Macroeconomics, 7e (Blanchard)

Chapter 16: Expectations, Output, and Policy

16.1 Expectations and Decisions: Taking Stock

1) Changes in future expected interest rates can affect current consumption. Suppose individuals
expect future interest rates to decrease. Consumption will change as a result of this lower
expected future interest rate because of its effects on which of the following?
A) human wealth
B) the value of stocks
C) the value of bonds
D) all of the above
E) none of the above
Answer: D
Diff: 2

2) Which of the following will not cause aggregate private spending to increase?
A) an increase in expected future real interest rates
B) an increase in government spending
C) a reduction in future taxes
D) all of the above
E) none of the above
Answer: A
Diff: 1

3) Which of the following will cause aggregate private spending to decrease?

A) a reduction in government spending
B) an increase in expected future interest rates
C) an increase in expected future taxes
D) all of the above
E) none of the above
Answer: D
Diff: 1

4) The IS curve shifts to the left where there is

A) a reduction in current taxes.
B) an increase in expected future taxes.
C) an increase in expected future output.
D) all of the above
E) none of the above
Answer: B
Diff: 1

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5) Suppose individuals now believe that there will be a future tax cut. This reduction in expected
future taxes will cause which of the following to occur in the current period?
A) the LM curve to shift down
B) the LM curve to shift up
C) the IS curve to shift rightward
D) the IS curve to shift leftward
E) none of the above
Answer: C
Diff: 1

6) Suppose individuals now believe that there will be an increase in the future expected interest
rate. This increase in the expected future interest rate will cause which of the following to occur
in the current period?
A) an upward shift of the LM curve
B) a leftward shift of the IS curve
C) the IS curve to become flatter
D) the LM curve to become steeper
E) none of the above
Answer: B
Diff: 1

7) Suppose there is a fiscal expansion in the current period. This fiscal expansion will tend to
cause a smaller increase in current output when
A) an increase in current output causes an increase in expected future output.
B) an increase in the current interest rate causes expectations of expansionary monetary policy in
the future.
C) an increase in the current interest rate causes an increase in expected future interest rates.
D) both A and B
E) all of the above
Answer: C
Diff: 2

8) Which of the following will not cause aggregate private spending to decrease?
A) a reduction in expected future real interest rates
B) a reduction in government spending
C) an increase in future taxes
D) all of the above
E) none of the above
Answer: A
Diff: 1

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9) Which of the following will cause aggregate private spending to increase?
A) an increase in government spending
B) a reduction in expected future interest rates
C) a reduction in expected future taxes
D) all of the above
E) none of the above
Answer: D
Diff: 1

10) The IS curve shifts to the right where there is

A) an increase in current taxes.
B) a reduction in expected future taxes.
C) a reduction in expected future output.
D) all of the above
E) none of the above
Answer: B
Diff: 1

11) Suppose individuals now believe that there will be a future tax increase. This increase in
expected future taxes will cause which of the following to occur in the current period?
A) the LM curve to shift down
B) the LM curve to shift up
C) the IS curve to shift rightward
D) the IS curve to shift leftward
E) none of the above
Answer: D
Diff: 1

12) Suppose there is a reduction in expected future output. This will cause which of the
following to occur?
A) the IS curve to shift left in the current period
B) the IS curve to shift right in the current period
C) the LM curve to shift up in the current period
D) the LM curve to shift down in the current period
Answer: A
Diff: 2

13) Suppose there is a reduction in the expected future interest rate. This will cause which of the
following to occur?
A) the IS curve to shift left in the current period
B) the IS curve to shift right in the current period
C) the LM curve to shift up in the current period
D) the LM curve to shift down in the current period
Answer: B
Diff: 2

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14) Explain why the new IS curve that takes into account expectations is likely steeper than the
original IS curve that ignored expectations.
Answer: There are several factors that determine the size of the slope of the IS curve: the
multiplier and the interest rate sensitivity of investment. The multiplier is now smaller because
changes in current Y do not have as large an effect on current C. So, the mpc is smaller, the
multiplier smaller, and the IS curve steeper. Also, a drop in the interest rate that is now
temporary will not cause I to increase as much so the IS curve will be steeper. In the original IS-
LM model, changes in Y and the interest rate were implicitly assumed permanent.
Diff: 2

15) Explain the determinants of aggregate private spending.

