ECS 2602 ASSIGNMENT 2

This assignment contributes 40% towards your semester mark. Please ensure that this assignment reaches the university before the due date. Answer all questions on a mark-reading sheet. 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. Page 2 of 18 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 Statement a is correct. To derive the IS curve, we change the interest rate to determine the effect on the level of output and income. Statement b is incorrect. To d