Answers to Questions in Chapter 8

1. An increase in the price level reduces the real money stock. As a consequence, the interest rate must
rise to lower real money demand and re-equilibrate the money market. (The LM schedule shifts up.)
The rise in the interest rate lowers investment and, therefore, aggregate demand. Hence the aggregate
demand curve portrays all combinations of output and prices such that both the money and product
markets are in equilibrium.
4. If the price level is variable and the aggregate supply schedule slopes upward to the right, then as an
expansionary fiscal policy action increases aggregate demand, the price level will rise. As we have
seen, this will shift the LM schedule up because the real stock of money will fall. The result will be a
price-induced increase in the interest rate, in addition to the usual income-induced increase in the
interest rate in the fixed price IS-LM curve model. As a consequence, there will be more crowding
out of investment and, hence, the fiscal policy multipliers will be smaller.
When the money wage is variable, the aggregate supply curve will be steeper and, therefore, the price
increase will be larger for any given shift in the aggregate demand curve. Because the price level will
rise by more, the price-induced increase in the interest rate will also be larger. The crowding out of
investment will be greater and the fiscal policy multiplier smaller.
8. An exogenous shock that lowered the price of oil on world markets would have just the opposite
effect on the unfavorable supply shock. The aggregate supply schedule would shift downward to the
right. Output would rise and the aggregate price level would fall.
9. Whether money is more important in the classical or Keynesian theory depends on which variables
you look at. In the classical theory, money is the determinant of aggregate demand and, therefore, the
price level. If real income is fixed by supply conditions in the short run, money will, therefore,
determine nominal income. As a result, money has no effect on real variables in the classical system.
Within the Keynesian system, money is only one of a number of influences on aggregate demand, but
changes in the money stock affect real variables such as output and employment.
10. The differences between the classical and Keynesian theories of aggregate supply center on the
assumptions made about the flexibility of the money wage and about the labor supply function. A
perfectly flexible money wage and perfect information concerning the level of the real wage are the
assumptions required for the classical view of the labor market.
The Keynesians offer several reasons for believing that wages will be sticky, especially in the
downward direction, in the short run.
13. An increase in money demand would cause the LM schedule to shift to the left since the excess
demand for money would increase interest rates. The increase in interest rates would shift the AD
schedule to the left, resulting in a decrease in the level of real output and the aggregate price level.
The decline in the price level would increase the real money balance and thus shift the LM schedule
to the right, causing the nominal rate of interest to decrease and thus picks up investment and
consumption spending.
The net result within the variable price-fixed wage Keynesian model is an increase in interest rates, a
decrease in the price level and a decrease in the level of output.

ANSWERS TO QUESTIONS IN CHAPTER 9

1. In the Keynesian model, velocity depends positively on the interest rate. As the interest rate rises, the
level of money demand for a given level of income falls. A given money stock will, therefore, support
a higher level of income. In the monetarist view, an increase in the interest rate would also be
expected to lower money demand, but because the monetarists believe that the demand for money is
quite interest inelastic they would expect the decline in money demand to be small. Consequently,
velocity would vary very little in the short run.
With stable velocity, there is a very close relationship between the money stock and the level of
nominal income in the monetarist model. Monetary policy is, therefore, the dominant influence on
nominal income whereas fiscal policy is ineffective. In the Keynesian view, monetary policy is
important, but in the Keynesian view fiscal policy, as well as other changes in autonomous
expenditures, will also have significant effects on income.
2. The early Keynesians, relying on what they believed to be the experience of the 1930s, thought that
the demand for money was highly interest elastic and that investment was highly interest inelastic;
the LM curve was flat although the IS curve was steep. In this case, increases in the quantity of
money have little effect on the level of income. The early Keynesians also believed that the demand
for money was unstable and, therefore, changes in the money supply would not have very predictable
effects on either the interest rate or the level of income.
3. A simplified version of Friedmans money demand function was written as:
Md = L(P, y, rB, rE, rG, )
which can be compared to the Keynesian specification expressing money demand as a function of
income and the interest rate. The main differences between the two specifications discussed in the text
were:
Friedman views the money demand function as stable although Keynes did not.
Friedmans function includes separate yields for bonds, equities, and durable goods although
Keynes aggregates all non-money assets into one category bonds, with a single interest rate.
Friedman believes the money demand function to be highly interest inelastic although Keynes did
not.
4. In the monetarist case, the LM schedule would be quite steep though not vertical and the IS schedule
would be quite flat. In this case, it can be illustrated by shifting the curves, as shown in Chapter 7, that
monetary policy will be very effective although fiscal policy will be ineffective.
7. The effects of a decrease in taxes would be qualitatively the same as for an increase in government
spending. The IS schedule would shift to the right and both income and the interest rate would rise.
Because the LM schedule was steep, the rise in income would be small.
If we were considering a pure fiscal policy shift, we would assume that the money stock was
unchanged. The deficit caused by the tax cut would be financed by selling bonds to the public. The
sale of bonds would increase the wealth of the public; the demand for money would rise, and the LM
schedule would shift to the left. This would cause the interest rate to rise by more and push income
back toward its original (pre-tax cut) level. On net, the monetarists would expect little sustained
expansionary effect from the tax cut.

ANSWERS TO QUESTIONS IN CHAPTER 10

3. Both the monetarists and the Keynesians believe that changes in aggregate demand will affect real
output and employment in the short run but that the effect will not persist in the long run.
The differences between the monetarists and Keynesians in this area concern the determinants of
aggregate demand. The monetarists and Keynesians reach different conclusions on the need for
activist policies. Essentially, the Keynesian position follows from their view that, in a private
enterprise economy, aggregate demand needs to be stabilized and policies can be designed to do so.
The monetarists believe that due to stable money demand, reasonably stable velocity, and a stable
private sector, all the policymaker needs to do is keep money growth on track.
4. The economy had experienced high inflation rates over much of the 1970s. The monetarists would,
therefore, have expected inflationary expectations to have adjusted upward over the decade. By 1980,
they would have expected the Phillips curve to have shifted outward. As monetary policy became
restrictive, the economy would move along this unfavorable Phillips curve. In the short run, the
inflation rate would fall but the unemployment rate would rise. Eventually, the Phillips curve would
shift downward as inflationary expectations decline. The inflation rate would fall further and the
unemployment rate would also begin to fall.
9. This data is consistent with a natural rate of unemployment that differs across countries. Remember,
the natural rate of unemployment is not a constant, but may differ over time and across countries
depending upon factors such as unemployment benefits and productivity.