# 6. The Neoclassical IS-LM Model - Sample Problems

### Contents

1. IS-LM Model
2. The IS Curve
3. The LM Curve
4. IS-LM Equilibrium and Multiplier
5. Fiscal Policy and Monetary Policy

### 2. The IS Curve

1. The IS Curve:

a. is positively sloped
b. has a negative slope
c. indicates a lower equilibrium real income level is compatible with a lower interest rate
d. indicates a lower interest rate is compatible with a higher equilibrium income level
e. the interest rate and national incomne are positively related
f. national income and the interest rate are negatively related
g. shifted by changes in the demand for money
h. shifted by changes in fiscal policy
i. shifted by changes in money supply

Answer: Correct answers are (b), (d), (f), and (h). Note that money supply and demand have no effect on the IS curve. Only fiscal policy changes (government spending, tax, transfer payments) cause the IS curve to shift. In answers (c) and (d) as well as (e) and (f) the order in which interest rate and income appear is unimportant. What is important is that lower interest rates mean higher investment spending and higher national income, i.e., a negative relationship and downward sloping curve.

2. If there is a decrease in government expenditures

a. The IS-curve will shift to the right
b. The IS-curve will shift to the left
c. The IS-curve will become flatter and shift to the right
d. The IS-curve will become steeper and shift to the left
e. The multiplier will become smaller and the IS-curve will shift to the left

Answer: (b). A decrease in government expenditures will lead to a decrease in national income at a given interest rate. The IS curve shifts to the left. The IS curve will also shift to the left with an increase in taxes or reduction in government transfer payments. Money supply and money demand have no affect on the IS curve.

### 3. The LM Curve

1. Which of the following would result in a shift of the LM-curve to the right?

a. A decrease in taxes
b. A decrease in money supply
c. An increase in autonomous consumption
d. An increase in money supply
e. An increase in interest rates

### 4. IS-LM Equilibrium and Multiplier

1. In an IS-LM model the interest rate will decline if

a. the IS-curve shifts to the left
b. the IS-curve shifts to the right
c. the LM-curve shifts to the left and the IS-curve shifts to the right
d. the LM-curve shifts to the right and the IS-curve shifts to the left
e. both (A) and (D)

Answer: (e). Note one option that was left off - both the IS and LM curves shift to the right. The interest rate result is ambiguous. The IS curve shift raises the interest rate while the LM curve shift lowers the interest rate. The interest rate could rise, it could fall, or it could remain unchanged. It depends on how much each curve shifts and the slopes of the curves.

2. In an IS-LM model, an increase in government purchases increases

a. interest rates
b. investment
c. consumption
d. national income
e. the quantity of money supplied

Answer: The correct answers are (a), (c), and (d). An increase in government spending shifts the IS curve to the right. National income increases because of the spending increase. Higher national income leads to an increase in consumption spending. The increase in income also leads to an increase in the quantity of money demanded. To return the quantity of money demanded back down to the quantity of money supplied (which does not change) the interest rate must increase. The higher interest rate reduces investment spending.

3. In an IS-LM model, an increase in money supply will tend to:

a. lower the interest rate
b. shift the LM-curve and the IS-curve to the right
c. shift the IS-curve to the right
d. lower interest rates and therefore decrease investment expenditures
e. stimulate investment spending
f. increase government spending since more funds are available
g. increase the interest rate and decrease income

Answer: Correct answers are (a) and (e). An increase in money supply leads to an disequilibrium between the quantity of money supplied and the quantity of money demanded. The interest rate must decline in order to increase the quantity of money demanded to match the quantity supplied. The LM curve shifts to the right. Changes in money supply have no effect on the IS curve. The lower interest rate increases investment expenditures. The higher investment spending leads to higher national income, which leads to increases in consumption expenditures (and further increases in income) through the multiplier effect.

### 5. Fiscal Policy and Monetary Policy

1. Fiscal policy is more effective when

a. investment is relatively sensitive to the interest rate
b. money demand is more interest elastic
c. investment is relatively insensitive to the interest rate
d. fiscal policy is never effective
e. Investment is more interest elastic
f. The IS curve is flat
g. The IS curve is steep

Answer: Correct answers are (b), (c), and (g). Answers (a) and (e) say the same thing, which is the opposite of the correct answer. Fiscal policy is more effective when investment is less sensitive and money demand is more sensitive to changes in the interest rate. When investment is less sensitive to changes in the interest rate the IS curve is steep. When money demand is more sensitive to changes in the interest rate the LM curve is flat. A rightward shift in the IS curve resulting from an increase in government spending leads to the greatest increase in national income with a steep IS curve and flat LM curve.