Universidad Carlos III de Madrid – Department of Economics

Principles of Economics - Problem Set 13

These answers and solutions are only a general guide because they are preliminary.

Conceptual Questions

Write down a short and concise answer. When you are asked to solve the question in class,
explain the concept clearly and give examples or pieces of evidence.

1.Use the theory of liquidity preference to explain how a decrease in the money supply
affects the aggregate-demand curve. According to the theory of liquidity preference, the
interest rate adjusts to balance the supply and demand for money. Therefore, a
decrease in the money supply will increase the equilibrium interest rate. This
decrease in the money supply reduces aggregate demand because the higher interest
rate causes households to buy fewer houses, reducing the demand for residential
investment, and causes firms to spend less on new factories and new equipment,
reducing business investment.

2. Give an example of a government policy that acts as an automatic stabilizer. Explain

why the policy has this effect. Government policies that act as automatic stabilizers
include the tax system and government spending through the unemployment-
benefit system. The tax system acts as an automatic stabilizer because when
incomes are high, people pay more in taxes, so they cannot spend as much. When
incomes are low, so are taxes; thus, people can spend more. The result is that
spending is partly stabilized. Government spending through the unemployment-
benefit system acts as an automatic stabilizer because in recessions the
government transfers money to the unemployed so their incomes do not fall as
much and thus their spending will not fall as much.

3. The government spends $3 billion to buy police cars. Explain why aggregate demand
might increase by more than $3 billion. Explain why aggregate demand might increase by
less than $3 billion. If the government spends $3 billion to buy police cars, aggregate
demand might increase by more than $3 billion because of the multiplier effect on
aggregate demand. Aggregate demand might increase by less than $3 billion because
of the crowding-out effect on aggregate demand.

4. Suppose government spending increases. Would the effect on aggregate demand be

larger if the Federal Reserve held the money supply constant in response or if the Fed were
committed to maintaining a fixed interest rate? Explain. If government spending increases,
aggregate demand rises, so money demand rises. The increase in money demand leads to a rise in
the interest rate and thus a decline in aggregate demand if the Fed keeps the money supply

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constant. But if the Fed maintains a fixed interest rate, it will increase money supply, so aggregate
demand will not decline. Thus, the effect on aggregate demand from an increase in government
spending will be larger if the Fed maintains a fixed interest rate.

Problems

1.Explain how each of the following developments would affect the supply of money, the
demand for money, and the interest rate. Illustrate your answers with diagrams.
a. The Fed’s bond traders buy bonds in open market operations.
b. An increase in credit-card availability reduces the cash people hold.
c. The Federal Reserve reduces banks’ reserve requirements.
d. Households decide to hold more money to use for holiday shopping.
e. A wave of optimism boosts business investment and expands aggregate demand.
1. a. When the Fed’s bond traders buy bonds in open-market operations, the money-
supply curve shifts to the right from MS 1 to MS 2, as shown in Figure 1. The result
is a decline in the interest rate.

Figure 1 Figure 2

b. When an increase in credit card availability reduces the cash people hold, the
money-demand curve shifts to the left from MD 1 to MD 2, as shown in Figure 2.
The result is a decline in the interest rate.

c. When the Federal Reserve reduces reserve requirements, the money supply
increases, so the money-supply curve shifts to the right from MS 1 to MS 2, as
shown in Figure 1. The result is a decline in the interest rate.

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 d. When households decide to hold more money to use for holiday shopping, the
money-demand curve shifts to the right from MD 1 to MD 2, as shown in Figure 3.
The result is a rise in the interest rate.

Figure 3

e. When a wave of optimism boosts business investment and expands aggregate

demand, money demand increases from MD 1 to MD 2 in Figure 3. The increase in
money demand increases the interest rate.

Figure 4

2 . The Federal Reserve expands the money supply by 5 percent.

a. Use the theory of liquidity preference to illustrate in a graph the impact of this
policy on the interest rate.

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 b. Use the model of aggregate demand and aggregate supply to illustrate the
impact of this change in the interest rate on output and the price level in the short
run.
c. When the economy makes the transition from its short-run equilibrium to
its long-run equilibrium, what will happen to the price level?
d. How will this change in the price level affect the demand for money and
the equilibrium interest rate?
e. Is this analysis consistent with the proposition that money has real effects
in the short run but is neutral in the long run?

