**Essay Questions and Answers for Chapter 24**
1. Using the ISLM model, show graphically and explain the effects of a monetary expansion combined with a fiscal contraction. How do the equilibrium level of output and interest rate change?
The monetary expansion shifts the LM curve to the right, from LM to LM, and the fiscal contraction shifts the IS curve to the left, from IS to IS. The equilibrium interest rate unambiguously falls, while the effect on output is indeterminate. The graph below shows Y increasing, but that result depends on the way the graph is drawn. Students should know the outcome cannot be determined unambiguously.
2. Using the ISLM model, show graphically and explain the effects of a monetary contraction. What is the effect on the equilibrium interest rate and level of output?
The monetary contraction shifts the LM curve from LM to LM. The result is that the equilibrium level of output falls from Y to Y, and the equilibrium interest rate increases from i to i.
3. Using the ISLM model, explain and show graphically the effect of a fiscal expansion when the demand for money is completely insensitive to changes in the interest rate. What is this effect called?
This is the total crowding out effect. The LM curve is vertical, so any shift of the IS curve affects only interest rates. The level of output is constant at Y. The fiscal expansion shifts the IS curve rightward, increasing the interest rate from i to i.
4. Show graphically and explain why targeting an interest rate is preferable when money demand is unstable and the IS curve is stable.
Unstable money demand causes the LM curve to shift between LM and LM. If the money supply is targeted, output fluctuates between Y and Y. With an interest rate target, output remains stable at Y. Since the objective is to minimize output fluctuations, targeting the interest rate is preferable.
5. Using the long-run ISLM model, explain and demonstrate graphically the neutrality of money, for the case of an increase in the money supply.
The increase in the money supply shifts LM to the right, increasing output to Y, above the natural rate Y^{*}. The interest rate falls from i to i. Excess demand increases the price level, reducing the real value of the money supply. The LM curve shifts back until the all pressure on prices is eliminated by the return to the natural rate of output. The initial and final levels of output and interest rate are the same. No real variables have changed.
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