ECS2602 ASSIGNMENT 2 SEMESTER 1 2021 POSSIBLE SOLUTIONS

1. Which of the following are fully exogenous variables in the IS-LM model? 1. Level of output, interest rate, investment, consumption spending. 2. Government spending, taxation, money supply, marginal propensity to consume. 3. Interest rate, demand for money, supply of money. 4. Consumption spending, investment, government spending. Explanation Government spending and money supply are the factors that are regarded as exogenous variables in the IS-LM model. The level of output and income, the interest rate and investment spending are endogenous variables in the IS-LM model. 2. Which of the following statements regarding investment spending in the IS-LM model is/are correct? a. The interest rate is the cost of borrowing money, expressed as a percentage, usually over a period of one year. An increase in the cost of borrowing money causes households and firms to borrow less money. b. An increase in the level of output increases investment spending in the economy. c. A decrease in the interest rate increases investment spending. d. An increase in investors’ confidence increases investment spending. 1. a, b, c and d 2. Only a, b and c 3. Only b, c and d 4. Only b and c 5. Only d Explanation 3. In the event of a rise in the interest rate a(n) _________ an investment curve takes place while an increase in output will cause a(n) ________ an investment curve. 1. rightward shift of; downward movement along 2. downward movement along; rightward shift of 3. upward movement along; leftward shift of 4. upward movement along; rightward shift of 5. downward movement along; upward movement along Explanation In the event of a rise in the interest rate an upward movement along an investment curve takes place while an increase in output will cause a rightward shift of an investment curve. 4. Assume the interest rate increases when deriving the IS curve. In the goods market model, if the interest rate increases … 1. government spending increases, the demand for goods increases and the equilibrium level of income rises. 2. investment spending decreases which decreases the demand for goods and the equilibrium level of output and income falls. 3. investment spending increases which increases the demand for goods and the equilibrium level of income rises. 4. taxation decreases, disposable income of households increases which increases the demand for goods, and the equilibrium level of income rises. Explanation When deriving the IS curve we assume a change in the interest rate. In this case, the interest rate increases. A negative relationship exists between the interest rate and investment spending. The chain of events will look as follows: i↑ → I↓ → Z↓ → Y↓. 5. Which of the following statements is/are correct regarding the derivation of the IS curve? a. To derive the IS curve, we change the interest rate to determine the effect on the level of income. b. To derive the IS curve, we change the level of output and income to determine the effect on the interest rate. c. The IS curve represents combinations of output and interest rates where the financial market is in equilibrium, given that all autonomous variables are unchanged. d. The IS curve represents combinations of output and interest rates where the goods and financial markets are in equilibrium, given that all autonomous variables are unchanged. 1. None of the statements is correct 2. Only a 3. Only b 4. Only c 5. a and d Explanation Statements a) and d) are correct. To derive the IS curve, we change the interest rate to determine the effect on the level of income. The IS curve represents the combinations of output and the interest rate where the goods market is in equilibrium. 6. Which of the following statements are correct? a. The steepness of the IS curve depends on the interest sensitivity of investment spending and the output and income sensitivity of investment spending. b. The interest rate sensitivity of investment spending measures how sensitive investment spending is to a change in the output and income. c. The output sensitivity of investment spending measures how sensitive investment spending is to a change in output and income. d. If investment spending is not very sensitive to a change in the interest rate, a given change in the interest rate will have a greater impact on investment spending and, consequently, the greater the change in the level of output and income will be. e. The flatter the IS curve the more sensitive is investment spending to a change in the level of output and income. 1. a, c and e 2. a, c, d and e 3. Only c and e 4. b, d and e 5. Only a and c Explanation Study guide pages 85-92   Question 7 is based on the following diagram: 7. Which one of the following statements is correct? 1. Goods market equilibrium exists only at points a and b. 2. At point c the level of autonomous spending is lower than at point a. 3. At point c the level of autonomous spending is the same as at point a. 4. At point a the demand for goods is lower than at point b. Explanation Tutorials 102, Activity 4.5 (d) 8. Which of the following statement(s) is/are correct? a. A shift of the IS curve occurs when the interest rate changes. b. A change in investment spending due to a change in autonomous investment is represented by a movement along the IS curve. c. A change in investment spending due to a change in the interest rate is represented by a movement along the IS curve. d. The IS curve will shift to the right because of an increase in the tax rate. 1. Only a 2. Only b 3. Only c 4. Only d 5. c and d Explanation Study guide, page 85 Question 9 is based on the following diagram: 9. Which of the following statements is/are correct? a. The movement from point b to point a implies an increase in investment spending. b. The movement from point a to point b implies a decrease in the interest rate which will increase investment spending and the demand for goods. c. A change in investment spending does not always shift the IS curve because an increase in investment spending due to a decrease in the interest rate is represented by a movement along the IS curve. d. An increase in business confidence and a decrease in the interest rate both increase investment spending. The increase in investment spending due to an increase in business confidence shifts the IS curve to IS1 while an increase in investment due to a decrease in the interest rate causes a downward movement along the IS curve from point a to point d. e. A shift from IS to IS1 can be the result of a change in government spending, a change in consumer confidence, or a change in any of the autonomous factors that change the demand for goods. f. The movement from point b on the IS curve to point d on the IS1 curve can be the result of a decrease in taxation. 