2. a. The increase in the money supply will cause the equilibrium interest rate to
decline, as shown in Figure 4. Households will increase spending and will invest in
more new housing. Firms too will increase investment spending. This will cause
the aggregate demand curve to shift to the right as shown in Figure 5.

Figure 5

b. As shown in Figure 5, the increase in aggregate demand will cause an increase in

both output and the price level in the short run (point B).

c. When the economy makes the transition from its short-run equilibrium to its long-
run equilibrium, short-run aggregate supply will decline, causing the price level to
rise even further (point C).

d. The increase in the price level will cause an increase in the demand for money,
raising the equilibrium interest rate.

e. Yes. While output initially rises because of the increase in aggregate demand, it
will fall once short-run aggregate supply declines. Thus, there is no long-run effect
of the increase in the money supply on real output.

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 Figure 6

3. Suppose the government reduces taxes by $20 billion, that there is no crowding out, and
that the marginal propensity to consume is 3/4
a. What is the initial effect of the tax reduction on aggregate demand?
b. What additional effects follow this initial effect? What is the total effect of the tax cut on
aggregate demand?
c. How does the total effect of this $20 billion tax cut compare to the total effect of a $20
billion increase in government purchases? Why?
d. Based on your answer to part (c), can you think of a way in which the government can
increase aggregate demand without changing the government’s budget deficit?

a. The initial effect of the tax reduction of $20 billion is to increase aggregate
demand by $20 billion × 3/4 (the MPC ) = $15 billion.

b. Additional effects follow this initial effect as the added incomes are spent. The
second round leads to increased consumption spending of $15 billion × 3/4 =
$11.25 billion. The third round gives an increase in consumption of $11.25 billion
× 3/4 = $8.44 billion. The effects continue indefinitely. Adding them all up gives a
total effect that depends on the multiplier. With an MPC of 3/4, the multiplier is
1/(1 – 3/4) = 4. So the total effect is $15 billion × 4 = $60 billion.

c. Government purchases have an initial effect of the full $20 billion, because they
increase aggregate demand directly by that amount. The total effect of an
increase in government purchases is thus $20 billion × 4 = $80 billion. So
government purchases lead to a bigger effect on output than a tax cut does. The
difference arises because government purchases affect aggregate demand by the
full amount, but a tax cut is partly saved by consumers, and therefore does not
lead to as much of an increase in aggregate demand.

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 d. The government could increase taxes by the same amount it increases its
purchases. If not all the increase in taxes (and the implied reduction of disposable
income) is transformed in a reduction in consumption, the aggregate demand
would increase.

Other questions
1.According to the theory of liquidity preference,
a. if the interest rate is below the equilibrium level, then the quantity of money people
want to hold is less than the quantity of money the Fed has created.
b. if the interest rate is above the equilibrium level, then the quantity of money people
want to hold is greater than the quantity of money the Fed has created.
c. the demand for money is represented by a downward-sloping line on a supply-and-
demand graph.
d. All of the above are correct.
2. In a certain economy, when income is $100, consumer spending is $60. The value of the
multiplier for this economy is 4. It follows that, when income is $101, consumer
spending is
a. $60.25.
b. $60.75.
c. $61.33.
d. $64.00.

3.Which of the following correctly explains the crowding-out effect?

a. An increase in government expenditures decreases the interest rate and so increases
investment spending.
b. An increase in government expenditures increases the interest rate and so reduces
investment spending.
c. A decrease in government expenditures increases the interest rate and so increases
investment spending.
d. A decrease in government expenditures decreases the interest rate and so reduces
investment spending.

4. Economists who are skeptical about the relevance of “liquidity traps” argue that
a. a central bank continues to have tools to stimulate the economy, even after its
interest rate target hits its lower bound of zero.
b. a central bank continues to have the option of committing itself to future

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 monetary contraction, even after its interest rate target hits its lower bound of
zero.
c. a central bank can greatly reduce the likelihood of a liquidity trap by setting the
target rate of inflation at zero.
d.while the concept of a liquidity trap is theoretically possible, nothing resembling a
liquidity trap ever has been observed in the real world.