Answer: Aggregate private spending, A, equals C plus I. So, A is a function of current income,
future expected income, current taxes, future expected taxes, current interest rates, and future
expected interest rates.
Diff: 2

16) Explain what effect an increase in future expected output will have on the IS curve and LM
curve in the current period.
Answer: An increase in Ye will cause human wealth to be higher. Individuals will increase their
current consumption and the IS curve will shift right. An increase in Ye will also cause firms to
increase their expectations of future expected profits. When this occurs, the discounted present
value of future profits is higher causing I to increase. As I increases, the IS curve shifts right.
This will have no effect on the LM curve.
Diff: 2

17) Explain what effect a reduction in the future expected interest rate will have on the IS curve
and LM curve in the current period.
Answer: A reduction in the future expected interest rate will cause an increase in the present
value of future disposable income and, therefore, human wealth. This causes current C to
increase and the IS curve to shift right. The reduction in the future expected rate will also cause
an increase in the present value of future profits. This will cause an increase in investment and
another rightward shift in the IS curve. The LM curve will not be affected.
Diff: 2

18) Compare the following three ways to model expectations: animal spirits, adaptive
expectations, and rational expectations.
Answer: Animal spirits assumed that expectations were simply random. Adaptive expectations
assumed that individuals formed expectations by looking at past changes in a variable. Rational
expectations assumed that individuals form expectations by using all currently available
information and an understanding of the model and policy.
Diff: 2

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19) Explain what effect a reduction in future expected output will have on the IS curve and LM
curve in the current period.
Answer: A reduction in Ye will cause human wealth to be higher. Individuals will reduce their
current consumption and the IS curve will shift left. A reduction in Ye will also cause firms to
decrease their expectations of future expected profits. When this occurs, the discounted present
value of future profits is lower causing I to decrease. As I decreases, the IS curve shifts left. This
will have no effect on the LM curve.
Diff: 2

20) Explain what effect an increase in the future expected interest rate will have on the IS curve
and LM curve in the current period.
Answer: An increase in the future expected interest rate will cause a reduction in the present
value of future disposable income and, therefore, human wealth. This causes current C to
decrease and the IS curve to shift left. The increase in the future expected rate will also cause a
reduction in the present value of future profits. This will cause a reduction in investment and
another leftward shift in the IS curve. The LM curve will not be affected.
Diff: 2

16.2 Monetary Policy, Expectations, and Output

1) Which of the following will cause the LM curve to shift up?

A) an increase in the expected future interest rate
B) an increase in current income
C) an increase in expected future taxes
D) all of the above
E) none of the above
Answer: E
Diff: 1

2) A change in which of the following will have a direct effect on the amount of money
individuals wish to hold in the current period?
A) the current nominal interest rate
B) the current real interest rate
C) the expected future nominal interest rate
D) the expected future real interest rate
E) all of the above
Answer: A
Diff: 2

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3) A reduction in which of the following variables will cause an increase in the amount of money
individuals wish to hold in the current period?
A) current income
B) the current nominal interest rate
C) the current real interest rate
D) expected future income
E) all of the above
Answer: B
Diff: 2

4) Suppose individuals expect that interest rates will increase in the future. Also assume that the
Fed wants to prevent any change in current output. Given this goal of the Fed, the Fed should
implement a policy in the current period that
A) shifts the IS curve rightward.
B) shifts the IS curve leftward.
C) shifts the IS curve leftward and the LM curve upward.
D) shifts the LM curve upward.
E) shifts the LM curve downward.
Answer: E
Diff: 2

5) A change in which of the following variables will cause a shift of the IS curve in the current
period?
A) the current interest rate
B) current output
C) current taxes
D) all of the above
E) none of the above
Answer: D
Diff: 1

6) The IS curve becomes steeper when

A) government spending is relatively small.
B) the income tax rate in the current period is relatively small.
C) current changes in the real interest rate cause large changes in current real output.
D) changes in the current real interest rate cause small changes in current demand.
E) none of the above
Answer: D
Diff: 2

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7) Assume that the current demand for goods DOES depend on expectations in the IS-LM
model. A monetary expansion in the current period will cause a rightward shift in the IS curve if
A) current and expected future real interest rates are positively related.
B) current and expected future real interest rates are negatively related.
C) current and expected future real interest rates are unrelated.
D) the central bank is expected to reverse any current movements in monetary policy in the
future.
E) monetary policy cannot affect, directly or indirectly, the position of the IS curve in the current
period.
Answer: A
Diff: 2

