DEMOLEC4
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Demonstration Lecture 4: Suggested Solutions 1. True. This question requires a detailed discussion of the interest rate effect in the process of deriving the AD curve from the IS-LM model. Note that up until this point in time we have assumed that the price level is constant and so an exogenous variable, which is either determined outside of our model or pre- determined. Given the initial assumption of a fixed or constant nominal money supply, a change in the price level is effectively changing the real money supply in the economy at any particular point in time. Hence the price level now changes from an exogenous variable to an endogenous variable, or one that is determined inside of the model. With a fixed nominal money supply, and a constant price level for example it means that our initial LM curve is drawn or constructed for a real money supply level. Now with a change in the price level, such as reduction in the price level, MSo/Po to MSo/P1, as demonstrated in Figure 4.1(a) in the Brooks manuscript, the real money supply has increased. As a result the LM curve will shift to the right. This shift produces a new combination of a lower interest rate and a higher level of Y or real GDP. Plotting the various price levels against the various levels of related Y or real GDP, we can derive the Aggregate Demand curve. Note that it is negatively sloped, and shows the relationship between aggregate expenditure as determined by the IS-LM framework, and the various price levels. The derivation can also be shown with an increase in the price level. 2. True. The position of the AD curve is determined by those autonomous factors which impact upon either the positions of the IS or LM curves. In the case of a change in autonomous consumption expenditure or Co, it will produce a shift to the right of the original IS curve, as is demonstrated in Figure 4.4 (a). As this is a non-price factor that is changing, its resultant impact upon the AD curve will not be a movement along the curve but a shift of the curve per se. Note that in Figure 4.4 (b), the shift in the AD curve produces an increase in Y or real GDP but with the maintenance of the original price level of Po. Students should also consider how this change in autonomous expenditure, Co, will lead to an increase in Y or real GDP using the 45 degree line model approach. 3. True. An increase in the real money supply can come about from 2 sources, either a change in the nominal money supply, with no change in the underlying price level, and/or a change in the price level with no change in the nominal money supply. It is clear from previous work done on the IS-LM model that an increase in the real money supply will shift the LM curve to the left. But now
Transcript of DEMOLEC4
Demonstration Lecture 4: Suggested Solutions
1. True. This question requires a detailed discussion of the interest rate effect in the process of deriving the AD curve from the IS-LM model. Note that up until this point in time we have assumed that the price level is constant and so an exogenous variable, which is either determined outside of our model or pre-determined. Given the initial assumption of a fixed or constant nominal money supply, a change in the price level is effectively changing the real money supply in the economy at any particular point in time. Hence the price level now changes from an exogenous variable to an endogenous variable, or one that is determined inside of the model. With a fixed nominal money supply, and a constant price level for example it means that our initial LM curve is drawn or constructed for a real money supply level. Now with a change in the price level, such as reduction in the price level, MSo/Po to MSo/P1, as demonstrated in Figure 4.1(a) in the Brooks manuscript, the real money supply has increased. As a result the LM curve will shift to the right. This shift produces a new combination of a lower interest rate and a higher level of Y or real GDP. Plotting the various price levels against the various levels of related Y or real GDP, we can derive the Aggregate Demand curve. Note that it is negatively sloped, and shows the relationship between aggregate expenditure as determined by the IS-LM framework, and the various price levels. The derivation can also be shown with an increase in the price level.
2. True. The position of the AD curve is determined by those autonomous factors which impact upon either the positions of the IS or LM curves. In the case of a change in autonomous consumption expenditure or Co, it will produce a shift to the right of the original IS curve, as is demonstrated in Figure 4.4 (a). As this is a non-price factor that is changing, its resultant impact upon the AD curve will not be a movement along the curve but a shift of the curve per se. Note that in Figure 4.4 (b), the shift in the AD curve produces an increase in Y or real GDP but with the maintenance of the original price level of Po. Students should also consider how this change in autonomous expenditure, Co, will lead to an increase in Y or real GDP using the 45 degree line model approach.
3. True. An increase in the real money supply can come about from 2 sources, either a change in the nominal money supply, with no change in the underlying price level, and/or a change in the price level with no change in the nominal money supply. It is clear from previous work done on the IS-LM model that an increase in the real money supply will shift the LM curve to the left. But now students must differentiate between the 2 types of change in the real money supply. If the increase in Ms/P comes form a fall in the price level then this effectively translates to a movement along the AD curve. On the other hand if the increase in Ms/P is due to am increase in the nominal money supply or Ms, then this translates to a rightward shift of the AD curve. Students should refer to Figures 4.5 (a), and (b) in the Brooks manuscript to see the effect of the latter change in real money supply.
4. True. The interest elasticity is directly related to the price elasticity of the AD curve. Students should refer to Section 4.1.5 in the Brooks manuscript. It follows that with a relatively elastic IS curve, and a normal LM curve, for example , a change in the price level, such as a fall in price, will shift the LM curve to the right. As a result of the latter, it is logical to expect a fairly large increase in Y or real GDP. Hence one can conclude that a relatively small fall in price will lead to a large increase in Y. If students were to plot thee outcomes along a price/Y set of axes, this would produce a relatively elastic AD curve. However one should also be aware of the significance of the relative elasticity/inelasticity of the LM curve, and its impact upon the ultimate shape/slope of the AD curve. This relationship is addressed in the answer to Question 5.
5. True. When the demand for money is interest elastic, it means that the total money demand curve is relatively elastic. Hence a small change in the interest rate will have a relatively large impact upon the demand for money as opposed to other financial asset forms. In turn this corresponds to a relatively elastic LM curve , as shown in Case 2 in Section 4.1.5 of the Brooks manuscript. Assuming a given IS curve which is neither highly elastic nor inelastic in respect to interest rate variations, a change in the price level will lead to an increase in real money supply if there is a
reduction in price. The LM curve will shift to the right but produce a relatively small increase in Y or real GDP. In conclusion an average change in the price level will produce a disproportionately small increase in Y or real GDP. In effect one is left with a relatively inelastic AD curve. The rule that follows is that a relatively elastic LM curve leads to a relatively inelastic AD curve and vice versa.
6. True. If the investment demand curve is totally inelastic, it means that planned investment expenditure is totally insensitive to variations in the interest rate. It follows that on the basis of previous theoretical work done in this subject that the associated IS curve is totally inelastic., as is demonstrated in Figure 4.6 (a) of the Brooks manuscript. Assuming a conventional LM curve, then a fall in the price level will move the LM curve out to the right. However, given the vertical IS curve, this will produce a reduction in the interest rate but no change in Y or real GDP. It therefore follows that the resultant Ad curve will also be perfectly price inelastic. In conclusion the change in the rate of interest generated by the change in the real money supply (due to the fall in the price level), will have no impact upon expenditure and so no impact upon Y. Students should also attempt to see the effect of a totally inelastic investment demand curve, when placed in the context of the 45 degree model. Given the latter a change in i will produce no change in Io, and so the Aggregate Expenditure function remains constant. This effectively means that in the 45 degree model, there would be no change in AE , and so Ye1 would be identical to Ye2.
