#### Transcript Mankiw 5/e Chapter 1: The Science of Macroeconomics

macro Macroeconomics of Business Cycles Growth rates of real GDP, consumption Percent change from 4 quarters earlier 10 Real GDP growth rate 8 Consumption growth rate 6 Average growth rate 4 2 0 -2 -4 1970 1975 1980 1985 1990 1995 2000 2005 2010 Growth rates of real GDP, consumption, investment Percent change from 4 quarters earlier Investment growth rate 40 30 20 Real GDP growth rate 10 0 Consumption growth rate -10 -20 -30 1970 1975 1980 1985 1990 1995 2000 2005 2010 Unemployment Percent of labor force 12 10 8 6 4 2 0 1970 1975 1980 1985 1990 1995 2000 2005 2010 Okun’s Law Percentage 10 change in real GDP 8 Y 1966 1951 3 2 u Y 1984 6 2003 4 1971 1987 2008 2 0 1975 2001 -2 1991 1982 -4 -3 -2 -1 0 1 2 Change in unemployment rate 3 4 Facts about the business cycle GDP growth averages about 3 percent per year over the long run with large fluctuations in the short run. Consumption and investment fluctuate with GDP, but consumption tends to be less volatile and investment more volatile than GDP. Unemployment rises during recessions and falls during expansions. Okun’s Law: the negative relationship between GDP and unemployment. Index of Leading Economic Indicators Published monthly by the Conference Board. Aims to forecast changes in economic activity 6-9 months into the future. Used in planning by businesses and govt, despite not being a perfect predictor. Components of the LEI index Average workweek in manufacturing Initial weekly claims for unemployment insurance New orders for consumer goods and materials New orders, nondefense capital goods Vendor performance New building permits issued Index of stock prices M2 Yield spread (10-year minus 3-month) on Treasuries Index of consumer expectations Index of Leading Economic Indicators 120 110 2004 = 100 100 90 80 70 60 50 40 Source: 30 Conference 1970 Board 1975 1980 1985 1990 1995 2000 2005 2010 Time horizons in macroeconomics Long run Prices are flexible, respond to changes in supply or demand. Short run Many prices are “sticky” at a predetermined level. The economy behaves much differently when prices are sticky. AD/AS Model The paradigm most mainstream economists and policymakers use to think about economic fluctuations and policies to stabilize the economy Shows how the price level and aggregate output are determined Shows how the economy’s behavior is different in the short run and long run Aggregate demand We use a simple theory of AD based on the quantity theory of money. Recall the quantity equation MV = PY For given values of M and V, this equation implies an inverse relationship between P and Y : Y = (M V) / P The downward-sloping AD curve An increase in the price level causes a fall in real money balances (M/P ), P causing a decrease in the demand for goods & services. AD Y Shifting the AD curve P An increase in the money supply shifts the AD curve to the right. AD2 AD1 Y Aggregate supply in the long run Recall from Chapter 3: In the long run, output is determined by factor supplies and technology Y F (K , L ) Y is the full-employment or natural level of output, at which the economy’s resources are fully employed. “Full employment” means that unemployment equals its natural rate (not zero). The long-run aggregate supply curve P LRAS Y does not depend on P, so LRAS is vertical. Y F (K , L ) Y Long-run effects of an increase in M P In the long run, this raises the price level… LRAS P2 An increase in M shifts AD to the right. P1 AD2 AD1 …but leaves output the same. Y Y The short-run aggregate supply curve P The SRAS curve is horizontal: The price level is fixed at a predetermined level, and firms sell as much as buyers demand. P SRAS Y Short-run