Deck 12: The Determination of Aggregate Output, the Price Level, and the Interest Rate

Question 1

Assume the following graph for money supply and money demand. Explain the adjustment process that would take place in this money market if the interest rate is 12 percent. Make sure that your answer includes a discussion of what happens to money balances and bond prices.

Answer 1

If the interest rate is 12 percent then the quantity of money in circulation will exceed the amount that households will want to hold. This excess supply of money will cause the interest rate to drop as people try to shift their funds into interest bearing bonds. The increased demand for bonds will bid their price up; i.e., the interest rate will drop.

Question 2

Related to the Economics in Practice on p. 221 [533]: What was the estimates of the study concerning a one-percentage point increase in the interest rate? Be specific.

Answer 2

According to their estimates, a one-percentage-point increase in the interest rate appropriate for a firm's borrowing leads to a drop in investment spending of more than one percentage point.

Question 3

Table 27.1
Use the Table 27.1 to answer the following question. What will be the change in investment spending if the interest rate falls from 9% to 6%?

Answer 3

Investment will increase by $40 billion ($360 - $320 billion).

Question 4

Scenario 1
Assume that the investment demand function is represented by the following algebraic function: I = $300 - 2000r where $300 represents autonomous investment and "r" represents the interest rate.
Using Scenario 1 calculate how high the interest rate would have to rise to drive planned investment to zero. Calculate the amount of investment that would take place at an interest rate of zero.

Question 5

Scenario 1
Assume that the investment demand function is represented by the following algebraic function: I = $300 - 2000r where $300 represents autonomous investment and "r" represents the interest rate.
Using Scenario 1, if the interest rate were 10%, calculate the level of investment.

Question 6

Draw a flowchart showing the impact of an increase in interest rates on planned investment, planned aggregate expenditure and equilibrium output.

Question 7

Graphically illustrate the relationship between interest rate changes and the level of planned investment.

Question 8

Suppose the investment demand function is given as the following algebraic function: I = 300 - 1000r where r is the interest rate. Calculate the amount of investment that would take place at an interest rate of ten percent. How much investment would there be if interest rates rose to fifteen percent?

Question 9

Critically evaluate the assumption of autonomous investment.

Question 10

Why is there a negative relationship between the interest rate and the level of investment?

Question 11

Describe in broad terms what the money market is.

Question 12

The textbook discusses the "crowding out effect". Can you think of any circumstances in which just the opposite effect could take place?

Question 13

Table 27.1
Use the Table 27.1 to answer the following question.. Suppose the expenditure multiplier is 3. What impact on equilibrium output will there be by an increase in the interest rate from 6% to 9%, ceteris paribus?

Question 14

If the amount of money demanded by household and firms is less than the amount in circulation as determined by the Fed what will happen to the rate of interest and why?

Question 15

As interest rates increase what happens to planned investment and aggregate expenditure?

Question 16

Scenario 1
Assume that the investment demand function is represented by the following algebraic function: I = $300 - 2000r where $300 represents autonomous investment and "r" represents the interest rate.
Using Scenario 1, calculate the interest rate that would be necessary to bring about an investment of $200.

Question 17

Draw a planned investment curve as it relates to the interest rate.

Question 18

Discuss the two links between the goods market and the money market.

Question 19

Assume the money supply is set by the Fed at $1000 billion and the money demand function is represented by the following algebraic equation Md = 3000 - 20000r, where r = the interest rate. Calculate the interest rate which will clear this money market.

Question 20

Describe in broad terms what the goods market is.

Question 21

Table 27.1
Use the Table 27.1 to answer the following question. Suppose the expenditure multiplier is 4. What will be the impact on equilibrium output of a drop in the interest rate from 15% to 9%, ceteris paribus?

Question 22

Describe the chain of events that are likely to unfold when the government reduces net taxes. Explain your answer in terms of its impact on aggregate output, the demand for money, the interest rate and planned investment.

Question 23

Table 27.1
Use the Table 27.1 to answer the following question. Suppose the expenditure multiplier is 5 and the initial interest rate is 12%. Where will the interest rate have to move to in order to cause equilibrium output to fall by 400 billion?

