I have Economics tests. I will post 9 graphs questions and needs to be answered answered in 75 min
ures
r
P
Y
Y
LM
IS
r*
P*=Pe*
Y*
=Yn*
SRAS
LRAS
AD
Y*
Initial Equilibrium
r
P
Y
Y
LM
IS
r*
P*=Pe*
Y*=Yn* = YL
SRAS
LRAS
AD
Y* = YL
Problem 1:
C0 Falls, IS Left
Short run:
Unemployment up
Prices down
Long run:
Unemployment unchanged
Prices down (more)
IS2
AD2
PS
LMS
rS
YS
LML
rL
YS
SRASL
PL =Pe-L
r
P
Y
Y
LM = LML
IS
r* = rL
P*=Pe*
Y*=Yn*=YL
SRAS
LRAS
AD
LM2
AD2
rs
Ps
Ys
SRASL
LMS
Y*=YL
rL
PL =Pe-L
Ys
Problem 2:
Increase money supply:
Buy bonds
Lower discount rate
Lower reserve requirements
Quantitative easing
(buy long-term assets)
Lower interest rate
paid on reserves
Problem 3:
MS up, LM shifts right
Short run:
Unemployment down
Prices up
Long run:
Unemployment unchanged
Prices up (more)
r
P
Y
Y
LM
IS
r*
P*=Pe*
Y*=Yn*
SRAS
LRAS
AD = ADreact
Y*
Problem 4
C0 Falls, MS rises
Move AD back where it started
r lower, but P and Y unchanged
No change from short run to long run
IS2
AD2
rS =
LMreact
rL
r
P
Y
Y
LM
IS
r*
P*=Pe*
Y*=Yn*
SRAS
LRAS
AD
Y*
LRAS2
SRAS2
Ps
rs
Ys
LMS
Ys
SRASL
LML
rL
PL =Pe-L
YL=YnL
YL
Problem 5:
Increase technology: LRAS right
Short run:
r down, Y up, P down
C up, I up, Un down
Pe unchanged
Long run:
r down, Y up, P down
C up, I up, Un down
Pe down
Everything looks good…
But can we do better?
r
P
Y
Y
LM
IS
r*
P*=Pe*=Ps=PL
Y*=Yn*
SRAS
LRAS
AD
Y*
LRAS2
SRAS2
rs
LMReact
=rL
YS=YnL=YL
YS=YL
AD2
Problem 6:
Increase money supply:
Buy bonds
Lower discount rate
Lower reserve requirements
Quantitative easing
(buy long-term assets)
Lower interest rate
paid on reserves
Problem 7:
Increase technology + MS
Jump to better long-run outcomes!
Short run:
r down, Y up, P unchanged
C up, I up, Un down
Pe unchanged
Long run:
Prices equal expected prices, so short-run equals long-run
I received a few questions about how to get started on IS-LM problems.
Here’s a quick guide:
1. If it’s a change in money supply (anything the Fed can do, buy bonds, sell bonds, raise/lower
the discount rate, etc.) then it alters money supply, so that moves LM.
2. If it’s something that is a prediction about the future, especially relating to prices or
inflation, that’s a change in Pe and that moves SRAS
Pe is the only exogenous variable we have that moves SRAS. MS is the only exogenous variable
we have that moves LM.
Everything else is broken down into two categories:
3. If it’s something that is related to SPENDING, then it’s going to affect IS:
Autonomous Consumption, MPC, Desire to Save, Tax Rates (on individuals): These affect C, so
they affect IS
Autonomous Investment affects I, so that affects IS
Government Spending affects G so that affects IS
Changes in foreign economies affect exports, so do tariffs, and just generally anything that
alters imports or exports affects NX so that affects IS.
So if it’s spending, it’s IS.
4. Finally, if something affects our ability to produce, that will move LRAS.
– Technology
– Physical Capital / factories / etc
– Labor (immigration usually)
– Human Capital (Education / health / experience)
– Natural Resources (oil, climate, etc.)