effects of an increase in M P In the short run when prices are sticky,… …an increase in aggregate demand… SRAS AD2 AD1 P …causes output to rise. Y1 Y2 Y From the short run to the long run Over time, prices gradually become “unstuck.” When they do, will they rise or fall? In the short-run equilibrium, if then over time, P will… Y Y rise Y Y fall Y Y remain constant The adjustment of prices is what moves the economy to its long-run equilibrium. The SR & LR effects of M > 0 P A = initial equilibrium B = new shortrun eq’m after Fed increases M C = long-run equilibrium LRAS C P2 P B A Y Y2 SRAS AD2 AD1 Y The effects of a negative demand shock AD shifts left, P depressing output and employment in the short run. Over time, prices fall and the economy moves down its demand curve toward fullemployment. P LRAS B P2 A SRAS C AD1 AD2 Y2 Y Y Supply shocks A supply shock alters production costs, affects the prices that firms charge (also called price shocks) Examples of adverse supply shocks: – Bad weather reduces crop yields, pushing up food prices – Workers unionize, negotiate wage increases – New environmental regulations require firms to reduce emissions Favorable supply shocks lower costs and prices CASE STUDY: The 1970s oil shocks Early 1970s: OPEC coordinates a reduction in the supply of oil Oil prices rose 11% in 1973 68% in 1974 16% in 1975 CASE STUDY: The 1970s oil shocks The oil price shock shifts SRAS up, causing output and employment to fall. In absence of further price shocks, prices will fall over time and economy moves back toward full employment. P P2 LRAS B SRAS2 A P1 SRAS1 AD Y2 Y Y CASE STUDY: The 1970s oil shocks 70% Predicted effects of the oil shock: • inflation • output • unemployment …and then a gradual recovery. 12% 60% 50% 10% 40% 8% 30% 20% 6% 10% 0% 1973 1974 1975 1976 Change in oil prices (left scale) Inflation rate-CPI (right scale) Unemployment rate (right scale) 4% 1977 CASE STUDY: The 1970s oil shocks 60% Late 1970s: As economy was recovering, oil prices shot up again, causing another huge supply shock!!! 14% 50% 12% 40% 10% 30% 8% 20% 6% 10% 0% 1977 4% 1978 1979 1980 Change in oil prices (left scale) Inflation rate-CPI (right scale) Unemployment rate (right scale) 1981 CASE STUDY: The 1980s oil shocks 1980s: A favorable supply shock-a significant fall in oil prices. As the model predicts, inflation and unemployment fell: 40% 10% 30% 8% 20% 10% 6% 0% -10% 4% -20% -30% 2% -40% -50% 1982 0% 1983 1984 1985 1986 Change in oil prices (left scale) Inflation rate-CPI (right scale) Unemployment rate (right scale) 1987 Stabilization policy def: policy actions aimed at reducing the severity of short-run economic fluctuations. Example: Using monetary policy to combat the effects of adverse supply shocks… Stabilizing output with monetary policy P The adverse supply shock moves the economy to point B. P2 LRAS B SRAS2 A P1 SRAS1 AD1 Y2 Y Y Stabilizing output with monetary policy But the Fed accommodates the shock by raising agg. demand. results: P is permanently higher, but Y remains at its fullemployment level. P P2 LRAS B C SRAS2 A P1 AD1 Y2 Y AD2 Y Aggregate Demand I: The IS-LM Model The IS-LM model determines income and the interest rate in the short run when P is fixed The Big Picture Keynesian Cross Theory of Liquidity Preference IS curve LM curve IS-LM model Agg. demand curve Agg. supply curve Explanation of short-run fluctuations Model of Agg. Demand and Agg. Supply The Keynesian Cross A simple closed economy model in which income is determined by expenditure. Notation: I = planned investment PE = C + I + G = planned expenditure Y = real GDP = actual expenditure Difference between actual & planned expenditure = unplanned inventory investment Elements