market is in equilibrium B) tells us how consumption expenditures fall as the real interest rises C) tells us that as the real interest rate rises planned expenditures go down leading to increases in savings that satisfy the goods market equilibrium D) all of the above E) none of the above Answer: D Topic: 9.2 Goods Market Equilibrium AACSB: Reflective Thinking 6 Copyright © 2012 Pearson Education, Inc.

4) If aggregate output is below its equilibrium level ________. A) there is an excess demand for goods B) actual output is below planned expenditure C) firms will tend to replenish their low inventories driving output up toward equilibrium D) all of the above E) none of the above Answer: D Topic: 9.2 Goods Market Equilibrium AACSB: Reflective Thinking 5) If aggregate output is above its equilibrium level ________. A) there is an excess supply of goods B) actual output is below planned expenditure C) firms will tend to replenish their low inventories driving output up toward equilibrium D) all of the above E) none of the above Answer: A Topic: 9.2 Goods Market Equilibrium AACSB: Reflective Thinking 6) In the IS curve, if Y falls for any given level of the real interest rate ________. A) consumption decreases B) output increases C) saving increases D) all of the above E) none of the above Answer: A Topic: 9.2 Goods Market Equilibrium AACSB: Reflective Thinking 7) In the IS curve, if Y increases for any given level of the real interest rate ________. A) consumption increases B) output decreases C) saving decreases D) all of the above E) none of the above Answer: A Topic: 9.2 Goods Market Equilibrium AACSB: Reflective Thinking

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8) In the IS curve, if Y falls for any given level of the real interest rate ________. A) consumption increases B) output increases C) saving increases D) all of the above E) none of the above Answer: E Topic: 9.2 Goods Market Equilibrium AACSB: Reflective Thinking 9) In the IS curve, a cut in taxes ________. A) causes planned expenditures and hence equilibrium output to rise when the interest rate increases B) causes planned expenditures and hence equilibrium output to fall when the interest rate increases C) causes the equilibrium interest rates to fall D) all of the above E) none of the above Answer: E Topic: 9.2 Goods Market Equilibrium AACSB: Reflective Thinking 10) The reason for the downward-sloping IS curve is that ________. A) lower interest rates lead to lower saving and lower output B) lower interest rates lead to lower saving and higher output C) higher interest rates lead to lower saving and higher output D) all of the above E) none of the above Answer: B Topic: 9.2 Goods Market Equilibrium AACSB: Reflective Thinking 11) The reason for the downward-sloping IS curve is that ________. A) lower interest rates lead to higher saving and higher output B) higher interest rates lead to higher saving and lower output C) higher interest rates lead to lower saving and higher output D) all of the above E) none of the above Answer: B Topic: 9.2 Goods Market Equilibrium AACSB: Reflective Thinking

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IS Curve Exogenous Variables and Parameters Table 1 =2

mpc = 0.75

=3

c = 0.05

= 1.45

d = 0.3

= 1.6

x = 0.15

=1 12) Given the values in the table above, the IS curve is ________. A) Y = 34.6 - 2r B) Y = 8.65 - 2r C) Y = 25 - 2r D) Y = 8.33 - 0.67r E) none of the above Answer: C Topic: 9.2 Goods Market Equilibrium AACSB: Analytical Skills 13) Given the values in the table above, equilibrium output Y = ________ when the real interest rate r = 4. A) 26.6 B) 0.65 C) 17 D) 5.65 E) none of the above Answer: C Topic: 9.2 Goods Market Equilibrium AACSB: Analytical Skills 14) Given the values in the table above, the real interest rate r = ________ when equilibrium output Y = 15. A) 9.8 B) 5 C) 3.18 D) 10 E) none of the above Answer: B Topic: 9.2 Goods Market Equilibrium AACSB: Analytical Skills

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15) Given the values in the table above, consumption is ________ when equilibrium output is 15. A) 12.3 B) 11.8 C) 12.05 D) 11.55 E) none of the above Answer: B Topic: 9.2 Goods Market Equilibrium AACSB: Analytical Skills 16) Given the values in the table above, if the real interest rate rises from 5 to 6, the change in household saving is ________. A) negative 0.5 B) negative 1.55 C) negative 0.45 D) 1.55 E) none of the above Answer: C Topic: 9.2 Goods Market Equilibrium AACSB: Analytical Skills IS Graph 1

17) On the graph above, output is above planned expenditures at point ________. A) A B) B C) G D) H E) none of the above Answer: C Topic: 9.2 Goods Market Equilibrium AACSB: Analytical Skills 10 Copyright © 2012 Pearson Education, Inc.