8) Rational expectations assumes that individuals

A) can accurately predict the future.
B) make predictions based on the past behavior of the economy.
C) form their predictions of macroeconomic variables randomly.
D) have perfect foresight.
E) none of the above
Answer: E
Diff: 1

9) Adaptive expectations assumes that individuals

A) can accurately predict the future.
B) base predictions on random events (i.e., animal spirits).
C) form their predictions of macroeconomic variables randomly.
D) use all available information in predicting the future.
E) none of the above
Answer: E
Diff: 1

10) "Animal spirits" refers to

A) the stubborn refusal of many economic decision-makers to use rational expectations.
B) movements in investment that cannot be explained by changes in current variables.
C) the often-observed Fed refusal to cooperate with the government in setting its monetary
policy.
D) the impact of tax-evasion on the budget deficit.
E) an exotic alcoholic drink favored by Wall Street traders.
Answer: B
Diff: 1

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11) Which of the following would be a violation of the rational expectations assumption?
A) "Over the past twenty years, people have consistently under-predicted the inflation rate for
the following year."
B) "Over the past twenty years, people have never once accurately predicted the inflation rate for
the following year."
C) "The Fed's announcement that it might ease interest rates caused an immediate drop in short-
term rates, even before the Fed took any action."
D) all of the above
E) none of the above
Answer: A
Diff: 1

12) Suppose the Fed increases the money supply in the current period with no other policy
change implemented or anticipated. This policy action will cause which of the following shifts in
the IS and/or LM curves in the current period?
A) IS left; LM up
B) IS right; LM up
C) no shift in IS; LM down
D) IS left; LM down
E) IS right; LM down
Answer: C
Diff: 2

13) Assume individuals consider only the short-run effects of changes in future macro variables
when forming expectations of future output and future interest rates. A permanent increase in the
money supply, with no other policy change implemented or anticipated, will most likely cause
A) an increase in the current interest rate.
B) an increase in future output and an increase in the future interest rate.
C) an unknown effect on the current interest rate.
D) all of the above
E) none of the above
Answer: C
Diff: 2

14) Suppose the central bank reduces the money supply. This monetary contraction will always
cause a greater reduction in output when it is accompanied by
A) an increase in expected future taxes.
B) an increase in expected future interest rates.
C) a reduction in expected future output.
D) all of the above
E) none of the above
Answer: D
Diff: 2

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15) Which of the following will cause the LM curve to shift down?
A) a reduction in the expected future interest rate
B) a reduction in current income
C) a reduction in expected future taxes
D) all of the above
E) none of the above
Answer: E
Diff: 1

16) An increase in which of the following variables will cause a reduction in the amount of
money individuals wish to hold in the current period?
A) current income
B) the current nominal interest rate
C) the current real interest rate
D) expected future income
E) all of the above
Answer: B
Diff: 2

17) Suppose individuals expect that interest rates will decrease in the future. Also assume that
the Fed wants to prevent any change in current output. Given this goal of the Fed, the Fed should
implement a policy in the current period that
A) shifts the IS curve rightward.
B) shifts the IS curve leftward.
C) shifts the IS curve leftward and the LM curve upward.
D) shifts the LM curve upward.
E) shifts the LM curve downward.
Answer: D
Diff: 2

18) Suppose the Fed reduces the money supply in the current period with no other policy change
implemented or anticipated. This policy action will cause which of the following shifts in the IS
and/or LM curves in the current period?
A) IS left; LM up
B) IS right; LM up
C) no shift in IS; LM up
D) IS left; LM down
E) IS right; LM down
Answer: C
Diff: 2

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19) Since the end of 2008, the Federal Reserve has adopted an unconventional monetary tool
called
A) quantitative easing.
B) open market operation.
C) change required reserve ratio.
D) discount loan.
Answer: A
Diff: 2

20) Suppose the central bank implements a monetary expansion in the current period and is
expected to continue this monetary expansion in the future. Use the IS-LM model to illustrate
graphically and explain the effects of this policy on current output and the current interest rate.
Answer: In the current period, the LM curve will shift down causing r to fall and Y to rise. The
expectation that this will continue will cause individuals to expect lower future rates and higher
future output. The lower future rates will increase current C and current I. The higher future Y
will do the same. So, we will also see a rightward shift in the current IS curve. This will tend to
increase the current r and current Y as well.
Diff: 2