of the Keynesian Cross C C (Y T ) consumption function: G G , govt policy variables: for now, planned investment is exogenous: planned expenditure: T T I I P E C (Y T ) I G equilibrium condition: actual expenditure = planned expenditure Y PE The equilibrium value of income PE PE =Y planned expenditure PE =C +I +G income, output, Y Equilibrium income An increase in government purchases PE At Y1, there is now an unplanned drop in inventory… PE =C +I +G2 PE =C +I +G1 G …so firms increase output, and income rises toward a new equilibrium. Y PE1 = Y1 Y PE2 = Y2 Solving for Y Y C I G Y C I G C G MPC Y G Collect terms with Y on the left side of the equals sign: (1 M P C ) Y G equilibrium condition in changes because I exogenous because C = MPC Y Solve for Y : 1 Y G 1 MPC The government purchases multiplier Definition: the increase in income resulting from a $1 increase in G. In this model, the govt purchases multiplier equals Y G 1 1 MPC Example: If MPC = 0.8, then Y G 1 1 0 .8 5 An increase in G causes income to increase 5 times as much! Why the multiplier is greater than 1 Initially, the increase in G causes an equal increase in Y: Y = G. But Y C further Y further C further Y So the final impact on income is much bigger than the initial G. An increase in taxes PE Initially, the tax increase reduces consumption, and therefore PE: PE =C1 +I +G PE =C2 +I +G At Y1, there is now an unplanned inventory buildup… C = MPC T …so firms reduce output, and income falls toward a new equilibrium Y PE2 = Y2 Y PE1 = Y1 Solving for Y eq’m condition in changes Y C I G I and G exogenous C M PC Y T Solving for Y : Final result: (1 M P C ) Y M PC T MPC Y T 1 MPC The tax multiplier def: the change in income resulting from a $1 increase in T : Y T MPC 1 MPC If MPC = 0.8, then the tax multiplier equals Y T 0 .8 1 0 .8 0 .8 0 .2 4 The IS curve def: a graph of all combinations of r and Y that result in goods market equilibrium i.e. actual output = planned expenditure The equation for the IS curve is: Y C (Y T ) I ( r ) G J.R. Hicks Deriving the IS curve PE =Y PE =C +I (r )+G 2 PE PE =C +I (r1 )+G r I PE Y I r Y1 Y Y2 r1 r2 IS Y1 Y2 Y Shifting the IS curve: G At any value of r, PE =Y PE =C +I (r )+G 1 2 PE PE =C +I (r1 )+G1 G PE Y …so the IS curve shifts to the right. The horizontal distance of the IS shift equals Y 1 1 M P C r Y1 Y Y2 r1 Y G Y1 IS1 Y2 IS2 Y The Theory of Liquidity Preference Due to John Maynard Keynes A simple theory in which the interest rate is determined by money supply and money demand Money supply The supply of real money balances is fixed: M P s r interest rate M P s M P M P M/P real money balances Money demand Demand for real money balances: M P d r interest rate M P s L (r ) L (r ) M P M/P real money balances Equilibrium The interest rate adjusts to equate the supply and demand for money: M P r interest rate M P s r1 L (r ) L (r ) M P M/P real money balances How the Fed raises the interest rate r To increase r, Fed reduces M interest rate r2 r1 L (r ) M P 2 M1 P M/P real money balances The LM curve Now let’s put Y back into the money demand function: d M P L (r ,Y ) The LM curve is a graph of all combinations of r and Y that equate the supply and demand for real money balances. The equation for the LM curve is: M P L ( r ,Y ) Deriving the LM curve (a) The market for r real money balances (b) The LM curve r LM r2 r2 L (r , Y2 ) r1 r1 L (r , Y1 ) M1 P M/P Y1 Y2 Y How M shifts the LM curve (a) The market for r real money balances (b) The LM curve r LM2 LM1 r2 r2 r1 r1 L ( r , Y1 ) M P 2 M1 P M/P Y1 Y The short-run equilibrium The short-run equilibrium is the combination of r and Y that simultaneously satisfies the equilibrium conditions in the goods & money markets: Y