ECS2602 ASSIGNMENT 2 SEMESTER 1

1. The fully exogenous variables in the IS-LM model are ... 1. government spending and investment spending. 2. investment spending and money supply. 3. interest rate and government spending. 4. government spending and money supply. 5. level of output and income and the interest rate. Explanation: The correct option is 4. In the IS-LM model, the most important variables that we wish to explain are the level of output and income (Y) and the interest rate (i). These variables are therefore our endogenous or dependent variables. Any variable that is influenced by these endogenous variables is by implication also an endogenous variable. In the IS-LM model, the value of the exogenous variables is determined by the model builder, while the values of the endogenous variables are determined by the exogenous variables and the specifications of the model. 2. Which of the following statements are correct? a. According to the IS-LM model investment spending will increase if there is a decrease in the interest rate and/or an increase in income or output. b. The higher the interest rate, the higher the cost of borrowing will be and the higher the opportunity cost of holding own funds will be. c. There is a positive relationship between the level of output and income and the level of investment spending and a negative relationship between interest rate and level of investment spending. d. Investment takes place when firms increase their spending on capital goods. 1. a, b, c and d 2. Only a, b and d 3. Only b, c and d 4. Only a, c and d 5. Only a and d Explanation: The correct option is 1. Statement a is correct. Investment spending is a negative function of the interest rate (i↓ → I↑) and a positive function of the level of output and income (Y↑ → I↑). Statement b is correct. The interest rate as the opportunity cost of your own funds refers to the fact that, if you put your own funds into bonds or some other financial assets, or lend these funds to someone else, you will be able to earn interest on them. Statements c and d are correct. 5. Which of the following statements are correct? To derive the IS curve … a. the interest rate changes. b. the income changes. c. a negative relationship exists between investment spending and the interest rate. d. a change in the income level will have an impact on the goods market. e. investment is regarded as autonomous. 1. Only a and c 2. Only b and d 3. b, d and e 4. a, c and e 5. Only b and e Explanation: To derive the IS curve we change the interest rate to determine the effect on the level of income and not the other way round. To derive the IS curve, we change the interest rate to determine the effect on the level of output and income. In the goods market the ZZ curve will shift downwards because of the decrease in investment spending.