21) Suppose the central bank announces that it will pursue a monetary expansion in the current
period and a monetary expansion in the future. Explain how the credibility of the central bank
might influence the effectiveness of this monetary policy action and announcement of a future
monetary policy action.
Answer: If individuals do not believe the Fed, we will observe the downward shift in the LM
curve causing current rates to fall and current output to rise (with no shift in the IS curve). If
individuals believe that the Fed will follow through with this in the future, the LM curve will
shift down causing r to fall and Y to rise. The expectation that this will continue will cause
individuals to expect lower future rates and higher future output. The lower future rates will
increase current C and current I. The higher future Y will do the same. So, we will also see a
rightward shift in the current IS curve. This will tend to increase the current r and current Y as
well. In short, we would observe a shift in the IS curve causing current Y to increase even more.
So, the credibility of the Fed plays a critical role in influencing the effectiveness of monetary
policy.
Diff: 2

22) Suppose the central bank implements a monetary contraction in the current period and is
expected to continue this monetary contraction in the future. Use the IS-LM model to illustrate
graphically and explain the effects of this policy on current output and the current interest rate.
Answer: In the current period, the LM curve will shift up causing r to rise and Y to fall. The
expectation that this will continue will cause individuals to expect higher future rates and lower
future output. The higher future rates will decrease current C and current I. The lower future Y
will do the same. So, we will also see a leftward shift in the current IS curve. This will tend to
decrease the current r and current Y as well.
Diff: 2

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23) Explain the three channels economists have identified through which quantitative or credit
easing may affect the economy.
Answer: 1) When arbitrage fails, credit easing can work. 2) Quantitative easing may affect
expectations of future nominal interest rates. 3) Quantitative easing may affect expectations of
inflation.
Diff: 1

16.3 Deficit Reduction, Expectations, and Output

1) Suppose policy makers pass a budget that reduces the budget deficit. A deficit reduction
package such as this has a greater chance of increasing current output when
A) the policy is front-loaded.
B) financial markets believe that taxes will not increase in the future.
C) financial markets believe the Fed will lower interest rates in the future.
D) all of the above
E) none of the above
Answer: C
Diff: 2

2) Suppose there is an increase in expected future output. This will cause which of the following
to occur?
A) the IS curve to shift left in the current period
B) the IS curve to shift right in the current period
C) the LM curve to shift up in the current period
D) the LM curve to shift down in the current period
Answer: B
Diff: 2

3) Suppose there is a simultaneous reduction in expected future output and reduction in the
future expected interest rate. This will cause which of the following to occur?
A) the IS curve to shift left in the current period
B) the IS curve to shift right in the current period
C) the LM curve to shift up in the current period
D) the LM curve to shift down in the current period
E) an ambiguous effect on the position of the IS curve in the current period
Answer: E
Diff: 2

4) Suppose there is an increase in the expected future interest rate. This will cause which of the
following to occur?
A) the IS curve to shift left in the current period
B) the IS curve to shift right in the current period
C) the LM curve to shift up in the current period
D) the LM curve to shift down in the current period
Answer: A
Diff: 2

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5) Suppose there is a simultaneous reduction in the expected future interest rate and increase in
future expected output. This will cause which of the following to occur?
A) the IS curve to shift left in the current period
B) the IS curve to shift right in the current period
C) the LM curve to shift up in the current period
D) the LM curve to shift down in the current period
E) an ambiguous effect on the position of the IS curve in the current period
Answer: B
Diff: 2

6) Suppose there is an increase in expected future taxes. This will cause which of the following
to occur?
A) the IS curve to shift left in the current period
B) the IS curve to shift right in the current period
C) the LM curve to shift up in the current period
D) the LM curve to shift down in the current period
Answer: A
Diff: 2

7) Suppose there is a reduction in expected future taxes. This will cause which of the following
to occur?
A) the IS curve to shift left in the current period
B) the IS curve to shift right in the current period
C) the LM curve to shift up in the current period
D) the LM curve to shift down in the current period
Answer: B
Diff: 2

8) Which of the following individuals was responsible for introducing rational expectations into
macroeconomic models?
A) Keynes
B) Tobin
C) Phillips
D) Solow
E) none of the above
Answer: E
Diff: 2

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9) When answering this question, assume individuals consider only the short-run effects of
changes in future variables when forming expectations of future output and future interest rates.
Suppose policy makers announce a reduction in future government spending. Which of the
following will occur as a result of this expected reduction in government spending?
A) a reduction in the expected future interest rate and no change in expected future output
B) a reduction in the expected future interest rate and an increase in expected future output
C) a reduction in the expected future interest rate and an ambiguous effect on expected future
output
D) none of the above
Answer: D
Diff: 2