C (Y T ) I ( r ) G r LM IS Y M P L ( r ,Y ) Equilibrium interest rate Equilibrium level of income Policy analysis with the IS -LM model Y C (Y T ) I ( r ) G r LM M P L ( r ,Y ) We can use the IS-LM model to analyze the effects of • fiscal policy: G and/or T • monetary policy: M r1 IS Y1 Y An increase in government purchases 1. IS curve shifts right by 1 1 M P C r causing output & income to rise. 2. This raises money demand, causing the interest rate to rise… 2. r2 r1 1 1 M P C IS2 1. IS1 3. …which reduces investment, so the final increase in Y is sm a lle r th a n LM G G Y1 Y2 3. Y A tax cut Consumers save r (1MPC) of the tax cut, so the initial boost in spending is smaller for T r2 than for an equal G… 2. r1 and the IS curve shifts by 1. M P C 1 M P C LM 1. T 2. …so the effects on r and Y are smaller for T than for an equal G. IS2 IS1 Y1 Y2 2. Y Monetary policy: An increase in M 1. M > 0 shifts the LM curve down (or to the right) 2. …causing the interest rate to fall 3. …which increases investment, causing output & income to rise. r LM1 LM2 r1 r2 IS Y1 Y2 Y The Fed’s response to G > 0 Suppose Congress increases G. Possible Fed responses: 1. hold M constant 2. hold r constant 3. hold Y constant In each case, the effects of the G are different… Response 1: Hold M constant If Congress raises G, the IS curve shifts right. r If Fed holds M constant, then LM curve doesn’t shift. r2 r1 LM1 IS2 IS1 Results: Y Y 2 Y 1 r r 2 r1 Y1 Y2 Y Response 2: Hold r constant If Congress raises G, the IS curve shifts right. To keep r constant, Fed increases M to shift LM curve right. r LM1 r2 r1 IS2 IS1 Results: Y Y 3 Y 1 r 0 LM2 Y1 Y2 Y3 Y Response 3: Hold Y constant If Congress raises G, the IS curve shifts right. To keep Y constant, Fed reduces M to shift LM curve left. LM2 LM1 r r3 r2 r1 IS2 IS1 Results: Y 0 r r 3 r1 Y1 Y2 Y Estimates of fiscal policy multipliers from the DRI macroeconometric model Assumption about monetary policy Estimated value of Y / G Estimated value of Y / T Fed holds money supply constant 0.60 0.26 Fed holds nominal interest rate constant 1.93 1.19 Romer & Bernstein (2009) 1.55 0.90 Barro & Redlick (2010) 0.90 1.10 Shocks in the IS -LM model IS shocks: exogenous changes in the demand for goods & services. Examples: – stock market boom or crash change in households’ wealth C – change in business or consumer confidence or expectations I and/or C Shocks in the IS -LM model LM shocks: exogenous changes in the demand for money. Examples: – a wave of credit card fraud increases demand for money. – more ATMs or the Internet reduce money demand. CASE STUDY: The U.S. recession of 2001 During 2001, – 2.1 million jobs lost, unemployment rose from 3.9% to 5.8%. – GDP growth slowed to 0.8% (compared to 3.9% average annual growth during 1994-2000). CASE STUDY: The U.S. recession of 2001 Index (1942 = 100) Causes: 1) Stock market decline C 1500 S&P 500 1200 900 600 300 1995 1996 1997 1998 1999 2000 2001 2002 2003 CASE STUDY: The U.S. recession of 2001 Causes: 2) 9/11 – increased uncertainty – fall in consumer & business confidence – result: lower spending, IS curve shifted left Causes: 3) Corporate accounting scandals – Enron, WorldCom, etc. – reduced stock prices, discouraged investment CASE STUDY: The U.S. recession of 2001 Fiscal policy response: shifted IS curve right – tax cuts in 2001 and 2003 – spending increases • airline industry bailout • NYC reconstruction • Afghanistan war CASE STUDY: The U.S. recession of 2001 Monetary policy response: shifted LM curve right 7 6 5 4 3 2 1 0 Three-month T-Bill Rate Deriving the AD curve r Intuition for slope of AD curve: P (M/P ) LM shifts left r I Y LM(P2) LM(P1) r2 r1 IS P Y2 Y1 Y P2 P1 AD Y2 Y1 Y Monetary policy and the AD