1. (4 marks) Explain the impact of an increase in the government expenditure
on the economy (1) under conditions of classical aggregate supply and (2)
under conditions of Keynesian aggregate supply.
2. (3 marks) In a closed economy, the consumption function is :
C = 1.15 + .75 ( Y - T).
The tax function is:
T = 0.1Y + .1
Planned investment is $1 billion, and planned government expenditures are
$ 1.5 billion.
a. Real GDP at the equilibrium expenditure
b. Consumer expenditure
d. The investment multiplier
e. The government budget deficit
f. The leakages from and injections in to the circular flow of income and
expenditure. Do leakages equal injections?
3. (4 marks) In an open economy, the consumption, tax, and import functions
are as follows:
C = 1.7 + .8 (Y - T)
T = .1Y +.2
IM = .06 + .1Y
Planned investment is $2 billion, planned government expenditures are $ 1
billion, and planned exports are $ 1 billion.
a. Real GDP at equilibrium expenditure
b. The investment multiplier
c. The autonomous tax multiplier
d. The marginal tax rate multiplier
e. The government budget deficit
f. Net export
g. The change in GDP resulting from a $ 1 billion rise in government
i. In problem (g) the changes in saving, consumer expenditures and
government budget deficit.
4. (3 marks) In problem 3, the government is planning to change taxes to
balance its budget.
a. If the government adjusts only autonomous taxes, by how much do they
b. If the government adjusts only marginal tax rate, by how much does it
c. Compare the effects of the tax changes in (a) and (b) on real GDP.
Which plan would you recommend the government adopt? Why?
5. (4 marks) Consider the following numerical version of the IS-LM model:
C = 180 + .08 Yd
I = 100 - 18 R + .1Y
Yd = Y - T
T = 400
G = 400
Md = 6Y - 120 R
Ms = 5400
R is the interest rate, Md is Money demand, Ms is Money supply.
a. Write down the equation of IS curve.
b. Write down the equation of LM curve.
c. Solve for equilibrium real output.
d. At equilibrium, what is the level of consumption and investment.
6. (4 marks) One of the attractive features of the IS-LM model is that it can be
used to illustrate some of basic principles of monetary and fiscal
a. Use the IS-LM model to show that in an economy which is subject to
shock in the goods market (for instance, autonomous changes in planned
investment) monetary policies could not be used to stabilize real output
without exacerbating the fluctuations of the interest rate.
b. Use the IS-LM model to show that in an economy which is subject to
shock in the money market (for instance, autonomous changes in
demand for money) fiscal policies could not be used to stabilize real
output without exacerbating the fluctuations of the interest rate.
Macroeconomic Theory and Its Applications 1 ECON 2470 5
7. (3 marks) Let's assume that investment is a function of both interest rate (R)
and income (Y). Investment spending depends positively on income and
negatively on interest rates. We can formalize this as follows:
I = aY - bR
a. What is the expression for the IS curve in this case?
b. What will be the implication for the slope of IS curve? Will it be steeper,
flatter, or the same, relative to the case where investment depends only
on interest rate?
c. What will be the implication for the slope of AD curve? Will it be
steeper, flatter, or same, relative to the case where investment depends
only on interest rate?
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