ECO 320L -- IS-LM Model and
Aggregate Demand Exam 2025
Questions and Answers
Standard "IS-LM" approach to aggregate demand, based on Keynes and Hicks -
ANSWER-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.
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,Part 1: The Saving (Loanable Funds) - ANSWER-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 - ANSWER-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? - ANSWER-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.
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, What could describe aggregate consumption? - ANSWER-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 - ANSWER-Consumption and
consumer sentiment (CS)
What is decreasing in after-tax income Y-T - ANSWER-Real interest rate (r)
What is increasing in aggregate savings? - ANSWER-real interest rate (r)
What is decreasing in aggregate saving? - ANSWER-Consumer Sentiment (CS)
How does an increase in Y affect savings? - ANSWER-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 - ANSWER-Marginal Propensity
to save (MPS)
When an increase in consumption from a 1$ change in after-tax income is known
as - ANSWER-Marginal Propensity to consume (MPC)
....COPYRIGHT ©️ 2025 ALL RIGHTS RESERVED...TRUSTED & VERIFIED 3
Aggregate Demand Exam 2025
Questions and Answers
Standard "IS-LM" approach to aggregate demand, based on Keynes and Hicks -
ANSWER-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.
....COPYRIGHT ©️ 2025 ALL RIGHTS RESERVED...TRUSTED & VERIFIED 1
,Part 1: The Saving (Loanable Funds) - ANSWER-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 - ANSWER-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? - ANSWER-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.
....COPYRIGHT ©️ 2025 ALL RIGHTS RESERVED...TRUSTED & VERIFIED 2
, What could describe aggregate consumption? - ANSWER-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 - ANSWER-Consumption and
consumer sentiment (CS)
What is decreasing in after-tax income Y-T - ANSWER-Real interest rate (r)
What is increasing in aggregate savings? - ANSWER-real interest rate (r)
What is decreasing in aggregate saving? - ANSWER-Consumer Sentiment (CS)
How does an increase in Y affect savings? - ANSWER-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 - ANSWER-Marginal Propensity
to save (MPS)
When an increase in consumption from a 1$ change in after-tax income is known
as - ANSWER-Marginal Propensity to consume (MPC)
....COPYRIGHT ©️ 2025 ALL RIGHTS RESERVED...TRUSTED & VERIFIED 3
