Question

9. Assume that the money demand function is ( M P)d= 2,200 – 200r, where r is the interest rate in percent. The money supply M is 2,000, and the price level P is 2. If the price level is fixed and the supply of money is raised to 2,800, then the equilibrium interest rate will: A) drop by 4 percent. B) drop by 2 percent. C) drop by 1 percent. D) remain unchanged. 10. The reason that the income response to a fiscal expansion is generally less in the IS-LM model than it is in the Keynesian-cross model is that the Keynesian-cross model assumes that: A) investment is not affected by the interest rate, whereas in the IS-LM model fiscal expansion raises the interest rate and crowds out investment. B) investment is not affected by the interest rate, whereas in the IS-LM model fiscal expansion lowers the interest rate and crowds out investment. investment is autonomous, whereas in the IS-LM model fiscal expansion encourages higher investment, which raises the interest rate. D) the price level is fixed, whereas in the IS-LM model it is allowed to vary.

Answer 1

(9) (B)

Initially,

(M/P) = 2,000/2 = 1,000

2,200 - 200r = 1,000

200r = 1,200

r = 6%

After increase in M,

(M/P) = 2,800/2 = 1,400

2,200 - 200r = 1,400

200r = 800

r = 4%

Decrease in r = 6% - 4% = 2%

(10) (A)

In Keynesian cross, investment is assumed autonomous. But in IS LM model, investment is negatively related to interest rate. So when fiscal expansion increases government borrowing, thus increasing interest rate, it dampens investment, crowding out investment demand.