Solutions to Problems

Chapter 29
1a.

A decrease in government expenditures leads to a decrease in aggregate demand, which in turn sets up a
process in which real GDP starts to decrease and the price level starts to fall.
The decrease in government expenditures has a multiplier effect on aggregate demand. Aggregate
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demand decreases and shifts the AD curve in figure 1(a) leftward by $50b from AD0 to AD0 . Real GDP
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begins to decrease and the price level starts to fall towards the new equilibrium a .
1b.

Real GDP decreases and the interest rate falls.

In the first round, real GDP begins to decrease and the price level begins to fall. In the second round, as
real GDP decreases the demand for money decreases from MD0 to MD1 in figure 1(b). As the price level falls,
the quantity of real money increases from MS0 to MS1 in figure 1(b). As a result, the interest rate falls from
5% to 4%. The fall in the interest rate limits the decrease in real GDP.

1c.

As the interest rate falls, interest-sensitive expenditure increases from $100b to $112b in figure 1(c).

1d.

The increase in interest-sensitive expenditure increases aggregate demand and the aggregate demand
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curve starts to shift rightward from AD0 to AD1 in figure 1(a). This second-round increase in aggregate
demand is less than the initial decrease. With an increase in investment and other interest sensitive
expenditure of $12b the AD curve in figure 1(a) will move to the right by $24b to AD1.

1e.

In the long run the equilibrium will be at potential real GDP.

Comparing the final equilibrium with the initial equilibrium, the decrease in government expenditures on
goods and services has lead to a decrease in real GDP, a fall in the price level, and a fall in the interest rate.
The new equilibrium real GDP is $580b and the price level of 97.5. Unless this is potential real GDP this is a
short-run equilibrium, long-run equilibrium is at potential real GDP.

Note: Apart from the initial decrease in aggregate demand to $550b the rest of the figures for GDP and price level
have no exactness. Their values will depend on the relative interest rate elasticities of money demand and
interest sensitive expenditure.

Figure 1(a)

Figure 1(b)

Figure 1(c)

3a.
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3b.

A decrease in the money supply raises the interest rate.

A decrease in the money supply with a constant price level decreases the real money supply and shifts the
real money supply curve in figure 3(a) leftward. The interest rate rises from 5% to 6%.
The increase in the interest rate decreases planned investment.
The higher interest rate decreases interest-sensitive expenditure by $25 billion, from $100b to $75b in figure
3(b).

3c.

Aggregate planned expenditure falls by twice the decrease in interest-sensitive expenditure when the
multiplier is two.
The decrease in interest-sensitive expenditure decreases aggregate demand and shifts the AD curve leftward
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by $50b, from AD0 to AD0 in figure 3(c). The decrease in interest-sensitive expenditure has a multiplier effect
of two on aggregate demand.

3d.

Real GDP decreases and the interest rate falls.

In the second round, the decreasing real GDP decreases the demand for money. The money demand curve in
figure 3(a) shifts leftward from MD0 to MD1 and the interest rate begins to fall from 6%. The falling price
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level increases the supply of real money and the real money supply curve shifts rightward from MS0 to MS1.
The interest rate falls further to 5.3%. As the interest rate falls, interest-sensitive expenditure increases from
$75b to $90b in figure 3(b). The increase in interest-sensitive expenditure increases aggregate demand and the
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aggregate demand curve starts to shift back to the right from AD0 to AD1. But aggregate demand increases by
less than the initial decrease in aggregate demand.
3e.

At the new equilibrium, the fall in aggregate demand is less than initially.
In the first round, real GDP begins to decrease and the price level begins to fall. In the second round, as real
GDP decreases the demand for money decreases. As the price level falls, the quantity of real money
increases. As a result, the interest rate falls. The fall in the interest rate limits the decrease in interest-sensitive
expenditure and limits the decrease in real GDP.

Figure 3(a)

Figure 3(b)

Figure 3(c)

Figure 3(c)
5a.

