Universitat

Pompeu Fabra
Introduction to Macroeconomics 2020-21
Teresa Garcia-Milà, María Gundín, Alberto Martín, Luigi Pascali
Problem set 4

SECTION A

Read the article: It is not the time for Britain to raise taxes. (Financial Times, January
24, 2021).

1. Consider the first paragraph and explain what the author means by “sound public
finances”.
The author means keeping the government deficit relatively low: expenditures do not
exceed by too much the tax revenues net of government transfers (here we can
discuss the difference between primary deficit and overall deficit, including interest
payments of debt-cost of debt, and how important it is right now that interest rates
are so low)

2. In the second paragraph the author says “ … a decision must be made on which two
out of the three the Tories can live with”.
Which three items does the author refer to? Explain the “trilemma” faced by the
Tories. Which one of the three items do you think the Tories should give up at this
moment? Explain.
The three: i) achieve a balanced budget ii) no tax raise iii) no reduction in government
expenditures and transfers. Given that the starting point is a large deficit, to return to
a balanced budget the government needs to increase revenues and/or reduce
expenditures. If the government wants ii) and iii) it needs to give up its goal of
balancing the budget.
Each student may propose a different choice for what the government should do.
Given the covid19 recession, the soundest government decision now would be to give
up the goal of balancing the budget.

3. Assume that the COVID19 crises had a negative impact on the confidence of
consumers and companies about the future, leading to lower marginal propensity to
consume and to invest. Use the IS-LM model to describe the impact of this shock.
A change in consumer’s and investor’s confidence will shift the IS to the left, resulting
in a lower output of equilibrium.
PENDING: GRAPH

4. Given the situation described in the previous question, use the IS-LM model to
represent graphically the government and central bank policies that are currently in
place to smooth out the impact of the pandemic on the economy. Explain your graph.
PENDING: A graph that adds to the initial shift to the left of the IS (private shock), a
shift to the right of the IS (fiscal policy) and LM down (limited by zero lower bound)
5. Represent graphically what would be the impact in the economy if the British
government decided to give immediate priority to reach a balanced budget. Explain
the consequences for the economy.

PENDING: A graph with the IS fiscal policy shift going back to the left, and a lower
equilibrium Y. Lower deficit at the expense of lower equilibrium Y that without
adjustment of taxes will deliver low revenues and therefore pervasive deficit.

6. In the medium run, what does the article suggest it should be done in the British
economy in terms of fiscal policy? Is that consistent with the promises made by the
Tories? Explain
When the economy recovers from the covid19 shock, UK needs to think of a broad
look at the tax system, simplifying or eliminating tax deductions and other distortions
so that the tax scheme is less distortionary and able to obtain higher revenues.

SECTION B

Question 1
Consider the following IS-LM model:
IS: Y=C(Y-T)+I(Y,r+x)+G
LM: r=r

Where r is the real interest rate that results from the federal funds nominal rate, i, and
expected inflation. Unless otherwise stated, we consider expected inflation to be
constant. Assume that the rate at which firms can borrow is much higher than the
federal funds rate, equivalently that the risk premium, x, in the IS equation is high.

a1) Suppose that the government takes action to improve the solvency of the financial
system. If the government’s action is successful and banks become more willing to
lend -both to one another and to non-financial firms – what is likely to happen to the
premium?

Since the premium x reflects a risk premium, and after the government actions, the
solvency of the financial system improves, this implies that the risk associated to
lending (either among banks, and from banks to non-financial operators) decreases. In
other words, x decreases.

a2) What will happen to the IS-LM diagram? Show the changes in a diagram, and make
sure you label the axis appropriately.

Since the interest rate that enters in the IS equation (the borrowing rate, r+x) decreases
as x decreases, investment will go up, and the IS curve will shift to the right. Other
things being equal, this implies an increase in equilibrium output. Note that the interest
rate represented in the graph is now the real rate and not the nominal.
b1) Faced with a zero nominal interest rate, suppose the FED decides to purchase
bonds directly to facilitate the flow of credit in the financial markets. This policy is
called quantitative easing. If quantitative easing is successful, so that it becomes easier
for financial and non-financial firms to obtain credit, what is likely to happen to the
premium?

The purchase of securities by the FED will increase their price and therefore reduce
their interest rate, which was way above the interest rate of reference established by
the Fed. For the same r, the Fed nominal policy rate minus expected inflation, the
interest rate that some firms face now is lower, which means the premium x will go
down, if the QE policy is successful in improving solvency of the financial system.

b2) What effect will this have on the IS-LM diagram?