curve The Fed can increase aggregate demand: M LM shifts right r LM(M1/P1) LM(M2/P1) r1 r2 IS r I P Y at each value of P P1 Y1 Y1 Y2 Y2 Y AD2 AD1 Y Fiscal policy and the AD curve Expansionary fiscal policy (G and/or T ) increases agg. demand: r LM r2 r1 IS2 T C IS1 IS shifts right P Y at each value of P P1 Y1 Y1 Y2 Y2 Y AD2 AD1 Y IS-LM and AD-AS in the short run & long run Recall from Chapter 9: The force that moves the economy from the short run to the long run is the gradual adjustment of prices. In the short-run equilibrium, if then over time, the price level will Y Y rise Y Y fall Y Y remain constant The SR and LR effects of an IS shock r LRAS LM(P ) 1 A negative IS shock shifts IS and AD left, causing Y to fall. IS2 Y P IS1 Y LRAS P1 SRAS1 Y AD1 AD2 Y The SR and LR effects of an IS shock r LRAS LM(P ) 1 In the new short-run equilibrium, Y Y IS2 Y P IS1 Y LRAS P1 SRAS1 Y AD1 AD2 Y The SR and LR effects of an IS shock r LRAS LM(P ) 1 In the new short-run equilibrium, Y Y IS2 Over time, P gradually falls, causing • SRAS to move down • M/P to increase, Y P IS1 Y LRAS P1 SRAS1 which causes LM to move down Y AD1 AD2 Y The SR and LR effects of an IS shock r LRAS LM(P ) 1 LM(P2) IS2 Over time, P gradually falls, causing • SRAS to move down • M/P to increase, Y P IS1 Y LRAS P1 SRAS1 P2 SRAS2 which causes LM to move down Y AD1 AD2 Y The SR and LR effects of an IS shock r LRAS LM(P ) 1 LM(P2) This process continues until economy reaches a long-run equilibrium with Y Y IS2 Y P IS1 Y LRAS P1 SRAS1 P2 SRAS2 Y AD1 AD2 Y NOW YOU TRY: Analyze SR & LR effects of M a. Draw the IS-LM and AD-AS r diagrams as shown here. LRAS LM(M /P ) 1 1 b. Suppose Fed increases M. Show the short-run effects on your graphs. IS c. Show what happens in the transition from the short run to the long run. d. How do the new long-run equilibrium values of the endogenous variables compare to their initial values? Y P Y LRAS P1 SRAS1 AD1 Y Y The Great Depression 30 Unemployment (right scale) 220 25 200 20 180 15 160 10 Real GNP (left scale) 140 120 1929 5 0 1931 1933 1935 1937 1939 percent of labor force billions of 1958 dollars 240 THE SPENDING HYPOTHESIS: Shocks to the IS curve asserts that the Depression was largely due to an exogenous fall in the demand for goods & services – a leftward shift of the IS curve. evidence: output and interest rates both fell, which is what a leftward IS shift would cause. THE SPENDING HYPOTHESIS: Reasons for the IS shift Stock market crash exogenous C – Oct-Dec 1929: S&P 500 fell 17% – Oct 1929-Dec 1933: S&P 500 fell 71% Drop in investment – “correction” after overbuilding in the 1920s – widespread bank failures made it harder to obtain financing for investment Contractionary fiscal policy – Politicians raised tax rates and cut spending to combat increasing deficits. THE MONEY HYPOTHESIS: A shock to the LM curve asserts that the Depression was largely due to huge fall in the money supply. evidence: M1 fell 25% during 1929-33. But, two problems with this hypothesis: – P fell even more, so M/P actually rose slightly during 1929-31. – nominal interest rates fell, which is the opposite of what a leftward LM shift would cause. THE MONEY HYPOTHESIS AGAIN: The effects of falling prices asserts that the severity of the Depression was due to a huge deflation: P fell 25% during 1929-33. This deflation was probably caused by the fall in M, so perhaps money played an important role after all. In what ways does a deflation affect the economy? THE MONEY HYPOTHESIS AGAIN: The effects of falling prices The stabilizing effects of deflation: P (M/P ) LM shifts right Y Pigou effect: P (M/P ) consumers’ wealth C IS shifts right Y THE MONEY HYPOTHESIS AGAIN: The effects of falling prices The