So:
Money supply: LM
Spending: IS
Expectations: SRAS
Production: LRAS
Lecture finale: Try these problems without notes
First, a review:
1. Suppose there is a stock market crash, and therefore the country’s wealth is greatly reduced.
This will lower autonomous consumption. Show the short-run and long-run effects on our
model. Then state the impact on the price level and on unemployment in the short run and also
on both of those things in the long run.
2. If you are in charge of the Fed, you might want to react to this. State one specific policy you
might follow to try to
help the economy.
3. Go back to the initial equilibrium, and show what your chosen policy would do in both the short
run and in the long run. State the impact on the price level and on unemployment in the short
run and also on both of those things in the long run.
4. Next, start from the initial equilibrium, then assume both the change in question 1 and your
intervention from question 2+3 BOTH happen. Show the combined impact of both changes in
the short run and in the long run. Assume your adjustment is perfect in the short run (so you
don’t make it too big or too small). State the impact in the short run on r, Y, P, C, I,
Unemployment and Pe.
Next, a new problem:
5. Start in the initial equilibrium and show the effect of an increase in technology. State the impact
on P and on unemployment.
6. Again, if you are in charge of the Fed, state one specific policy change you might follow to try to
help the economy.
7. Finally, starting from the initial equilibrium, assume the change from question 5 is happening
and your intervention is also happening. Show the combined impact of both changes in the
short run and in the long run. Again, you can assume your adjustment is perfectly sized. State
the impact in the short run on r, Y, P, C, I, Unemployment and Pe.
Samplequestions:
1) Using only IS-LM, please show the effect of a tax cut. State the likely impact on r, Y, C and I.
2) Please answer the following in one to two sentences:
a. Is monetary policy more or less effective in a liquidity trap? Why?
b. Is fiscal policy more or less effective in a liquidity trap? Why?
c. Illustrate your answer from either a or b using an IS-LM graph.
3) Suppose there’s a stock market boom and as a result of increased wealth, consumer spending
[variable “a” in the equation C = a + m (Y-T)] goes up. Draw the effect in the IS-LM / AS-AD two-
graph model, and state the impact on r, Y, P, C, I, Unemployment rate and Pe.
4) If the Fed announces that they plan to reduce inflation – and people believe they will do so –
this alters the expected price level. Show the short run and long run impact on the two-graph
ISLM-ASAD model, and state the impact on r, Y, P, C, I, Unemployment rate and Pe.
5) Two part question:
a. Suppose the Democrats win control of the government in 2020 and decide their top
priority is reducing the deficit. Show the short-run effect on the ISLM-ASAD graph
b. Now, you are in charge of the Fed. Keeping in mind the dual mandate, how should you
react?
c. Suppose your reaction is exactly perfect. Show on a new graph the combined effect in
the short run and the long run of BOTH the change in A and the change in B. Then state
the effect on the 7 variables above.
Final Exam Topic List:
For graphing problems, be prepared for the following:
PPFs
• Straight-line
• Curved
• Changes
• Trade
• Opportunity costs
Supply and Demand
• Change in supply
• Change in demand
• Change in both
• Elasticity
• Price floors/price ceilings
• Consumer/producer surplus/dead weight loss
• Trade, quotas and tariffs
Money Supply – Money Demand
• Change in supply
• Change in demand
ISLM
• Changes in LM (MS or P)
• Changes in IS (C, I, G, NX including things like taxes & autonomous consumption)
• Outcome for r, Y, C, I, P, Unemployment
• Liquidity Trap and differences
ISLM with ASAD (MORE of these than anything else)
• Short run outcomes
• Long run outcomes (compared to initial equilibrium)
• Policy recommendations
• Outcome combined with policy recommendations (both short run and long run)
• Changes in Y, r, P, C, I, Un, Pe – know the formulas!
