True/False

i) When MPC increases and investment decreases, goods market equilibrium output
increases.
ii) If investment is really sensitive to changes in the interest rate, then IS curve is flatter.
iii) In a closed economy, investment exceeds private saving by Rs 5000 if budget deficit is Rs
5000.
iv) An increase in one unit of government expenditure leads to an increase of one unit in
equilibrium output.
v) From the Keynesian cross, aggregate output will fall if an increase in autonomous
consumption spending is matched by an equal increase in lump-sum tax.
vi) GDP is the value of all goods and services produced in the economy.
vii) The price of bonds increases when the interest rate rises.
viii) Exports can be larger than GDP.
ix) In the long-run, output is demand determined.
MCQs

i) Consider two economies that are identical, with the exception that one has a high marginal
propensity to consume (MPC) and one has a low MPC. If the money supply is increased by the
same amount in each economy, the high MPC economy will experience
a) A larger increase in output and a smaller decrease in the interest rate.
b) A smaller increase in output and a smaller decrease in the interest rate.
c) A larger increase in output and a larger decrease in the interest rate.
d) A smaller increase in output and a larger decrease in the interest rate.
e) None of the above
ii) Which of the following policy options would simultaneously increase interest rates and
decrease output?
a) The RBI sells bonds through open market operations.
b) The Govt. of India increases its defense purchases.
c) The RBI expands the money supply.
d) The Govt. of India increases the tax rate.
e) Actions described in both a) and d).
iii) Suppose an economy is running a government budget deficit. Assume that C = C0 +
MPC(YT). Which one of the following will cause this deficit to become larger?
a) Expansionary monetary policy.
b) An increase in exports.
c) A decrease in equilibrium GDP.
d) A decrease in taxes.
e) A decrease in government purchases.
iv) The IS curve will NOT shift when which of the following occurs?
a) A reduction in govt. spending.

b) A reduction in consumer confidence.

c) A reduction in the interest rate.
d) All of the above.
e) None of the above.
v) Which of the following calculations will yield the correct measure of real GDP?
a) Divide nominal GDP by the consumer price.
b) Divide the GDP deflator by the consumer price index.
c) Multiply nominal GDP by the GDP deflator.
d) Multiply nominal GDP by the consumer price index.
e) None of the above.

vi) Suppose that the LM curve is vertical. An increase in taxes would

a) Increase income and leave the interest rate unchanged.
b) Decrease income and leave the interest rate unchanged.
c) Increase the interest rate and leave the income unchanged.
d) Decrease the interest rate and leave the income unchanged.
e) None of the above.
vii) The IS-LM model predicts that an increase in the price level will
a) Increase the interest rate as well as the income.
b) Increase the interest rate and decrease the income.
c) Decrease the interest rate and increase the income.
d) Decrease the interest rate as well as the income.
e) None of the above.
viii) Suppose that investment (I) in the goods market is not responsive to the interest rate (that
is, I does not depend on the interest rate at all). Then
a) The IS curve is a vertical line and monetary policy is very effective in raising output.
b) The IS curve is a horizontal line and monetary policy is very effective in raising
output.
c) The IS curve is a vertical line and monetary policy does not affect output in the ISLM model.
d) The IS curve is a horizontal line and monetary policy does not affect output in the
IS-LM model.
e) The IS curve still has a negative slope, but monetary policy monetary policy does
not affect output in the IS-LM model.
ix) Suppose that there is an increase in the consumer confidence in the IS-LM model. As a
result which of the variables below MUST increase?
a) Consumption and Output.
b) Consumption, Investment and Output
c) Consumption.
d) Consumption and Investment.
e) Consumption, Output and the interest rate.
2

x) Suppose, as unrealistic as this might be, that disposable income of country is zero. It must
be that
a) Saving is negative.
b) Saving is zero.
c) Consumption is zero.
d) The MPC is zero.
e) Saving is positive.
xi) Which one of the following statements best describes the paradox of thrift?
a) People attempt to save more, output increases along with total saving.
b) People attempt to save less, output increases along with total saving.
c) People attempt to save less, output decreases but saving remains the same.
d) People attempt to save more, output decreases but saving remains the same.
e) None of the above.
Questions
1. Only two commodities - food and clothing - are used to compute CPI for an economy
with respective weights 60% and 40%. If food price rises by 10% and clothing price rises
by 15% what is the impact on CPI?
2. In the simple Keynesian income determination model, investment is taken as fixed (i.e. I
= I0). It may reasonably be expected that as the level of output expands, firms will be
induced to invest more. This means that the level of investment is also a function of
current output. Modify I = I0 suitably to capture this effect. From the relation Y = C + I,
determine the equilibrium level of Y, after putting your new investment function in place
of I above (you already know the form of consumption function). What is the value of
multiplier in this case?
3. The Indian economy has experienced a stock market boom in the near past. This sort of
boom, though, is not peculiar to the Indian economy. There has been considerable debate
about the possible real effects of such boom in the economy. The objective of this
exercise is to trace out such effects under alternative scenarios involving some special
assumptions about the behaviour of the economy.
Let us suppose that money demand does not depend on income. Rest of the model is the usual
IS-LM. Keeping these conditions in the mind, fill up the blanks with most appropriate
alternative. [10 points]
i) As a consequence of this stock market boom, the _____ [IS/LM] curve will shift to
_________ [left/right]. Support your response using appropriately labeled diagrams.

ii) The equilibrium income will ________________________ [increase/decrease/remain

unchanged] and interest rate will _______________________ [increase/decrease/remain
unchanged]. Support your response using appropriately labelled diagrams.

4. Consider the IS-LM model. Country A experiences random adverse shocks in investor
expectations regarding prospective yields, while Country B experiences random adverse
shocks in the rate of inflation expected by financiers (asset holders). The respective monetary
authorities, RBA and RBB, use monetary policy to stabilise real GDP in the face of exogenous
shocks. In both countries, monetary policy consists of either holding the money supply constant
(Policy M) or adjusting it so as to keep the interest rate constant (Policy R). This exercise is
about the determination of the preferred policy option in the two countries.
[Hint: refer to the pages 411-413 of the text book]
A. Because of the aforesaid shock in country A, the ___________________
[investment/money demand] function shifts to the _________ [left/ right]. If RBA did
nothing, that would cause the rate of interest to ____________________ [rise/ fall/ remain
the same], the money supply to _______________________ [rise/ fall/ remain the same], and
real output to ______________________ [rise/ fall/ remain the same]. The effect of RBA
using Policy M is to cause output to ___________________ [rise/ fall/ remain the same]. The
effect of RBA using Policy R is to cause output to _______________________ [rise more/
fall more/ remain unchanged]. Therefore the preferred option for country A is Policy ____
[M/R].
B. Suppose that in country B, the money demand function (drawn against the real rate of
interest) shifts to the left as a result of the shock. If RBB did nothing, that would cause the
rate of interest to ____________________ [rise/ fall/ remain the same], the money supply to
____________________ [rise/ fall/ remain the same] and real output to
______________________ [rise/ fall/ remain the same]. The effect of RBB using Policy M is
to cause output to _______________________ [rise/ fall/ remain the same]. The effect of
RBB using Policy R is to cause output to ______________________[rise/ fall/ remain
unchanged]. Therefore the preferred option for country B is Policy _______ [M/R].