destabilizing effects of expected deflation: E r for each value of i I because I = I (r ) planned expenditure & agg. demand income & output THE MONEY HYPOTHESIS AGAIN: The effects of falling prices The destabilizing effects of unexpected deflation: debt-deflation theory P (if unexpected) transfers purchasing power from borrowers to lenders borrowers spend less, lenders spend more if borrowers’ propensity to spend is larger than lenders’, then aggregate spending falls, the IS curve shifts left, and Y falls Why another Depression is unlikely Policymakers (or their advisors) now know much more about macroeconomics Federal deposit insurance makes widespread bank failures very unlikely. Automatic stabilizers make fiscal policy expansionary during an economic downturn. The Great Recession 2008-2009 NBER: December 2007 to June 2009 – Real GDP fell by 4%, u-rate hit 10.6% Important factors in the crisis: Interest rates and house prices 9 8 170 interest rate (%) 7 6 150 5 130 4 110 3 90 2 70 1 0 2000 2001 2002 2003 2004 50 2005 House price index, 2000=100 Federal Funds rate 30-year mortgage rate 190 Case-Shiller 20-city composite house price index Change in U.S. house price index and rate of new foreclosures, 1999-2009 14% 1.4 10% 1.2 8% 1.0 6% 0.8 4% 2% 0.6 0% 0.4 -2% 0.2 -4% -6% 1999 0.0 2001 2003 2005 2007 2009 New foreclosure starts (% of total mortgages) Percent change in house prices (from 4 quarters earlier) 12% US house price index New foreclosures House price change and new foreclosures, 2006:Q3 – 2009Q1 20% 18% Nevada Florida Illinois New foreclosures, % of all mortgages 16% 14% Michigan Ohio California Georgia 12% 10% 8% Colorado Arizona Rhode Island New Jersey Texas 6% S. Dakota Hawaii 4% Oregon Alaska 2% 0% -40% -30% -20% -10% 0% Wyoming N. Dakota 10% Cumulative change in house price index 20% U.S. bank failures by year, 2000-2010 180 Number of bank failures 160 140 120 100 80 60 40 20 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 7/20/2009 100% 11/11/2008 120% 3/5/2008 (% change from 52 weeks earlier) 6/28/2007 10/20/2006 2/11/2006 6/5/2005 9/27/2004 1/20/2004 5/14/2003 9/5/2002 12/28/2001 4/21/2001 140% 8/13/2000 12/6/1999 Major U.S. stock indexes DJIA S&P 500 NASDAQ 80% 60% 40% 20% 0% -20% -40% -60% -80% Consumer sentiment and growth in consumer durables and investment spending 110 15% 10% 100 5% 90 0% 80 -5% -10% 70 -15% Durables -20% Investment 60 UM Consumer Sentiment Index -25% 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 50 Consumer Sentiment Index, 1966=100 % change from four quarters earlier 20% Real GDP growth and Unemployment 10% 10 Real GDP growth rate (left scale) Unemployment rate (right scale) 8 6% 7 6 4% 5 2% 4 3 0% 2 -2% 1 -4% 1995 0 1997 1999 2001 2003 2005 2007 2009 % of labor force % change from 4 quaters earlier 8% 9 The Great Recession 2008-2009 NBER: December 2007 to June 2009 – Real GDP fell by 4%, u-rate hit 10.6% Important factors in the crisis: – – – – – – early 2000s Federal Reserve interest rate policy sub-prime mortgage crisis bursting of house price bubble, rising foreclosure rates falling stock prices failing financial institutions declining consumer confidence, drop in spending on consumer durables and investment goods Policy Responses to Great Recession Fiscal Policy – – – – – Economic Stimulus Act of 2008 TARP (2008) American Recovery and Reinvestment Act of 2009 Cash for Clunkers (2009) Additional UI Monetary Policy – Quantitative Easing I, II – New Credit Facilities Financial Regulation – Stress tests – Dodd-Frank (2010) International Trade Policy Clicker Review Over the business cycle, investment spending ______ consumption spending. a) is inversely correlated with b) is more volatile than c) has about the