1. a, c and d 2. b, c, e and f 3. Only d and e 4. c, d and e 5. None of the options 1 to 4 is correct Explanation Only statements b and c are correct. It is important that you know the factors that will cause a shift of the IS curve and the factors that will cause a movement along the IS curve. Revise section 4.3, subsection with the heading “Shifts of the IS curve” in the study guide. Statement a is incorrect. The movement from point b to point a implies a decrease in investment spending since the interest rate increases. Statement d is incorrect. The first part of the statement is correct but the second part is incorrect. An increase in investment due to a decrease in the interest rate causes a downward movement along the IS curve from point a to point b on the same IS curve (not to point d). Statements e and f are correct. It is important that you know the factors that will cause a shift of the IS curve and the factors that will cause a movement along the IS curve. Revise section 4.3, subsection with the heading “Shifts of the IS curve” in the study guide. Statements d are incorrect. Both statements include the monetary policy (money supply). Only the fiscal policy (G and/or T) has an influence on the IS curve. 10. Which of the following statements are correct? a. The nominal value of a good is its value in terms of money while the real value is its value in terms of some other good, service, or bundle of goods. b. The nominal money supply is the money supply expressed in terms of its purchasing power in terms of goods. c. A decline in the general price level results in a decrease in the real money supply and less goods and services can be bought. d. If the nominal money supply is R500 and the price level is R20, then the real money supply is 25. e. Given the price level, the nominal money supply divided by the price level defines the real money supply. 1. a, b, c, d and e 2. Only a, b, d and e 3. Only a, d and e 4. Only b, c and e 5. Only a, b, d and e 11. Which of the following statements is/are correct? a. To derive the LM-curve we change the level of income to determine the effect on the interest rate. b. The derivation of the LM curve is described by the following chain of events; Y↑ → Ms↑ → I↓ → Z↓ → i↑. c. When we derive the LM curve an increase in income will cause an increase in the demand for money, which is represented by the shift of the demand for money curve to the right, and it will cause an increase in the equilibrium interest rate. 1. a, b and c 2. Only a and b 3. Only a and c 4. Only b and c 5. None of the options 1 to 4 is correct Explanation The correct option is 3. Statements a and c are correct. To derive the LM-curve we change the level of income to determine the effect on the interest rate and therefore the derivation of the LM curve is described by the following chain of events; Y↑ → Md↑ → i↑. The opposite is also true: Y↓ → Md↓ → i↓. Statement b is therefore incorrect because the nominal money supply is kept constant with the derivation of the LM curve. 12. The statement that the LM curve is upward sloping since an increase in the interest rate increases the demand for money is incorrect because it is … 1. upward sloping since an increase in the interest rate decreases the demand for money. 2. upward sloping since an increase in the interest rate increases the money supply. 3. upward sloping since an increase in the level of output and income increases the demand for money and the interest rate. 4. upward sloping since an increase in the interest rate increases the level of output and income. 5. upward sloping since an increase in the level of output and income increases the money supply. Explanation The statement that the LM curve is upward sloping since an increase in the interest rate increases the demand for money is incorrect because it is upward sloping since an increase in income increases the demand for money and the interest rate. Remember that the key to the derivation of the LM curve is the events that take place in the financial market when the level of output and income changes. 13. Which one of the following will cause a downward shift of the LM curve? 1. An increase in the demand for money and expansionary monetary policy. 2. An increase in the level of output and income and expansionary monetary policy. 3. An increase in the money supply and expansionary monetary policy. 4. A decrease in the money supply and contractionary monetary policy. 5. An increase in the interest rate and expansionary monetary policy. Explanation Study guide, pages 96-97 Question 14 is based on the following LM curve: 14. Given the LM curve the situation at point a compared to point b is described the best by which one of the following? Demand for money Supply of money Interest rate Output 1. Higher Higher Higher Higher 2. Lower Lower Lower Lower 3. Higher The same Higher Higher 4. The same Higher Higher Higher 5. Lower The same Lower Lower   15. Which of the following statements is/are correct regarding the IS curve and the LM curve? a. An expansionary monetary policy will shift the LM curve downwards. b. An expansionary fiscal policy will shift the LM curve downwards. c. A contractionary fiscal policy will shift the IS curve to the left. d. A contractionary monetary policy will shift the LM curve upwards. 1. a, c and d 2. Only a and d 3. Only c and d 4. Only b 5. Only a Explanation Chain of events summary 16. In the IS-LM model which of the following policy actions will bring about an increase in the level of output and income and an increase in the interest rate? a. An increase in the money supply. b. An increase in government spending. c. A decrease in the money supply. d. A decrease in government spending. e. An increase in the budget deficit. 1. a, b and d 2. b, c and e 3. Only b and c 4. Only b and e 5. a, b and e Explanation An increase in government spending causes an increase in the level of output and an increase in the interest rate. 17. In the IS-LM model an increase in government spending increases the demand for goods and the … 1. IS curve shifts to the right. As government spending increases the supply of money increases and the LM curve shifts downwards. 2. IS curve shifts to the right. The demand for money increases and the interest rate rises and a movement along the LM curve takes place. 3. IS curve shifts to the left. The demand for money increases and the interest rate rises causing the LM curve to shift upwards.