10) When answering this question, assume individuals consider only the medium-run effects of
changes in future variables when forming expectations of future output and future interest rates
Suppose policy makers announce a reduction in future government spending. Which of the
following will occur as a result of this expected reduction in government spending?
A) a reduction in the expected future interest rate and no change in expected future output
B) a reduction in the expected future interest rate and an increase in expected future output
C) a reduction in the expected future interest rate and a reduction in expected future output
D) a reduction in the expected future interest rate and an ambiguous effect on expected future
output
Answer: A
Diff: 2

11) Assume individuals consider only the long run effects of changes in future macro variables
when forming expectations of future output and future interest rates. Suppose individuals expect
future government spending to decrease. Given this information, individuals will expect
A) a reduction in the expected future interest rate and no change in expected future output.
B) a reduction in the expected future interest rate and an increase in expected future output.
C) a reduction in the expected future interest rate and a reduction in expected future output.
D) a reduction in the expected future interest rate and an ambiguous effect on expected future
output.
Answer: B
Diff: 2

12) Assume individuals consider only the short run effects of changes in future macro variables
when forming expectations of future output and future interest rates. Suppose individuals expect
future taxes to decrease. Given this information, individuals will expect
A) an increase in the expected future interest rate and no change in expected future output.
B) an increase in the expected future interest rate and an increase in expected future output.
C) an increase in the expected future interest rate and a reduction in expected future output.
D) an increase in the expected future interest rate and an ambiguous effect on expected future
output.
Answer: B
Diff: 2

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13) Assume individuals consider only the medium run effects of changes in future macro
variables when forming expectations of future output and future interest rates. Suppose
individuals expect future taxes to decrease. Given this information, individuals will expect
A) an increase in the expected future interest rate and no change in expected future output.
B) an increase in the expected future interest rate and an increase in expected future output.
C) an increase in the expected future interest rate and a reduction in expected future output.
D) an increase in the expected future interest rate and an ambiguous effect on expected future
output.
Answer: A
Diff: 2

14) Assume individuals consider only the long run effects of changes in future macro variables
when forming expectations of future output and future interest rates. Suppose individuals expect
future government spending to increase. Given this information, individuals will expect
A) an increase in the expected future interest rate and no change in expected future output.
B) an increase in the expected future interest rate and an increase in expected future output.
C) an increase in the expected future interest rate and a reduction in expected future output.
D) an increase in the expected future interest rate and an ambiguous effect on expected future
output.
Answer: C
Diff: 2

15) Assume individuals consider only the short run effects of changes in future macro variables
when forming expectations of future output and future interest rates. Suppose current taxes are
cut and that individuals expect future taxes to decrease. Given this information, we know with
certainty that
A) current output and the current interest rate will both increase.
B) current output will increase.
C) the current interest rate will increase.
D) the current output effects are ambiguous.
Answer: D
Diff: 2

16) Assume individuals consider only the medium run effects of changes in future macro
variables when forming expectations of future output and future interest rates. Suppose current
taxes are cut AND that individuals expect future taxes to decrease. Given this information, we
know with certainty that
A) current output and the current interest rate will both increase.
B) current output will increase.
C) the current interest rate will increase.
D) the expected future interest rate will increase.
Answer: D
Diff: 2

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17) Assume individuals consider only the long run effects of changes in future macro variables
when forming expectations of future output and future interest rates. Suppose current
government spending increases and that individuals expect future government spending to
increase. Given this information, we know with certainty that
A) current output and the current interest rate will both increase.
B) current output will not change.
C) future expected output will decrease.
D) future expected output will not change.
Answer: C
Diff: 2

18) Suppose current government spending increases and that individuals expect future
government spending to increase. Given this information, in which of the following cases will
output in the current period be more likely to increase?
A) Individuals consider only the short run effects of changes in future macro variables when
forming expectations of future output and future interest rates.
B) Individuals consider only the medium run effects of changes in future macro variables when
forming expectations of future output and future interest rates.
C) Individuals consider only the long run effects of changes in future macro variables when
forming expectations of future output and future interest rates.
D) The output effects will be the same in B and C.
Answer: A
Diff: 2

