Introduction to Macroeconomics 2020-21

Universitat Pompeu Fabra

Problem set 2

1. Focusing just on the GOODS Market, so far we have assumed that the fiscal policy variables G (public
expenditure) and T (taxes) are independent of the level of income. In the real world, however, this is not
the case. Taxes typically depend on the level of income and so tend to be higher when income is higher.
Consider the following economy: C = c 0 + c1(Y-T); T = t1Y (endogenous Taxes); G and I are exogenous; t1 is
between 0 and 1.

1.1. Find the multiplier in this economy. (start by solving for the equilibrium output. Y = …)
Consumption is given by
C = c0 + c1 (Y - T) =  c0 + c1 (Y - t1Y) = c0 + c1 (1 - t1) Y
Substituting this into the definition of output gives
Y = C + I + G = c0 + c1 (1 - t1) Y + I + G .
Solving for Y,
Y = 1 / [ 1 - c1 (1 - t1)] * [ c0  + I + G ] .

1
Y¿(C o+ I +G)
(1−c 1+c 1t 1)

The multiplier is the value 1 / [ 1 - c1 (1 - t1) ]

In this question, apart from getting the value, it is interesting to to explain what the multiplier is, what
does it mean for an economy to have a multiplier whose value is 2:

The multiplier tells you how much output changes when there is an exogenous change in spending (i.e.
change in c0 , I, or G). The multiplier effect arises because increases in spending translate to increases in
income for some households, who then want to increase their spending, which leads to further
increases in income, etc.
This means that when there is an increase of 1€ in the autonomous spending, the output will increase
1
by
(1−c 1+c 1t 1)

1.2. Going back to 1.1, imagine now that taxes become exogenous, so they do not depend on income
but have a constant value T. Which is the multiplier now? Compare it with the one obtained when
taxes were endogenous.
This is just the standard case from the lectures and the book. Consumption is now given by just
C= c0 + c1 (Y - T).
From definition of output,
Y = C + I + G = c0 + c1 (Y - T) + I + G .
Solving for Y,
 Y = 1 / [ 1 - c1 ] * [ c0  - c1 T+ I + G ] , implying that the multiplier is the standard one: m=1/[1
- c1 ] .
The multiplier now is 1/(1-c 1), since c1 and t1 are positive this multiplier has a higher value than the
previous multiplier 1/ (1- c1 + c1t1)

A variation in autonomous consumption will change output in a greater proportion if taxes are
exogenous: T. Under endogenous T (T= t 1Y) the multiplier effect will be weaker when t 1 is greater than
0.

1.3 For a better understanding of 1.2 regarding the effects of taxes on the economy, check if the
economy responds more, less or the same, to changes in autonomous spending when taxes depend on
income or when T are constant (exogenous). Try to explain why it is so.

When taxes depend on the income, the economy is less responsive to changes in autonomous
spending. As said in 1.2 the multiplier is smaller here.

This is because a part of the change in income will be paid as tax, so production will not increase by the
same amount as income (Y) and production will increase less when taxes depend on income than when
they do not. The economy responds by less to changes in autonomous spending. The reason is that
taxes adjust to offset some of the effects of any income change. For example, if income Y increases,
taxes T = t1Y increase as well, so that disposable income Y - T increases by less than it would in the
standard model. Thus consumers increase their consumption by less.

“fiscal policy acts as an automatic stabilizer because it counterbalances, softens, (equilibra, suaviza)
movements in GDP”

OPTIONAL EXTRA EXPLANATION:

2. Assume that improvements in bank regulations increase the stability of European banks. Savers
start believing that deposits are safer than they were before. How will this change the allocation of
money demand between currency and deposits? What will it happen to the money multiplier?
What will it happen to the total money supply?
• People put more money in the bank as this is perceived safer
• there is a reduction in c, the fraction of money people wants to hold as cash. Hence, the money
multiplier, 1/[c + (1−c)] = 1/[c(1 − ) + ] goes up.
• For a given level of high-power money (H), total money supply increases

3. Paul Krugman (Nobel prize in Economics 2008) writes in the New York Times (October 2011):
a. …” people deciding how to allocate their wealth are making tradeoffs between money and
bonds. There’s a downward-sloping demand for money – the higher the interest rate, the more
people will skimp on liquidity in favor of higher returns. Suppose temporarily that the Fed holds
the money supply fixed; in that case the interest rate must be such as to match that demand to
the quantity of money. And the Fed can move the interest rate by changing the money supply:
increase the supply of money and the interest rate must fall to induce people to hold a larger
quantity.”
 Represent graphically the content of the paragraph.

b. Paul Krugman continues …”, however, GDP must be taken into account: a higher level of GDP will mean
more transactions, and hence higher demand for money, other things equal. …”.