Also be prepared for anything on the topic list for midterm 1 and midterm 2.
Best sources for review:
• Midterm 1
• Midterm 2
• Posted Class notes, recitation notes and zoom lecture material
Policy Interventions
ISLM-ASAD Full Model
Remember key equations
IS: Y = C + I + G + NX
LM: MS/P = L (r, Y)
AD: Combine IS + LM
LRAS: Yn = A x F (K, L, N, H)
SRAS: Y = Yn + z (P – Pe)
C = C0 + m (Y – T)
I = I0 – j x r
Monetary Policy
Stimulus / Boost GDP
Increase money supply
Example: Buy bonds
r
P
Y
Y
LM
IS
r*
P*=Pe*
Y*=Yn*
SRAS
LRAS
AD
Y*
r
P
Y
Y
LM
IS
r*
P*=Pe*
Y*=Yn*=Y-L
SRAS
LRAS
AD
Y*=Y-L
LM2
AD2
Ps
Ys
Ys
LMs
rs
P
r
P
Y
Y
LM
IS
r*=r-L
P*=Pe*
Y*=Yn*=Y-L
SRAS
LRAS
AD
Y*=Y-L
LM2
AD2
Ps
Ys
Ys
LMs
rs
SRAS-L
P
P-L=Pe-L
LM-L
Fiscal Policy
Stimulus / Boost GDP
Increase government spending OR
Cut taxes
Goal: Raise GDP, lower unemployment
r
P
Y
Y
LM
IS
r*
P*=Pe*
Y*=Yn*
SRAS
LRAS
AD
Y*
r
P
Y
Y
LM
IS
r*
P*=Pe*
Y*=Yn*
SRAS
LRAS
AD
IS2
AD2
rs
Ps
Ys
LMS
Y*
Ys
r
P
Y
Y
LM
IS
r*
P*=Pe*
Y*=Yn*=YL
SRAS
LRAS
AD
IS2
AD2
rs
Ps
Ys
SRASL
LMS
LML
Y*=YL
rL
PL =Pe-L
Ys
r
P
Y
Y
LM
IS
r*
P*=Pe*
Y*=Yn*=YL
SRAS
LRAS
AD
IS2
AD2
rs
Ps
Ys
SRASL
LMS
LML
Y*=YL
rL
PL =Pe-L
Ys
r
P
Y
Y
LM
IS
r*=r-L
P*=Pe*
Y*=Yn*=Y-L
SRAS
LRAS
AD
Y*=Y-L
LM2
AD2
Ps
Ys
Ys
LMs
rs
SRAS-L
P
P-L=Pe-L
LM-L
Monetary Policy
Fight inflation
Lower money supply
Example: Sell bonds
r
P
Y
Y
LM
IS
r*
P*=Pe*
Y*=Yn*
SRAS
LRAS
AD
Y*
r
P
Y
Y
LM
IS
r*
P*=Pe*
Y*=Yn*
SRAS
LRAS
AD
LM2
AD2
rs
Ps
Ys
LMS
Y*
Ys
r
P
Y
Y
LM = LML
IS
r* = rL
P*=Pe*
Y*=Yn*=YL
SRAS
LRAS
AD
LM2
AD2
rs
Ps
Ys
SRASL
LMS
Y*=YL
PL =Pe-L
Ys
Federal Reserve Dual Mandate
Stabilize prices
Maximize employment
Policy tools:
Buy/sell bonds
Raise/lower discount rate
Etc.
NOT: Change gov’t spending or taxes
Problem: Stock market crash
Wealth falls, so C0 drops
First: Show what happens in the short run with no intervention
What is our policy recommendation?
