ECO 320L -- IS-LM Model and Aggregate
Demand UPDATED ACTUAL Exam
Questions and CORRECT Answers
Standard "IS-LM" approach to aggregate demand, based on Keynes and Hicks - CORRECT
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.
Part 1: The Saving (Loanable Funds) - CORRECT 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 - CORRECT 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? - CORRECT 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.
What could describe aggregate consumption? - CORRECT 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 - CORRECT ANSWER Consumption and
consumer sentiment (CS)
What is decreasing in after-tax income Y-T - CORRECT ANSWER Real interest rate (r)
What is increasing in aggregate savings? - CORRECT ANSWER real interest rate (r)
What is decreasing in aggregate saving? - CORRECT ANSWER Consumer Sentiment (CS)
How does an increase in Y affect savings? - CORRECT 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 - CORRECT ANSWER Marginal Propensity
to save (MPS)
Demand UPDATED ACTUAL Exam
Questions and CORRECT Answers
Standard "IS-LM" approach to aggregate demand, based on Keynes and Hicks - CORRECT
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.
Part 1: The Saving (Loanable Funds) - CORRECT 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 - CORRECT 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? - CORRECT 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.
What could describe aggregate consumption? - CORRECT 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 - CORRECT ANSWER Consumption and
consumer sentiment (CS)
What is decreasing in after-tax income Y-T - CORRECT ANSWER Real interest rate (r)
What is increasing in aggregate savings? - CORRECT ANSWER real interest rate (r)
What is decreasing in aggregate saving? - CORRECT ANSWER Consumer Sentiment (CS)
How does an increase in Y affect savings? - CORRECT 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 - CORRECT ANSWER Marginal Propensity
to save (MPS)