18) On the graph above, assuming that G = 0 and NX = 0, saving is above planned investment at point ________. A) A B) B C) G D) H E) none of the above Answer: C Topic: 9.2 Goods Market Equilibrium AACSB: Analytical Skills 19) On the graph above, unplanned inventory investment is negative at point ________. A) A B) B C) G D) H E) none of the above Answer: D Topic: 9.2 Goods Market Equilibrium AACSB: Analytical Skills 20) On the graph above, the labeled point at which investment -- planned plus unplanned -- is highest is point ________. A) A B) B C) G D) H E) not inferable from the information given Answer: B Topic: 9.2 Goods Market Equilibrium AACSB: Analytical Skills 21) On the graph above, assuming that G = 0 and NX = 0, the labeled point at which saving is lowest is point ________. A) A B) B C) G D) H E) not inferable from the information given Answer: E Topic: 9.2 Goods Market Equilibrium AACSB: Analytical Skills

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22) If planned expenditure is below output, as the economy approaches equilibrium, ________. A) planned expenditure is falling B) output is rising C) saving is rising D) all of the above E) none of the above Answer: A Topic: 9.2 Goods Market Equilibrium AACSB: Analytical Skills 23) If planned expenditure is below output, as the economy approaches equilibrium, ________. A) planned expenditure is rising B) output is rising C) saving is rising D) all of the above E) none of the above Answer: E Topic: 9.2 Goods Market Equilibrium AACSB: Analytical Skills IS Curve Exogenous Variables and Parameters Table 2 =3

mpc = 0.6

=5

c = 0.08

=2

d = 0.4

=2

x = 0.1

=1 24) Using the values in the table above, and assuming that the real interest rate equals 4, calculate equilibrium values for consumption, household saving, investment, and net exports. Use these values to confirm that the goods market is in equilibrium. Answer: Entering the given values in the IS curve equation yields Y = 18.7. Plugging Y and r into the consumption equation yields C = 12.7. Subtracting C + T from Y gives household saving = 4. The investment equation using these values of Y and r yields I = 3.4. The net exports equation yields NX = 0.6. Note that S = NX + I - (G - T), so the goods market is in equilibrium. Also, Y = C + I + G + NX, so the goods market is in equilibrium. Topic: 9.2 Goods Market Equilibrium AACSB: Analytical Skills

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25) In the text, the equivalence of the goods market equilibrium in the IS model to the equilibrium in which desired investment equals desired saving is demonstrated, assuming that both government purchases and net exports are zero. Demonstrate the equivalence when both G and NX are non-zero. Answer: In terms of output and expenditures, the equilibrium condition is Y = C + I + G + NX. Rearranging terms, Y - C - G = I + NX. For households, saving is Y - T - C. Government saving is T - G. National saving S = Y - T - C + T - G = Y - C - G. Substituting into the equilibrium equation, S = I + NX. Now, the combined saving by households and the government may be greater or less than investment, with the difference made up by a capital outflow (NX > 0) or capital inflow (NX < 0), respectively. Topic: 9.2 Goods Market Equilibrium AACSB: Analytical Skills 9.4 Understanding the IS Curve 1) There are no questions for this section. Answer: 9.5 Factors that Shift the IS Curve 1) The IS curve ________ when the real interest rate increases. A) shifts to the right B) shifts to the left C) shifts up D) all of the above E) none of the above Answer: E Topic: 9.3 Factors that shift the IS Curve AACSB: Analytical Skills 2) The IS curve ________. A) shifts to the right when autonomous consumption increases B) shifts up when the real interest rate increases C) shifts to the left when autonomous investment increases D) all of the above E) none of the above Answer: A Topic: 9.3 Factors that shift the IS Curve AACSB: Reflective Thinking