19) Suppose current government spending increases and that individuals expect future
government spending to increase. Given this information, in which of the following cases will
output in the current period be more likely to decrease?
A) Individuals consider only the short run effects of changes in future macro variables when
forming expectations of future output and future interest rates.
B) Individuals consider only the medium run effects of changes in future macro variables when
forming expectations of future output and future interest rates.
C) Individuals consider only the long run effects of changes in future macro variables when
forming expectations of future output and future interest rates.
D) The output effects will be the same in B and C.
Answer: C
Diff: 2

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20) Suppose current government spending decreases and that individuals expect future
government spending to decrease. Given this information, in which of the following cases will
output in the current period be more likely to decrease?
A) Individuals consider only the short run effects of changes in future macro variables when
forming expectations of future output and future interest rates.
B) Individuals consider only the medium run effects of changes in future macro variables when
forming expectations of future output and future interest rates.
C) Individuals consider only the long run effects of changes in future macro variables when
forming expectations of future output and future interest rates.
D) The output effects will be the same in B and C.
Answer: A
Diff: 2

21) Suppose current government spending decreases and that individuals expect future
government spending to decrease. Given this information, in which of the following cases will
output in the current period be more likely to increase?
A) Individuals consider only the short run effects of changes in future macro variables when
forming expectations of future output and future interest rates.
B) Individuals consider only the medium run effects of changes in future macro variables when
forming expectations of future output and future interest rates.
C) Individuals consider only the long run effects of changes in future macro variables when
forming expectations of future output and future interest rates.
D) The output effects will be the same in B and C.
Answer: C
Diff: 2

22) Assume individuals consider only the short run effects of changes in future macro variables
when forming expectations of future output and future interest rates. Suppose individuals expect
the central bank to pursue a monetary expansion in the future. Given this information, we know
with certainty that
A) current output and the current interest rate will both increase.
B) current output will decrease.
C) the current interest rate will decrease.
D) the current output effects are ambiguous.
Answer: A
Diff: 2

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23) Assume individuals consider only the medium run effects of changes in future macro
variables when forming expectations of future output and future interest rates. Suppose
individuals expect the central bank to pursue a monetary expansion in the future. Given this
information, we know with certainty that
A) current output and the current interest rate will both increase.
B) current output will decrease.
C) the current interest rate will decrease.
D) the current output effects are ambiguous.
E) current output will not change.
Answer: E
Diff: 2

24) Suppose fiscal policy makers pass a budget that increases taxes in the current period and are
expected to raise taxes in the future. Use the IS-LM model to illustrate graphically and explain
the effects of this policy on current output and the current interest rate.
Answer: The increase in current T will cause disposable income to fall and current C to fall.
This will cause the IS curve to shift left. The increase in future expected taxes will, all else fixed,
decrease human wealth and current consumption. This will also cause the IS curve to shift left.
As future T is raised, future Y will fall. This will depress both current C and I and, again, IS
shifts to the left. The drop in future interest rates will have the opposite effect on C and I causing
the IS curve to shift right. In theory, the effects on current output are ambiguous. The lower
expected future interest rates have a positive effect on current demand. All other factors have the
opposite effect.
Diff: 2

25) Explain whether a policy that results in a larger budget deficit in the current period can lead
to a reduction in current output.
Answer: In short, yes. If the effects of the higher future interest rates dominate the other effects,
current demand could fall causing current Y to fall.
Diff: 2

26) Explain whether a fiscal policy that causes an increase in current and future government
spending can cause a reduction in current output.
Answer: Current output could fall. The increase in G will cause the IS curve to shift to the right.
The increase in future G will cause an increase in future output which will also shift the IS curve
to the right. The increase in future rates, however, will cause current demand to fall and shift the
current IS curve to the left. If these effects dominate (or if the Fed is expected to contract in the
future), Y could fall in the current period.
Diff: 2

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27) Suppose fiscal policy makers pass a budget that cuts taxes in the current period and are
expected to cut taxes in the future. Use the IS-LM model to illustrate graphically and explain the
effects of this policy on current output and the current interest rate.
Answer: The cut in current T will cause disposable income to rise and current C to rise. This
will cause the IS curve to shift right. The reduction in future expected taxes will, all else fixed,
increase human wealth and current consumption. This will also cause the IS curve to shift right.
As future T is cut, future Y will rise. This will increase both current C and I and, again, IS shifts
to the right. The increase in future interest rates will have the opposite effect on C and I causing
the IS curve to shift left. In theory, the effects on current output are ambiguous. The higher
expected future interest rates have a negative effect on current demand. All other factors have the
opposite effect.
Diff: 2

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