TUTORIAL 4 SOLUTIONS

4. Compare the effects of an autonomous increase in government spending in the IS-LM

curve version of the Keynesian model with the effect of the same shift within the classical
model.

In the classical model, an increase in government spending has no impact on output. In

the Keynesian model, higher government spending increases the IS curve, which
increases interest rates and increases income.

8. (a) Why do the Keynesians prefer a policy mix of "tight" fiscal policy and "easy"
monetary policy?
Explain this preference.

An expansionary monetary policy increases investment. With an expansionary fiscal

Policy investment declines. Therefore, the Keynesians prefer an expansionary monetary
policy since investment is important for the long-run growth of the economy.

(b) Since the Keynesians prefer a policy mix of relatively "tight" fiscal policy and "easy"
monetary policy, how would they respond to an income tax cut in order to expand the
economy?

They would like to see an accommodating monetary policyan accommodating increase

in the money supply that will prevent the interest rate from rising and, thus, prevent the
crowding out of investment.
9. Using an IS-LM graph, illustrate how the central bank could target interest rates in
response to expansionary fiscal policy.

Expansionary fiscal policy, such as increases in government spending or reductions in

taxes, will shift up the IS curve and increase interest rates. In this case, the central bank
must respond by increasing the money supply to shift the LM curve to the right and
reduce interest rates. On the other hand, in response to reductions in government
spending or increases in taxes, the central bank will have to reduce the money supply to
keep interest rates from changing.

6. What is the key difference between the classical and Keynesian aggregate supply
functions? What is the key factor that drives these differences?

The main difference between the classical and Keynesian aggregate supply functions is the
slope of the function. The classical aggregate supply function is vertical whereas, in the
short-run, the Keynesian aggregate supply curve slopes upward to the right. The
difference is that the classical model is one of perfect competition, while in the Keynesian
model wages and prices are imperfectly flexible.

1. D 2. A 3. D 4. B