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3) The IS curve shifts to the left when ________. A) autonomous consumption increases B) taxes increase C) autonomous investment increases D) all of the above E) none of the above Answer: B Topic: 9.3 Factors that shift the IS Curve AACSB: Reflective Thinking 4) The IS curve shifts to the left when ________. A) autonomous consumption increases B) taxes decrease C) autonomous investment decreases D) all of the above E) none of the above Answer: C Topic: 9.3 Factors that shift the IS Curve AACSB: Reflective Thinking 5) The IS curve shifts to the right when ________. A) autonomous consumption decreases B) taxes increase C) autonomous investment increases D) all of the above E) none of the above Answer: C Topic: 9.3 Factors that shift the IS Curve AACSB: Reflective Thinking 6) If the government increases military spending ________. A) the IS curve would shift to the left B) output will decrease if interest rates remain fixed C) the unemployment rate could fall D) all of the above E) none of the above Answer: C Topic: 9.3 Factors that shift the IS Curve AACSB: Reflective Thinking

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7) If the government reduces spending ________. A) the IS curve will shift to the right B) output will increase if interest rates remain fixed C) consumption will increase D) all of the above E) none of the above Answer: E Topic: 9.3 Factors that shift the IS Curve AACSB: Reflective Thinking 8) If the government raises taxes ________. A) planned expenditures fall B) equilibrium output falls C) the IS curve shifts to the left D) all of the above E) none of the above Answer: D Topic: 9.3 Factors that shift the IS Curve AACSB: Reflective Thinking 9) If the government cuts taxes ________. A) disposable income falls B) planned expenditures rise C) the IS curve shifts to the left D) all of the above E) none of the above Answer: B Topic: 9.3 Factors that shift the IS Curve AACSB: Reflective Thinking 10) The 2009 fiscal stimulus package was passed ________. A) to prevent the real interest rate from rising B) to shift the IS curve to the left C) to raise aggregate output at any interest rate D) all of the above E) none of the above Answer: C Topic: 9.3 Factors that shift the IS Curve AACSB: Reflective Thinking

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11) The 2009 fiscal stimulus package did not work ________. A) in that the IS curve did not shift to the right B) because most of the intended increase in government spending took too long to kick in C) because the increase in government spending was not enough to offset the decline in autonomous expenditure D) all of the above E) none of the above Answer: D Topic: 9.3 Factors that shift the IS Curve AACSB: Reflective Thinking 12) The 2009 fiscal stimulus package did not work ________. A) because rising interest rates nullified increased expenditures B) because government spending rose too quickly and too briefly C) but it probably prevented the IS curve from shifting further to the left D) all of the above E) none of the above Answer: C Topic: 9.3 Factors that shift the IS Curve AACSB: Reflective Thinking 13) Qualitatively, an increase in government purchases has the same impact as an increase in autonomous ________. A) consumption B) investment C) net exports D) all of the above E) none of the above Answer: D Topic: 9.3 Factors that shift the IS Curve AACSB: Reflective Thinking 14) In the IS model, assuming that the real interest rate does not change, an increase in autonomous ________ leads to an increase in the equilibrium level of ________. A) investment; consumption B) consumption; investment C) net exports; investment D) all of the above E) none of the above Answer: A Topic: 9.3 Factors that shift the IS Curve

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15) In the IS model, assuming that the real interest rate does not change, an increase in autonomous ________ leads to an increase in the equilibrium level of ________. A) investment; net exports B) consumption; government purchases C) net exports; taxes D) all of the above E) none of the above Answer: E Topic: 9.3 Factors that shift the IS Curve 16) In the IS model, assuming that the real interest rate does not change, an increase in autonomous net exports causes total investment, planned plus unplanned, to ________. A) fall, then rise back to its initial level B) fall, then rise above its initial level C) rise, then fall back to its initial level D) all of the above E) none of the above Answer: A Topic: 9.3 Factors that shift the IS Curve 17) In the IS model, assuming that the real interest rate does not change, an increase in ________ leads to an increase in equilibrium saving by households. A) autonomous investment B) government purchases C) autonomous net exports D) all of the above E) none of the above Answer: D Topic: 9.3 Factors that shift the IS Curve 18) In the IS model, assuming that the real interest rate does not change, an increase in ________ leads to an increase in equilibrium saving by households. A) autonomous consumption B) taxes C) the price level D) all of the above E) none of the above Answer: E Topic: 9.3 Factors that shift the IS Curve

