Econ 375
Sample Exam 2

Part I: Multiple Choice.

1. The IS curve plots the relationship between interest rates and ____ that arises in the market for _____.
a) national income; goods
b) the price level; goods
c) national income; money
d) the price level; money

2. An explanation for the slope of the IS curve is that as the interest rate increases:
a) the quantity of investment increases, and this shifts the expenditure function downward, decreasing income.
b) the quantity of investment increases, and this shifts the expenditure function upward, increasing income.
c) the quantity of investment decreases, and this shifts the expenditure function upward, increasing income.
d) the quantity of investment decreases, and this shifts the expenditure function downward, decreasing income.

3. When the LM curve is drawn, the quantity that is held fixed is:
a) the nominal money supply
b) the real labor supply
c) government spending
d) the tax rate

4. An explanation of the slope of the LM curve is that:
a) as the interest rate increases, income becomes higher.
b) as the interest rate increases, income becomes lower.
c) as income rises, money demand rises, and a higher interest rate results.
d) as income rises, money demand falls, and a lower interest rate results.

5. According to the IS-LM model, when taxes are increased, the interest rate:
a) rises and output falls
b) rises and output rises
c) falls and output rises.
d) falls and output falls.

6. Start from long-run equilibrium, if the velocity of money increases (due to, for instance, the invention of automatic teller machines) and no action is taken by the government:
a) prices will rise both in the short run and the long run.
b) output will rise both in the short run and the long run.
c) prices will rise in the short run, and output will rise in the long run.
d) output will rise in the short run, and prices will rise in the long run.

7. The AD curve generally slopes downward and to the right because, for any given money supply M:
a) a higher price level P causes a lower real money supply M/P, which raises the interest rate and reduces spending.
b) a higher price level P increases the real money supply M/P, which lowers the interest rate and increases spending.
c) a higher price level P causes a lower real money supply M/P, which lowers the interest rate and increases spending.
d) a higher price level P increases the real money supply M/P, which raises the interest rate and reduces spending.

8. Explain how a change in monetary policy affects real GDP using the IS-LM model. Do not use any graphs.

9. According to the IS-LM model, what happens to the interest rate, income, consumption, and investment in the short run under each of the following situations? [No explanation is necessary; just tell me whether the variable increases, decreases, or is unaffected.]
a) there is an exogenous decrease in money demand
b) the government increases taxes

10. Suppose that OPEC (the oil cartel) suddenly collapsed and oil prices plummeted. Describe what happens in the short-run and the long-run using the AD-AS model and assuming that policymakers do not react. Illustrate your argument with the appropriate graph. (You may assume that the economy is initially in long run equilibrium.)

11. Suppose that the government wants to raise output but keep interest rates constant. In the IS-LM model, what mix of monetary and fiscal policy will achieve this goal? Explain and illustrate with the appropriate graph.

12. Assume that the following model describes the economy, with the price level fixed at 1.00 in the short run.

Y = C + I + G
C = 300 + 0.8(Y-T)
I = 1200 - 50r
G = 1500
T = 1500

Ms/P = Md/P = 0.5Y - 50r
Ms = 2750

a) Write down the equations for the IS curve and the LM curve.
b) What are the short-run equilibrium values of Y, r, C, and I?
c) Illustrate the short run equilibrium with an IS-LM graph and an AD-AS graph.
d) Assume that the full employment level of GDP is \$7000. How would you describe the current state of the economy relative to this full employment level?
e) Assuming no changes in government policy, what would happen to the price level in the long run? What would happen to the interest rate in the long run? What would happen to GDP in the long run? (No mathematical calculations are necessary here--just illustrate the changes on the diagram above.)