same volatility as d) is less volatile than Most economists believe that prices are: a) flexible in the short run but many are sticky in the long run. b) flexible in the long run but many are sticky in the short run. c) sticky in both the short and long runs. d) flexible in both the short and long runs. The vertical long-run aggregate supply curve satisfies the classical dichotomy because the natural rate of output does NOT depend on: a) the labor supply. b) the supply of capital. c) the money supply. d) technology. If the short-run aggregate supply curve is horizontal, then a change in the money supply will change ______ in the short run and change ______ in the long run. a) only output; only prices b) only prices; only output c) both prices and output; only prices d) both prices and output; both prices and output Assume that the economy is initially at point A with aggregate demand given by AD2. A shift in the aggregate demand curve to AD0 could be the result of either a(n) ______ in the money supply or a(n) ______ in velocity. a) increase; increase b) increase; decrease c) decrease; increase d) decrease; decrease In the IS-LM model, which two variables are influenced by the interest rate? a) supply of nominal money balances and demand for real balances b) demand for real balances and government purchases c) supply of nominal money balances and investment spending d) demand for real money balances and investment spending The equilibrium condition in the Keynesiancross analysis in a closed economy is: a) income equals consumption plus investment plus government spending. b) planned expenditure equals consumption plus planned investment plus government spending. c) actual expenditure equals planned expenditure. d) actual saving equals actual investment. In the Keynesian-cross model with a given MPC, the government-expenditure multiplier ______ the tax multiplier. a) is larger than b) equals c) is smaller than d) is the inverse of the An increase in taxes shifts the IS curve, drawn with income along the horizontal axis and the interest rate along the vertical axis: a) downward and to the left. b) upward and to the right. c) upward and to the left. d) downward and to the right. A decrease in the price level, holding nominal money supply constant, will shift the LM curve: a) upward and to the right. b) downward and to the right. c) downward and to the left. d) upward and to the left. In the Keynesian-cross analysis, if the consumption function is given by C = 100 + 0.6(Y – T), and planned investment is 100, G is 100, and T is 100, then equilibrium Y is: a) 350 b) 400 c) 600 d) 750 Based on the graph, starting from equilibrium at interest rate r1 and income Y1, a tax cut would generate the new equilibrium combination of interest rate and income: a) r2, Y2 b) r3, Y2 c) r2, Y3 d) r3, Y3 Based on the graph, starting from equilibrium at interest rate r3, income Y2, IS1, and LM1, if there is an increase in government spending that shifts the IS curve to IS2, then in order to keep the interest rate constant the Federal Reserve should _____ the money supply shifting to _____. a) increase; LM2 b) decrease; LM2 c) increase; LM3 d) decrease; LM3 Based on the graph, if the economy starts from a shortterm equilibrium at A, then the long-run equilibrium will be at ____ with a _____ price level. a) B; higher b) B; lower c) C; higher d) C; lower A tax cut combined with tight money, as was the case in the United States in the early 1980s, should lead to a: a) rise in the real interest rate and a fall in investment. b) fall in the real interest rate and a rise in investment. c) rise in both the real interest rate and investment. d) fall in both the real interest rate and investment.