Question 24

Explain the chain of events that results from an expansionary monetary policy. Explain your answer in terms of its impact on money supply, aggregate output, the demand for money, the interest rate and planned investment. Be sure to include any feedback effects in your answer.

Question 25

How does monetary policy affect the goods market?

Question 26

Figure 27.1
Assume that money demand is perfectly elastic. What implications would this have for an expansionary monetary policy?

Question 27

Did the anti-recession policies of 1974-1975 and 1980-1982 produce a crowding-out effect? Why or why not?

Question 28

Describe expansionary fiscal policy.

Question 29

Explain the "crowding-out effect."

Question 30

Assume the Federal Reserve contracted the money supply in the face of high deficit spending on the part of Congress. Would this lessen or aggragavate the crowding out problem? Explain.

Question 31

Graphically illustrate the impact of a decrease and increase in the interest rate on aggregate expenditure. On your graph, illustrate the impact of an increase and decrease in the interest rate upon aggregate expenditure. Summarize the relationship among changes in the rate of interest (r), the change in planned investment spending (I), its impact on the aggregate expenditure function (AE), and the multiple effect on income (Y).

Question 32

Describe expansionary monetary policy.

Question 33

What action could the Fed take to reduce the crowding-out effect of an expansionary fiscal policy?

Question 34

The size of the crowding-out effect, affecting the size of the government spending multiplier, depends on two things. Explain what those are.

Question 35

Table 27.1
Use the Table 27.1 to answer the following question. Suppose the expenditure multiplier is 5 and the initial interest rate is 12%. Where will the interest rate have to move to in order to cause equilibrium output to fall by 400 billion?

Question 36

Explain how the crowding out effect can be softened by the Federal Reserve accommodating an expansionary fiscal policy.

Question 37

What are the two primary things on which the size of the "crowding-out" effect depend?

Question 38

Figure 27.1
Use Figure 27.1 above to answer the following question. Assume that the aggregate expenditure function depicted in the graph is based on an interest rate of 3%. Now assume that the interest rate rises to let's say 6%. Graphically illustrate the impact that this will have on the aggregate expenditure function and equilibrium output. Explain your answer.

Question 39

Table 27.1
Use the Table 27.1 to answer the following question.. Suppose the expenditure multiplier is 10 and the initial interest rate is 15%. What would be the impact on the equilibrium output if the interest rate fell to 6%?

Question 40

Explain why a contractionary monetary policy would not necessarily result in interest rates rising by the full amount of what the initial contraction would produce. In other words, if there were no impact on the goods market the interest rate would rise to a higher level. Given that there is an impact explain how this works.

Question 41

Discuss the impact of an increase in the money supply upon the goods and money markets. What most importantly determines the effectiveness of monetary policy?

Question 42

Summarize the effects of a contractionary monetary policy where the changes in the money supply (Ms) impacts the rate of interest (r), investment spending (I), output and income (Y), and the demand for money (Md).

Question 43

Using short-hand symbols, explain the effects of a contractionary fiscal policy.

Question 44

Describe the sequence of events that occurs in response to an expansionary monetary policy. Explain in terms of the impact on aggregate output, money demand, interest rates and planned investment.

Question 45

What will be the impact on money demand, the interest rate and the level of planned investment if the government increases spending?

Question 46

In addition to the rate of interest, what other conditions affect the level of planned investment? Explain how these factors affect planned investment spending.
(a) Expectations regarding business and overall economic conditions
(b) Capital utilization rates
(c) Relative labor and capital costs

Question 47

Explain what is meant by a contractionary monetary policy.

Question 48

Using short-hand symbols, explain the effects of a contractionary monetary policy.

Question 49

Draw an investment demand curve that would render monetary policy completely ineffectual. Make sure to explain why it looks the way it does.

Question 50

How much crowding out would be expected from an expansionary fiscal policy if investment was completely insensitive to the interest rate: that is independent of the interest rate? Explain your answer.

Question 51

Assume investment demand is independent of the interest rate. Explain why an expansionary monetary policy designed to drive the interest rate to zero may not be enough to stimulate the economy.

Question 52

Explain the impact upon the crowding-out effect if the Federal Reserve changes the money supply when government spending increases.

