E322 Intermediate Macroeconomic Theory

Second Exam

Fall 1997

Dr. Christopher J. Waller

1. Derive the LM curve. Explain the reasoning behind the derivation. Then show and explain how an increase in the money supply affects the LM curve.

2. Using the indifference curve model of risk and return, derive the money demand curve.

3. Due to reductions in public spending and unexpected tax revenues, the federal budget deficit has been falling dramatically the past two years. In fact, the projected deficit for 1997 is $22.7 billion dollars, the lowest it has been in 24 years. Using the IS-LM model, show and explain how this would affect output, employment, interest rates and investment. Do the theoretical predictions appear to be consistent with the current state of the economy (4.7% unemployment, lowest in 24 years also, output growth of over 4% relative to the long-run average of 2.5% over the last 24 years)?

4. In class we assumed the money supply curve was vertical. However there is considerable evidence that it is actually upward sloping, i.e., the Fed increases the quantity of money supplied when interest rates rise. How would this affect the derivation of the LM curve? [Hint: Derive the LM curve with both a vertical money supply curve and an upward sloping one starting from the same initial equilibrium point in the money market.] What affects would this have on fiscal policy (i.e., now suppose there was an increase in government spending)?