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ECO 320L -- IS-LM Model and Aggregate
Demand Questions with Answers
Standard "IS-LM" approach to aggregate demand, based on Keynes and Hicks
Ans: Two important macroeconomic markets:
1. the market for savings
2. the market for money holdings.
We will consider each market independently, taking the level of output as exogenous in
each market but solving for the equilibrium interest rate in each market.
Then combine the two markets, using the IS-LM approach, to determine the equilibrium
level of output and interest rates that ensure that both markets clear.
Part 1: The Saving (Loanable Funds)
Ans: This is the market for savings and investment.
Examine what the supply and demand for savings are, as well as to characterize how the
price of savings (the real interest rate) is determined.
The supply of savings
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Ans: Total saving in the economy can be divided into two components: public and private
saving. Private saving Sp is the saving done by consumers and is equal to after-tax income
minus consumption:
S_p=Y-T-C.
Public saving Sg is the difference between tax revenues and government expenditures
S_g= T-G.
Total saving S is the sum of public and private saving, and so
S=S_p+S_g=(Y-T-C)+(T-G)=Y-C-G.
What does not directly depend on taxes?
Ans: Total savings. However, to the extent that changes in taxes can affect consumption
or output, total saving will in general change with exogenous changes in taxes.
What could describe aggregate consumption?
Ans: A function of current after-tax income, consumer sentiment (as a proxy for
permanent income), and the interest rate:
C=C(Y-T,CS,r).
Hence, plugging this into our expression for total saving, we get:
S=Y-C(Y-T,CS,r)-G
What is increasing in after-tax income Y-T
Ans: Consumption and consumer sentiment (CS)
What is decreasing in after-tax income Y-T
Ans: Real interest rate (r)
What is increasing in aggregate savings?
Ans: real interest rate (r)
What is decreasing in aggregate saving?
Ans: Consumer Sentiment (CS)
How does an increase in Y affect savings?
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Ans: An increase in Y has a direct positive effect on saving (since it is on the RHS of the
expression above) but it also increases consumption which tends to decrease savings.
The amount by which savings rises is known as
Ans: Marginal Propensity to save (MPS)
When an increase in consumption from a 1$ change in after-tax income is known as
Ans: Marginal Propensity to consume (MPC)
If MPC is 0.8, then if income goes up by a dollar, consumers will tend to raise their
consumption by $0.80. From PIH, we know that transitory changes in income have small
(less than one-for -one) effects on consumption which tells us what?
Ans: That as long as the change in Y is not permanent, then it must be that 0<mpc<1.
Consumption rises when income rises but by less than one-for one.
Therefore, when Y goes up by a dollar, consumption goes up by less than a dollar, which
means that total savings must rise.
The amount by which savings rises is known as the marginal propensity to save (mps). Since
income is either consumed or saved, it must be that mps=1-mpc.
Savings Function
Ans: (Insert savings function equation)
where + or - indicates whether an increase in that variable raises or lowers total savings. This
implies that we can plot the supply of savings as a function of the price of savings (r) as
follows:
(insert graph)
If the supply curve for savings is upward sloping, what does it reflect?
Ans: That as the interest rate rises, the incentive for consumers to save rises. Note also that
increases in Y and T and decreases in CS and G all shift the supply of savings curve to the
right.
The demand for savings: Investment
Q&A
ECO 320L -- IS-LM Model and Aggregate
Demand Questions with Answers
Standard "IS-LM" approach to aggregate demand, based on Keynes and Hicks
Ans: Two important macroeconomic markets:
1. the market for savings
2. the market for money holdings.
We will consider each market independently, taking the level of output as exogenous in
each market but solving for the equilibrium interest rate in each market.
Then combine the two markets, using the IS-LM approach, to determine the equilibrium
level of output and interest rates that ensure that both markets clear.
Part 1: The Saving (Loanable Funds)
Ans: This is the market for savings and investment.
Examine what the supply and demand for savings are, as well as to characterize how the
price of savings (the real interest rate) is determined.
The supply of savings
Q&A
, Q&A Q&A Q&A Q&A Q&A Q&A Q&A Q&A Q&A Q&A Q&A
Ans: Total saving in the economy can be divided into two components: public and private
saving. Private saving Sp is the saving done by consumers and is equal to after-tax income
minus consumption:
S_p=Y-T-C.
Public saving Sg is the difference between tax revenues and government expenditures
S_g= T-G.
Total saving S is the sum of public and private saving, and so
S=S_p+S_g=(Y-T-C)+(T-G)=Y-C-G.
What does not directly depend on taxes?
Ans: Total savings. However, to the extent that changes in taxes can affect consumption
or output, total saving will in general change with exogenous changes in taxes.
What could describe aggregate consumption?
Ans: A function of current after-tax income, consumer sentiment (as a proxy for
permanent income), and the interest rate:
C=C(Y-T,CS,r).
Hence, plugging this into our expression for total saving, we get:
S=Y-C(Y-T,CS,r)-G
What is increasing in after-tax income Y-T
Ans: Consumption and consumer sentiment (CS)
What is decreasing in after-tax income Y-T
Ans: Real interest rate (r)
What is increasing in aggregate savings?
Ans: real interest rate (r)
What is decreasing in aggregate saving?
Ans: Consumer Sentiment (CS)
How does an increase in Y affect savings?
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Ans: An increase in Y has a direct positive effect on saving (since it is on the RHS of the
expression above) but it also increases consumption which tends to decrease savings.
The amount by which savings rises is known as
Ans: Marginal Propensity to save (MPS)
When an increase in consumption from a 1$ change in after-tax income is known as
Ans: Marginal Propensity to consume (MPC)
If MPC is 0.8, then if income goes up by a dollar, consumers will tend to raise their
consumption by $0.80. From PIH, we know that transitory changes in income have small
(less than one-for -one) effects on consumption which tells us what?
Ans: That as long as the change in Y is not permanent, then it must be that 0<mpc<1.
Consumption rises when income rises but by less than one-for one.
Therefore, when Y goes up by a dollar, consumption goes up by less than a dollar, which
means that total savings must rise.
The amount by which savings rises is known as the marginal propensity to save (mps). Since
income is either consumed or saved, it must be that mps=1-mpc.
Savings Function
Ans: (Insert savings function equation)
where + or - indicates whether an increase in that variable raises or lowers total savings. This
implies that we can plot the supply of savings as a function of the price of savings (r) as
follows:
(insert graph)
If the supply curve for savings is upward sloping, what does it reflect?
Ans: That as the interest rate rises, the incentive for consumers to save rises. Note also that
increases in Y and T and decreases in CS and G all shift the supply of savings curve to the
right.
The demand for savings: Investment
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