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19) In the IS model, assuming that the real interest rate does not change, an increase in autonomous ________ leads to a decrease in equilibrium saving. A) investment B) consumption C) net exports D) all of the above E) none of the above Answer: E Topic: 9.3 Factors that shift the IS Curve 20) An increase in autonomous consumption ________. A) lowers planned expenditures B) raises equilibrium output for any level of the interest rate C) causes a movement down along the IS curve D) all of the above E) none of the above Answer: B Topic: 9.3 Factors that shift the IS Curve AACSB: Reflective Thinking 21) A decrease in autonomous consumption ________. A) lowers planned expenditures B) raises equilibrium output for any level of the interest rate C) causes a movement down along the IS curve D) all of the above E) none of the above Answer: A Topic: 9.3 Factors that shift the IS Curve AACSB: Reflective Thinking 22) A decrease in autonomous consumption ________. A) raises planned expenditures B) lowers equilibrium output for any level of the interest rate C) shifts the IS curve to the right D) all of the above E) none of the above Answer: B Topic: 9.3 Factors that shift the IS Curve AACSB: Reflective Thinking

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23) An increase in autonomous investment ________. A) increases equilibrium output at any interest rate B) causes a movement down along the IS curve C) shifts the IS curve to the left D) all of the above E) none of the above Answer: A Topic: 9.3 Factors that shift the IS Curve AACSB: Reflective Thinking 24) A decrease in autonomous investment ________. A) increases equilibrium output at any interest rate B) causes a movement down along the IS curve C) shifts the IS curve to the left D) all of the above E) none of the above Answer: C Topic: 9.3 Factors that shift the IS Curve AACSB: Reflective Thinking 25) A decrease in autonomous investment ________. A) decreases equilibrium output at any interest rate B) lowers planned expenditures C) shifts the IS curve to the left D) all of the above E) none of the above Answer: D Topic: 9.3 Factors that shift the IS Curve AACSB: Reflective Thinking 26) If people feel optimistic about the future of the economy ________. A) autonomous consumption might increase B) autonomous investment might increase C) it might shift the IS curve to the right D) all of the above E) none of the above Answer: D Topic: 9.3 Factors that shift the IS Curve AACSB: Reflective Thinking

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27) In a stock market boom ________. A) autonomous consumption might increase because stock holders might feel richer and consume more B) autonomous investment might increase because a higher stock value for a firm helps firms raise funds for increased investment C) the IS curve might shift to the right D) all of the above E) none of the above Answer: D Topic: 9.3 Factors that shift the IS Curve AACSB: Reflective Thinking 28) In a stock market boom ________. A) government spending will decrease B) interest rates will decrease C) saving is likely to decrease D) all of the above E) none of the above Answer: E Topic: 9.3 Factors that shift the IS Curve AACSB: Reflective Thinking

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IS Graph 2

29) On the graph above, a possible cause of the rightward shift of the IS curve is an increase in ________. A) foreign demand for domestic goods B) taxes C) domestic demand for foreign goods D) the exchange rate E) none of the above Answer: A Topic: 9.3 Factors that shift the IS Curve AACSB: Analytical Skills 30) On the graph above, unplanned inventory investment occurs if the economy is moving from point ________ to point ________. A) D; C B) C; B C) B; A D) all of the above E) none of the above Answer: D Topic: 9.3 Factors that shift the IS Curve AACSB: Analytical Skills

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31) On the graph above, the amount of inventory depletion will be greatest if the economy is moving from point ________ to point ________. A) A; D B) D; A C) D; C D) B; A E) B; C Answer: A Topic: 9.3 Factors that shift the IS Curve AACSB: Analytical Skills 32) On the graph above, if the economy is at point A when the real interest rate falls, the economy's new situation might be indicated by point ________. A) A B) B C) C D) D E) none of the above Answer: B Topic: 9.3 Factors that shift the IS Curve AACSB: Analytical Skills 33) On the graph above, if the U.S. economy is at point B in 2009, then the economy in 2010 is best represented by point ________. A) A B) B C) C D) D E) any of the labeled points is as good as the others Answer: B Topic: 9.3 Factors that shift the IS Curve AACSB: Reflective Thinking