A given change in the quantity of real money supplied has a larger effect on real GDP in economy B, the
economy with the less elastic demand for money.
Economy A has the more elastic (interest rate sensitive) demand for money function.
Consider a decrease in the money supply of $100 billion in figure 5(a). Because the demand for money is
more interest rate sensitive in economy A, the interest rate needs to rise by less to restore equilibrium in the
money market than it does in economy B.
The impact of monetary policy on real GDP is through its effect on interest rate sensitive components of
aggregate demand. Because the interest rate rises by less in economy A, other things remaining the same,
investment falls by less so there is a similar impact on aggregate demand. Economy B in figure 5(a) shows the
largest fall in aggregate demand.

5b.

The increase in government expenditure has a larger impact on real GDP in economy A, the economy
with the more elastic demand for money.
The effect of a change in government expenditure on goods and services occurs through its direct impact on
aggregate demand. But this is party offset by the induced change in interest rates affecting interest rate
sensitive components of aggregate demand as real GDP changes.
As government expenditure increases, the AD curve shifts to the right, increasing real GDP and the price
level in the short run, at given interest rates. But as real GDP increases, so does the demand for money. And
as the price level increases the quantity of real money decreases; see figure 5(b).
The interest rate rises by more in economy B than it does in economy A. Thus, there is a larger induced fall in
planned investment in economy B than in economy A. If interest sensitive spending falls by $5 billion in
economy A, then it will fall by $20 billion in economy B; see figure 5(b). The increase in government
expenditure has a larger impact in economy A than in economy B..

5c.

The crowdingout effect is weaker in economy A.

Crowding out refers to the offsetting effects on interest sensitive expenditure of an induced increase in
interest rates following an increase in government purchases.
Crowding out occurs more the greater the induced increase in interest rate from increased government
spending. This induced change in the interest rate is larger the more inelastic is the demand for money; see
figure 5(b).
Thus, the crowdingout effect is weaker in economy A.

Figure 5(a)
Figure 5(b)

Figure 6(b)

Figure 6(b)

7a.

An increase in government expenditures and a decrease in taxes are expansionary fiscal policies.
Aggregate demand increases in the first round. Real GDP and the price level begin to increase. In the second
round, the increasing real GDP increases the demand for money and the interest rate rises. The rising price
level decreases the supply of real money and increases the interest rate further. Interest-sensitive expenditure
decreases and limits the increase in real GDP. The decrease in interest-sensitive expenditure includes a
decrease in investment and net exports.
An increase in the money supply lowers the interest rate, increases interest-sensitive expenditure and
increases aggregate demand in the first round. Real GDP and the price level begin to increase. In the second
round, increasing real GDP increases the demand for money and the interest rate rises. The rising price level
decreases the supply of real money and the interest rate rises further. The decrease in interest-sensitive
expenditure limits the increase in real GDP. The resulting increase in interest-sensitive expenditure includes
an increase in investment and net exports.

7b.

The expansionary fiscal policies raise the interest rate and the interest-sensitive expenditure component of
aggregate demand decrease. The exchange rate rises, exports decrease, imports increase, and net exports
decrease.
An increase in the money supply lowers the interest rate and the interest-sensitive expenditure
component of aggregate demand increase. The exchange rate falls, exports increase, imports decrease, and net
exports increase.

7c.

All policies increase real GDP and raise the price level.

7d.

The best policy is to decrease interest rates.

Increasing the money supply results in a lower interest rate and lowers the exchange rate. The lower
interest rate increases investment and lowers the exchange rate increasing net exports.

9a.

A combination of an increase in the money supply and a decrease in government expenditures.

9b.

An increase in the money supply lowers the interest rate and increases interest-sensitive expenditure
including investment. The aggregate demand curve shifts rightward. A decrease in government expenditures
decreases aggregate demand and shifts the aggregate demand curve leftward. Real GDP decreases, the interest
rate decreases, and interest-sensitive expenditure, including investment, increases. If the decrease in
government expenditures is of the correct magnitude, the leftward shift of the aggregate demand curve will
offset the rightward shift created by the increase in the money supply. The price level will remain the same.

9c.

The lower interest rate will increase investment and consumption expenditure and the lower exchange
rate will increase exports.

9d.

In the short run, real GDP and the price level do not change. The aggregate demand curve remains the
sameonly the composition of aggregate demand changes.
In the long run, the increase in investment will encourage economic growth. Real GDP growth will
increase and the price level will remain the same.