– BUY BONDS
Then, show the short run and long run outcome of the initial problem COMBINED with our intervention
r
P
Y
Y
LM
IS
r*
P*=Pe*
Y*=Yn*
SRAS
LRAS
AD
Y*
r
P
Y
Y
LM
IS
r*
P*=Pe*
Y*=Yn*
SRAS
LRAS
AD
IS2
AD2
rs
Ps
Ys
LMS
Y*
Ys
r
P
Y
Y
LM
IS
r*
P*=Pe*=Ps=PL
Y*=Yn*=Ys =YL
SRAS
LRAS
AD = ADReact
IS2
AD2
rs
Y*
Ys
LMReact
Problem: We run out of oil
Fall in our supply of natural resources.
Show the short-run problem
Make a policy recommendation (For the Fed)
Show the short run and long run outcome of your recommendation
Federal Reserve Dual Mandate
Stabilize prices
Maximize employment
Policy tools:
Buy/sell bonds
Raise/lower discount rate
Etc.
NOT: Change gov’t spending or taxes
r
P
Y
Y
LM
IS
r*
P*=Pe*
Y*=Yn*
SRAS
LRAS
AD
Y*
r
P
Y
Y
LM
IS
r*
P*=Pe*
Y*=Yn*
SRAS
LRAS
AD
Y*
LRAS2
SRAS2
Ps
rs
Ys
LMS
Ys
YL=YnL
Option 1: Do Nothing
r
P
Y
Y
LM
IS
r*
P*=Pe*
Y*=Yn*
SRAS
LRAS
AD
Y*
LRAS2
SRAS2
Ps
rs
Ys
LMS
Ys
SRASL
LML
rL
PL =Pe-L
YL=YnL
YL
Option 1: Do Nothing
Short run:
Inflation, recession, high unemployment
Long run:
Even worse inflation, even worse recession, even worse unemployment
You’re fired.
Option 2: Stimulus
Buy bonds
Bring GDP back to initial level
r
P
Y
Y
LM = LMs
IS
r* = rs
P*=Pe*
Y*=Yn*
SRAS
LRAS
AD
Y*
LRAS2
SRAS2
Ps
Ys
LMReact
Ys
AD2
r
P
Y
Y
LM = LMs
IS
r* = rs
P*=Pe*
Y*=Yn*
SRAS
LRAS
AD
Y*
LRAS2
SRAS2
Ps
Ys
LMReact
Ys
YL=YnL
AD2
SRASL
PL =Pe-L
rL
LML
Option 2: Stimulus
Short run:
No recession! But massive Inflation
Long run:
Crushing inflation, even worse recession, even worse unemployment
You’re fired. But you might have kept your job for a year or two first.
Option 2: Contraction
Sell bonds
Stabilize prices
r
P
Y
Y
LM = LMs
IS
r*
Y*=Yn*
SRAS
LRAS
AD
Y*
LRAS2
SRAS2
Ys
LMReact
Ys
YL=YnL
AD2
rs = rL
P*=Pe*=Ps=PL
Option 2: Contraction
Short run:
Deep recession right away, but inflation controlled
Long run:
Stable prices, no further changes
Outcome: You’re probably fired, but you did your job
General rule
Stabilize prices first.
We solve this in reverse (start at the end and work backwards):
Move AD so it crosses LRAS at the current price level
To do that, move LM so it crosses IS at the same Y as your target for AD
Then find short run and long run outcomes
𝐶 = 𝐶0 + 𝑚(𝑌 − 𝑇)
𝐼(𝑝𝑙𝑎𝑛𝑛𝑒𝑑) = 𝐼𝑜 − 𝑗𝑟
AE = C + I + G + NX and Y = AE, so combining with the above we get:
(Investment = Savings) 𝐼𝑆: 𝑌 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋
(Liquidity = Money)𝐿𝑀:
𝑀𝑠
𝑃
= 𝐿(𝑟, 𝑌)
[think L is similar to
𝑘𝑌
𝑟
]
AD: Aggregate Demand: Combine IS + LM
– what is Y’s intersection as P changes (change in P moves LM)?