To build on the previous comment, we will consider that monetary policy has the explicit goal of
maintaining a fixed interest rate: in particular, given an increase in the demand for money, the Central Bank
adjusts the money supply to maintain the interest rate at a fixed level (following the interest rate rule).
Illustrate this situation by using two graphs: the graph for money market (MS and Md), and a graph (linked
to the previous one) relating interest rate and output. Explain with your own words.

The increase in Y, increases Md, but the Central Bank will increase Money supply in the same proportion so
that nominal interest rate stays constant. So, following this interest rate rule implies that an increase in
income, Y, does not increase i.

Ms´
LM without
“interest rule”

Flat LM

4. Assume the public holds no currency, the ratio of reserves to deposits is 0,02 and the demand for money
is given by Md = €Y(0,8 –2i). Initially, the monetary base (H) is € 61 billion, and nominal income is €4,200
billion.
4.1 Calculate the demand function for the Central Bank money (H)
Since the public holds no currency, CU d =0, implying that c=0.
Thus, demand for deposits D d =( 1−c ) M d =M d.
R
The reserve ratio θ= =0.02, which implies that R=θD=0.02 D=0.02 M d.
D
The demand for central bank money is given by
d d d d
H =CU + R =0.02 M
¿ 0.02 ∙Y ( 0.8−2i )
¿ 0.02 ∙ ( 4200 ) ∙ ( 0.8−2i )
d
H =ℜ=67.2−168 i
4.2 Determine the value of the money multiplier. Explain the meaning of the obtained value.
solution: mm = 1/ reserve ratio = 1/0.02 = 50, an increase in 1€ of monetary base increases overall money
supply in 50€
4.3 Find out the new interest rate (%) if the amount of central bank money increases in €5 billion, compare
it with the interest rate before the monetary expansion. What can be concluded from this? Draw a
graph which represents approximately this effect on the interest rate.
solve for i before the increase, and after the increase.
old new
H =61 as given, and H =61+5=66
6.2
old old
168 i =67.2−H =67.2−61=6.2  i old = =0.037∨3.7 %
168
new 1.2
168 i
new
=67.2−H
new
=67.2−66=1.2  i = =0.007∨0.7 %
168

Increasing the money supply by €5 billion leads to a decline of 3 percentage points in the interest rate
(from 3.7% to 0,7%)

5. Consider the article from the Riksbank (Central Bank of Sweden), “Why are people in Sweden no longer
using cash?” that you can find in the following link:
https://www.riksbank.se/en-gb/payments--cash/payments-in-sweden/payments-in-sweden-2020/1.-the-
payment-market-is-being-digitalised/why-are-people-in-sweden-no-longer-using-cash/cash-is-
disappearing-faster-in-sweden-than-in-other-countries/

5.1 Explain why, in general, countries are increasing their cash volume over the period 2009-2019 when in
general we perceive that transactions in all countries are less based on cash and more in other means of
payments?

Over those ten years the countries in the graph have experienced GDP growth (nominal GDP is the relevant
variable for demand of cash) and the overall increase in transactions in all countries except Norway and
Sweden, is large enough so that transactions in other means of payments, like debit cards or systems like
Bizum, are not large enough to reduce the need for cash. Norway and Sweden are exceptions to that rule.

5.2 Explain and discuss the combination of actions taken by the Swedish authorities that have encourage
people to substitute cash for other means of payment. Refer to the reforms to reduce tax evasion, mainly
introducing strict controls to cash payments. Also, the banknote and coin changeover that introduce costs
to those holding cash.

5.3 The article refers to Swish. Explain what it is and relate it to similar means of payment in our country.
Swish is a mobile payment system between private users and is similar to Bizum in our country.
5.4 Do you think that to avoid tax evasion cash should be banned? Explain pros and cons of that potential
measure. It would be effective for tax evasion, although tax evaders could use cryptocurrencies. On the
other hand, it cannot be compulsory for all the population to use financial intermediaries, needed for non-
cash transactions. The Riksbank (Swedish Central Bank) is studying the possibility of issuing a digital
currency, the e-Krona.