Problem Set 4
Chapter 12 (chapter 11 in 7th edition): Aggregate demand II: applying the ISLM model
1. Chapter 12, Question 6
Use the ISLM Diagram to describe the shortrun and longrun effects of the following
changes on national income, the interest rate, the price level, consumption, investment,
and real money balances.
a. An increase in the money supply
An increase in the money supply shifts the LM curve to the right in the short run.
The interest rate then falls, and output rises because the lower interest rate causes more
investment, which in turn increases output.
b. An increase in government purchases.
An increase in government purchases shifts the IS curve to the right. In the short
run, output increases and the interest rate increases.
c. An increase in taxes.
An increase in taxes reduces disposable income, shifting the IS curve to the left.
In the short run, output and the interest rate decline. In the longer run, prices begin to
decline because output is below its longrun equilibrium level, and the LM curve then
shifts to the right.
2. Chapter 12, Question 7
The Fed is considering two alternative monetary policies:
▯holding the money supply constant and letting the interest rate adjust, or
▯adjusting the money supply to hold the interest rate constant.
In the ISLM model, which policy will better stabilize output under the following
a. All shocks to the economy arise from exogenous chan