LRAS: Long-Run Aggregate Supply: YN = A x F (K, L, N, H)
SRAS: Short-run Aggregate Supply: Y = YN + z (P – Pe)
**: if Pe ≠ P then Pe will move toward P over time (SRAS shifts)
Colors:
Yellow: Exogenous
Blue: Endogenous variables, appear on axis, link equations together
Green: Other endogenous variables, have exogenous components
Gray: Long-run GDP, technically endogenous, only changes if LRAS components change
Endogenous:
P – Price level
r – Real interest rate
Y – Real GDP
YN – Long-run GDP / “natural level” of GDP
C – Consumption (parts of it are exogenous)
I – Investment (parts of it are exogenous)
Long-run Pe (Can change exogenously in the short run)
Exogenous: I could ask you to change ANY of these,
all else are held constant unless noted (ceteris paribus)
G – Government purchases
T – Taxes (more complex model – tax rate is exogenous but total taxes are endogenous
based on t x Y)
NX – Net Exports (Exports minus Imports, each exogenous)
Io – Autonomous Investment – Investment that does not depend on interest rates
C0 – Autonomous consumption – the amount of consumption that does not depend on
GDP (part of the Y intercept of the consumption function) is exogenous. Largely
depends on wealth.
m – MPC – Marginal propensity to consume is exogenous, though usually fixed.
Ms – Money supply – exogenous, largely controlled by the Fed
A – Technology
K – Physical capital (factories, tools, etc.)
L – Labor (number of workers or hours worked). This is NOT the “L” in the LM function.
N – Natural resources (can be obtained through trade)
H – Human capital (education, experience, health, etc. – requires resources to build, and
lost if the worker dies)
Pe – Expected price level (exogenous in the short run)
We also have a few exogenous parameters that, while they could change, I will not ask you to
alter for the exam:
j – parameter for the sensitivity of business investment to interest rates. Will not be
changed on the exam.
z – Businesses sensitivity to price changes in the short-run.
Graphing the linked IS-LM and AS-AD model – Follow the 7 steps:
1) Identify the variable that’s changing and so which line is moving & what direction
(IS: Y = C + I + G + NX
LM: MS/P = L(r,Y)
AD: Combine IS & LM, so never the initial change if IS-LM is available
LRAS: Yn= A x F(K,L,N,H)
SRAS: Y = Yn + a (P – Pe) where Pe is expected price level
(Bold/Yellow are the initial possible changes – more detail in the 2 sheets above)
2) Move the line.
3a) if you moved LRAS, move SRAS with LRAS it because SRAS always intersects LRAS where P = Pe
3b) If you moved IS or LM, move AD to the new temporary Y (where IS crosses LM) AT THAT ORIGINAL
PRICE LEVEL. You should NOT be crossing SRAS at this new temporary Y.
4) Find the point where the lines cross. Where AD crosses SRAS, that’s the short-run answer. Find
where it crosses LRAS, that’s the long-run answer.
5) If prices changed (which they should have), then move LM to cross IS (new IS, if you moved IS) – it
should cross at the same Y so you get the same short-run Y on the top and bottom graph.
If you can’t do step 5 because you’re already where you need to be, it’s probably because you did step
3b wrong.
END OF SHORT RUN
6) If P =/= Pe (so if SRAS is not crossing LRAS where AD crosses), move SRAS to where AD hits LRAS (the
answer for long run in #5 above). Expected price level is adjusting here toward the actual price level,
which is moving SRAS, and this continues until P = Pe, which only can happen where AD crosses LRAS.
7) If P changed, move LM again as in step #5 (same long-run Y on both graphs).
END OF LONG RUN
That’s the whole procedure.
Then analyze what happened to the following variables:
Y (on graph)
r (on graph)
P (on graph)
Pe (on graph, doesn’t move in short run unless it’s the initial change, moves in long run)
C – based on what happened to Y
I – based on what happened to r
Unemployment (should be opposite move to what happens with Y unless labor force was the initial
change, then it can be ambiguous)