34) Referring to the graph above, assume that the economy is in equilibrium at point A, then an 22 Copyright © 2012 Pearson Education, Inc.

increase in government purchases shifts the IS curve to the right, while the real interest rate remains constant. Explain, step-by-step, how the components of expenditure adjust to bring the economy to its new equilibrium. Answer: The increase in G causes negative unplanned inventory investment, so firms respond by increasing output. As output rises, consumption rises, so inventories continue to shrink and output continues to rise. The increase in consumption is always a fraction of the increase in output, because the marginal propensity to consume is less than one. The increase in consumption, the decline in inventories, and the increase in output all converge to zero as the economy approaches its new equilibrium at point C. Topic: 9.3 Factors that shift the IS Curve AACSB: Reflective Thinking 35) Assume that households decide to save more, so autonomous consumption is reduced. Explain, step-by-step, how the components of expenditure adjust to bring the economy to its new equilibrium. Using the IS curve equation and the consumption function, compare the initial and new equilibria with respect to saving and the real interest rate. Answer: Consumption is reduced, so there is unplanned inventory investment that signals firms to reduce output. Declining output causes consumption to decline further; unplanned inventory investment continues and output continues to fall. The decline in consumption is continually shrinking, since households respond to reductions in disposable income by reducing saving, as well as reducing consumption (the marginal propensity to consume is less than one). When the decrease in consumption converges to zero, inventories stop rising and output stops falling. The decline in output △Y =

. The change in consumption △C = △ + mpc ×  Y  - c × △r.

Substituting the first of these equations into the second, simplifying, then substituting with the first equation again, reveals that △C = △Y - c × △r. If the real interest rate does not change, then saving in the new equilibrium equals the original saving in the old equilibrium (since output has fallen by the same amount as consumption). And, if saving has not changed, then neither has the real interest rate changed. Topic: 9.3 Factors that shift the IS Curve AACSB: Reflective Thinking 36) Assume that the economy is in equilibrium when the real interest rate rises. Explain, step-bystep, how the components of expenditure adjust to bring the economy to its new equilibrium. Answer: An increase in the real interest rate reduces consumption, investment, and net exports. Reduced expenditures cause an unplanned inventory adjustment to which firms respond by reducing output. The economy is moving to the left along the IS curve. The slope of the IS curve reflects the further output declines that occur as consumption falls in response to declining output, until the change in consumption has converged to zero (the marginal propensity to consume is less than one). Topic: 9.3 Factors that shift the IS Curve AACSB: Reflective Thinking

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37) The IS model implies that a dollar of government spending has a larger impact on equilibrium output than does a dollar of taxes. Explain. Answer: In the IS equation, government purchases are a component of autonomous spending, no different than autonomous consumption, investment, and net exports. From the perspective of producers, a customer is a customer. Taxes, clearly, are not an expenditure. Taxes affect expenditure by reducing disposable income and, thus, consumption. Since only a fraction of disposable income is spent for consumption -- a fraction measured as the marginal propensity to consume -- each dollar of taxes corresponds to a fraction of a dollar taken from consumption expenditure. Topic: 9.3 Factors that shift the IS Curve AACSB: Reflective Thinking 38) For simplicity, the IS model assumes that neither net exports nor net taxes vary with income. A more realistic (and complicated) model would drop such assumptions. How would the behavior of the IS curve differ in the more realistic model? Answer: In a more realistic model, increases in income would result in both more imports being purchased and more taxes being paid. The purchase of imports instead of domestic output lessens the impact of expenditure changes on inventories and, thus, on equilibrium output. Shifts of the IS curve in response to changes in autonomous spending would be smaller. Taxes that rise with income reduce the size of changes in consumption spending in response to output changes, so again shifts of the IS curve are smaller. Changes in the real interest rate change expenditures, but the effect on output is reduced to the extent that imports and taxes are changing, so the more realistic IS curve is steeper than the curve in the text. Topic: 9.3 Factors that shift the IS Curve AACSB: Reflective Thinking

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