Review Questions
Macroeconomics After the Great Depression

The core of this section was the development of two closely-related models. The first was the IS-LM model, the second the AS-AD model. Each of these models is useful for different purposes. 
The IS-LM model is a nothing more than a neat way to keep track of two equilibirum conditions that must be satisfied at all points in time. The first is money market equilibrium: money supply must equal money demand. For any given values of money supply and the price level, money market equilibrium requires that a certain relationship between the nominal interest rate and national income be satisfied. This relationship is summarized by the LM curve. The second is goods market equilibrium, which is to say that the national income accounting identity, Y=C+I+G, must always be satisified. You should also recall that when Y=C+I+G, it is also true that national saving equals national investment. Thus, the goods market equilibrium is that S=I. For given values of government expenditure, taxes, and expected inflation, goods market equilibrium requires that another relationship between  the nominal interest rate and national income be satisfied. This relationship is summarized by the IS curve. 
When plotted on a graph with i and Y on the axes, we showed that the LM curve has a positive slope while the IS curve has a negative slope. The economy has to lie on the LM curve for the money market to be in equilibrium and it has to lie on the IS curve for the goods market to be in equilibrium. There is only one point, the intersection of the two curves, where both sectors of the economy are in equilibrium. We also showed how these curves shift when policies change. Whenever they shift, the intersection point changes, so the IS-LM model is a neat way to work out the effects of policy changes on the nominal interest rate and output.
The AS-AD model extends the IS-LM by allowing for price changes. The IS-LM curves were combined into a single curve plotted on a graph with price and output on the axes. This we called the Aggregate Demand curve. We then developed a concept of aggregate supply which depended on price expectations, and we introduced the concept of adapative expectations to model how price expectations develop over time. The AS-AD model provides a bridge between the short-run analysis of the Keynesian IS-LM model where prices are fixed, and the Classical AS-AD model, where prices are fully flexible. In developing this model, we concluded that (i) the IS-LM model is an appropriate tool to assess how policy changes might affect the economy over a time horizon of 6 to 9 months, (ii) the Keynesian AS-AD model is an appropriate tool to assess how policy changes might affect the economy over a time horizon of 9 months to 4 or 5 years, and (iii) the classical model with a vertical AS curve is an appropriate tool to analyze how policies introduced today will affect how the economy will look in 5 years or more.
We have tried to develop three specific skills in using these models. The first is to be able to calculate the effects of policy changes mathematically. The reason for this is that many of you may come across occasions when the question you want to study involves extending the basic model to introduce a new policy variable or some new factor than influences the economy. Problem set 3 was concerned with giving you practice at this skill. You were asked to modify the basic model and explain how the economy is predicted to behave in the new version of the model. Adapting the basic models to new questions is difficult to do without mastering the mathematical approach. 
The second skill is to use the models as a guiding framework to help you explain in a non-technical fashion how the economy will respond to a policy change. This is what I call conversational macroeconomics. I have tried to push this skill by getting you to explain verbally why the intersection moves in the way that it does. We saw repeated instances of this skill set in the applications we looked at: German unification, the Clinton-Greenspan policy mix, the macroeconomic effects of 9/11, and so on.
The third skill is to use the IS-LM model as a guide in interpreting data. This is what I call forensic macroeconomics. You are presented with some data on the behavior of the economy, perhaps as it is sliding into a recession. Your boss wants to know what is causing the recession. By studying what has happened to interest rates or to prices, you are able to pinpoint which part of the economy is causing the recession.

Links take you to to answers or hints. Although it is very tempting to do otherwise, you should make a serious attempt to answer a question before following the link. You will learn a lot about your mastery of the material by comparing your answer with mine. 
1. Consider the following two positions on tax policy:   Explain the rationale behind these two statements in the light of the economic models we have developed. (Hint: think first about propensities to save among rich and poor).
2. Media quote: "Personal saving habits peaked in the early 1970s, when average U.S. residents stashed away over 9 percent of take-home pay, and declined through the 1980s to a low of less than 3 percent. It seems that they prefer to cut down on their saving to maintain living standards: the catch is that a low saving rate makes it harder to increase living standards." Explain this saving paradox.
3. Nominal interest rates are at a record low level in Japan, leading to concerns that the economy is in a liquidity trip, making short-run monetary expansion ineffective. Explain precisely how long-term monetary expansion may nonetheless be effective in stimulating the economy.
4. The central bank is considering two alternative policies: (i) holding the money supply constant, and (ii) adjusting the money supply to hold the interest rate constant. Which policy will better stabilize GDP when short-run fluctuations are driven a) by money market shocks, and b) by goods market shocks?
5. Suppose that central bank A cares only about keeping the price level stable, and central bank B cares only about keeping output and employment stable. Explain how each central bank would respond to an increase in the price of oil.
6. Are fiscal policy multipliers larger or smaller when investment is sensitive to interest rates than when it is not? Explain the difference.
7. A vertical LM curve is often referred to as the "classical case". In what sense is this name appropriate?
8. What do you see as the essential differences between the Keynesian and classical theories of aggregate supply?
9. In the same way that we did in class for the effects of a change in the money supply (using both the AS-AD and IS-LM models), explain the immediate and long-run effects of a reduction in government expenditure on prices, output and the interest rate.
10. Suppose government wants to raise investment but keep output constant. In the IS-LM model, what mix of monetary and fiscal policy will achieve this goal?