Question 53

Explain what is meant by a contractionary fiscal policy.

Question 54

Describe the sequence of events that occurs in response to a contractionary fiscal policy. Explain in terms of the impact on aggregate output, money demand, interest rates and planned investment.

Question 55

Summarize the effects of a contractionary fiscal policy where the changes in government spending (G) and/or taxes (T) are changes upon output and income (Y), the demand for money (Md), the rate of interest (r), and investment spending (I).

Question 56

Using the short-hand symbols Ms, r, I, Y, and Md, demonstrate the effects of an expansionary monetary policy.

Question 57

Explain the only circumstance in which expansionary monetary policy is likely to be effective. Hint: Use the linkage between the interest rate and investment spending to explain your answer.

Question 58

According to the two investment demand schedules above which will allow an expansionary monetary policy to have its greater impact? Why?

Question 59

Using the short-hand symbols G, Y, Md, r and I, demonstrate the effects of an expansionary fiscal policy.

Question 60

Explain how the sensitivity of investment to the interest rate can have a bearing on the amount of crowding out that results from an expansionary fiscal policy.

Question 61

Suppose investment becomes less responsive to (i.e., sensitive to) changes in the interest rate. What effect will this have on the effectiveness of fiscal policy? Specifically, what will happen to the output effects of a given change in government spending?

Question 62

What would be the policy mix that would cause the interest rate to increase, and investment to decrease but have an indeterminate effect on aggregate output?

Question 63

Discuss the effects of a policy mix of an expansionary fiscal policy and an expansionary monetary policy on output and interest rates. Is there any ambiguity with regard to the effect on interest rates and why?

Question 64

Explain when fiscal policy is more effective in changing equilibrium output.

Question 65

Graphically illustrate and explain the effects of a reduction in the money supply on the equilibrium interest rate, investment, and equilibrium output. Clearly label all curves and the initial and final equilibria.

Question 66

Discuss what is meant by the crowding-out effects of fiscal policy.

Question 67

Explain the two key links between the goods market and the money market.

Question 68

Indicate the effect of each of the following policies on the variables: Y, C, S, r, I, Ms, and Md.
(a) The government reduces the personal income tax rates.
(b) Firms become more pessimistic about future sales.

Question 69

Suppose the Federal Reserve pursues expansionary monetary policy at the same time a reduction in taxes occurs (i.e., a fiscal expansion). Explain what effects this combination of monetary and fiscal policy will have on the macroeconomy.

Question 70

Suppose investment becomes more responsive to (i.e., sensitive to) changes in the interest rate. What effect will this have on the effectiveness of monetary policy? Specifically, what will happen to the output effects of a given change in the money supply?

Question 71

How can monetary policy be used to reduce the impact of the crowding-out effect?

Question 72

Define the crowding-out effect. What factors can influence the extent to which crowding-out occurs when the government implements an expansionary fiscal policy?

Question 73

What is determined in the goods market? What is determined in the money market? Explain the two links between the goods market and the money market.

Question 74

What is a policy mix?

Question 75

Summarize the effects of an expansionary fiscal policy in the aggregate expenditure model. That is graphically illustrate the effects of an expansionary fiscal policy on the equilibrium level of output.

Question 76

Explain what is meant by the "mix of macroeconomic policy" and explain how it can affect the level and composition of output (i.e., GDP).

Question 77

Between the spring of 1990 and the spring of 1991, interest rates in the United States dropped nearly two full percentage points, but this did not have much of an effect on investment spending plans. Explain how this could happen. Draw a graph of the investment demand schedule that would represent this situation. During this time period would an expansionary monetary policy have been an effective way to stimulate the economy? Explain.

Question 78

Explain why the effectiveness of an expansionary monetary policy in increasing aggregate output is partially dependent on the interest sensitivity of the demand for money.

Question 79

Graphically illustrate and explain the effects of a reduction in government spending on the equilibrium interest rate, investment, and equilibrium output. Clearly label all curves and the initial and final equilibria. Does any crowding-out take place when government spending falls? Explain.

Question 80

Briefly explain what type of policy mix existed in the United States in 1980-82. What effect did this policy mix have on the interest rate and investment?