If x goes down, the IS will shift to the right. For the same real interest rate (the nominal
interest rate does not change as it has reached the zero-lower bound, and we assume
there is no change in expected inflation), the interest rate faced by borrowers, r+x, will
decrease because x is smaller. That decrease in x increases investment for a given
value of r (shift of the IS to the right). The new equilibrium will be at a higher level of
output, higher consumption and higher investment.
b3) If quantitative easing has some effect, is it true that the FED has no policy options
to stimulate the economy when the federal fund rate is zero?

By buying securities directly, the FED increases the price of private bonds and
decreases therefore the interest rate firms face to borrow, stimulating investment. In
our model this is represented by a reduction in the risk premium, x, faced by firms. So,
the federal funds rate remains at zero, but the interest rate faced by borrowers
decreases, and has an expansionary effect on the economy.

c1) We will see later in this course that there is a high probability that the quantitative
easing will result in higher expected inflation. Suppose quantitative easing does
increase expected inflation. How does that affect the LM curve and the equilibrium of
the economy?
The LM curve considered here is r=r, where r is the federal funds rate adjusted for
inflation. By the Fisher equation we know that r = i - π e. Even if the nominal interest
rate cannot decrease when it has reached zero, the real rate will decrease when
expected inflation is higher as result of the QE.
Graphically, the LM curve (flat in this case) falls.
At a lower real interest rate investment will increase, resulting in a higher output and
higher consumption of equilibrium.

Question 2
Consider the following IS-LM model:
C= 200+0. 25(Y-T)
I= 400+0.25Y -200(r+x)
G=800
T=200
r= r =0.05
where r is the real interest rate that results from the nominal policy rate decided by
the central bank and expected inflation.
We assume that expected inflation is constant and equal to 0.05.
Assume that the risk premium is x=0.05

a) Derive the IS relation.

IS relation: Y = C + I + G
= 200+0. 25(Y-200) + 400+0.25Y -200(r+0.05) + 800
= (200+400+800-50-10) + 0.5Y – 200r ,
then

IS: Y = 2680 – 400r

b) What is the level of real money supply when the real interest rate is 5% and the
expected inflation is 5%? To answer this question, use the following equilibrium
equation in the money market:
M/P=4Y-5000i

Using the Fisher equation, we know: i = r + expected inflation

c) Solve for the equilibrium values of C, I and Y.

Yeq has been solved in a) and is equal to 2660.

2660 = Ieq + G + Ceq

d) Now suppose that the central bank cuts the policy nominal rate so that, with
constant expected inflation, the resulting real interest rate is 2%. How does this new
policy change the LM curve? Solve for the equilibrium values of Y, I and C, and describe
in words the effects of this policy. What is the new equilibrium for the real money
supply M/P? Show in a graph the changes.

The new (real) interest rate is r=0.02. LM curve shifts downwards.

Solving for equilibrium Y, I, C:

Ceq=200+0.25(2672-200)= 818
Ieq= 400+0.25*2672-200(0.02+0.05)= 1054

By decreasing the interest rate, investment is stimulated (from 1045 to 1054), and this
in turn increases aggregate demand and output (from 2660 to 2672). As an effect,
disposable income and therefore consumption go up.

The new level of money supply is:

Real money supply = M/P = 4Y-5000i , i= r + expected inflation

In other words, a decrease in interest implies necessarily that in equilibrium, money

e) Now return to the initial situation with the policy nominal rate such that, with
constant inflation, the real interest rate is equal to 5%. Suppose that economic
confidence has increased, solvency of the financial system has improved and as a
result the risk premium has decreased to 2%. How does this affect the IS and the LM
curves? Solve for the equilibrium values of Y, I and C, and compare with the initial
equilibrium values. Explain the differences. Show in a graph the changes.

LM curve does not change but the IS curve will shift to the right.
LM : r=0.05
x=0.02
NEW IS : Y = C + I + G
= 200+0.25(Y-200) + 400+0.25Y -200(r+0.02) + 800
= (200+400+800-50-4) + 0.5Y – 200r ,
IS: Y = 2692 – 400r
So Yeq = 2672.
Ceq=200+0.25(2672-200)=818
Ieq= 400+0.25*2672-200(0.07)= 1054

Even though the real interest rate, that results from the nominal interest rate set by
the Central Bank and the constant inflation, is higher than in section d, the interest
rate faced by investors is the same as in that section because the risk premium has
decrease by 3 percentage points, the same decrease that the real interest rate of
section d. Two different ways of reaching the same equilibrium output, consumption
and investment.