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30) The Federal Reserve increases interest rates when it wants to reduce aggregate demand to fight

inflation. How do increases in the interest rate reduce aggregate demand?


Answer: Increases in interest rates reduce planned investment. The decrease in investment reduces
equilibrium output by a multiple amount due to the multiplier effect. Also, increases in
interest rates increase the value of the dollar, reducing net exports,

20.3 ISLM Approach to Aggregate Output and Interest Rates
Chapter 21
Monetary and Fiscal Policy in the ISLM Model
21.1 Factors That Cause The IS Curve to Shift
21.2 Factors That Cause the LM Curve to Shift
Using the ISLM model, explain the effects of a monetary expansion combined with a fiscal
contraction. How do the equilibrium level of output and interest rate change?
Answer: The monetary expansion shifts the LM curve to the right which by itself would cause the
interest rate to decrease and aggregate output to increase. The fiscal contraction shifts the
IS curve to the left which by itself would cause the interest rate to decrease and aggregate
output to decrease. Therefore, the equilibrium

18) Using the ISLM model, show graphically and explain the effects of a monetary contraction.
What is the effect on the equilibrium interest rate and level of output?
Answer: See figure below.

The monetary contraction shifts the LM curve to the left. The result is that the equilibrium
level of output falls and the equilibrium interest rate increases.

21.4 Effectiveness Of Monetary Versus Fiscal Policy
12) Using the ISLM model, explain and show graphically the effect of a fiscal expansion when the
demand for money is completely insensitive to changes in the interest rate. What is this effect
called?
Answer: See figure below.

This is the total crowding out effect. The LM curve is vertical, so any shift of the IS curve
affects only interest rates. The level of output is constant. The fiscal expansion shifts the IS
curve rightward, increasing the interest rate.

Show graphically and explain why targeting an interest rate is preferable when money demand
is unstable and the IS curve is stable.
Answer: See figure below.

Unstable money demand causes the LM curve to shift between LM and LM . If the
money supply is targeted, output fluctuates between Y and Y . With an interest rate
target, output remains stable at Y. Since the objective is to minimize output fluctuations,
targeting the interest rate is preferable.

21.5 ISLM Model In The Long Run
21.6 ISLM Model And The Aggregate Demand Curve

Chapter 22
Aggregate Demand and Supply Analysis
22.1 Aggregate Demand
25) Explain through the component parts of aggregate demand why the aggregate demand curve
slopes down with respect to the price level. Be sure to discuss two channels through which
changes in prices affect demand.

Answer: A fall in the price level increases the real value of a fixed nominal money supply. This
increase in the real money supply lowers interest rates. Lower rates increase investment,
thereby increasing aggregate demand. Lower interest rates also cause depreciation of the
domestic currency, increasing net exports and aggregate demand.

22.2 Aggregate Supply
22.3 Equilibrium in Aggregate Supply and Demand Analysis
32) Using the aggregate demand- aggregate supply model, explain and demonstrate graphically the
short- run and long- run effects of an increase in the money supply.
Answer: See figure below.
An

An increase in the money supply increases aggregate demand, from AD to AD . The
economy moves from point 1 to point 2. In the short run both the price level and real
output increase. In the long run, wages adjust, decreasing short- run aggregate supply, to
AS , raising prices further and reducing real output until the economy returns to the
natural level of output. The long- run result is to only increase the price level. The path is
from 1 to 2 to 3.

33) Explain and demonstrate graphically the effects of a negative supply shock in both the
short- run and long- run.
Answer: See figure below.

The supply shock decreases short- run aggregate supply from AS1 to AS2, reducing real
output and raising the price level, or from points 1 to 2 in the graph. In the long run, the
supply curve eventually adjusts back to the original position as wages fall. The economy
adjusts from 2 back to 1.

22.4 APPENDIX: Aggregate Supply and the Phillips Curve
Chapter 23
Transmission Mechanisms of Monetary Policy: The Evidence
23.1 Framework for Evaluating Empirical Evidence
23.2 Transmission Mechanism of Monetary Policy
33) Explain the traditional interest- rate channel for expansionary monetary policy. Explain how a
tight monetary policy affects the economy through this channel.
Answer: In the traditional channel, a monetary expansion reduces real interest rates, lowering the
cost of capital and increasing investment spending. The increase in investment increases
aggregate demand. A monetary contraction has the opposite effect, raising real interest
rates, lowering investment and aggregate spending.
Ques Status: Previous Edition
34) Explain how expansionary and contractionary monetary policies affect aggregate demand
through the exchange rate channel.
Answer: An expansionary monetary policy reduces real interest rates, causing depreciation of the
domestic currency. This depreciation increases net exports and aggregate spending. A
monetary contraction increases real interest rates, causing appreciation of the domestic
currency, reducing net exports and aggregate spending.
Ques Status: Previous Edition
35) Discuss three channels by which monetary policy affects stock prices and aggregate spending.
Answer: The answer should include three of the following:
In Tobin s q theory, a monetary expansion increases stock prices, increasing the value of
the firm relative to the cost of new capital. This stimulates investment in new capital
goods, which in turn increases aggregate spending.
A monetary expansion increases stock prices, increasing wealth and stimulating
consumption and aggregate spending.
Expansionary monetary policy increases equity prices. This improves firms balance
sheets, reducing adverse selection and moral hazard and increasing lending for
investment, which increases aggregate spending.
In the household liquidity effect, the increase in equity prices due to a monetary
expansion improves consumer balance sheets, reducing the probability of financial
distress, and increasing consumer spending on durable goods and housing.

23.3 Lessons for Monetary Policy

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