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Universitat Pompeu Problem Set 4: You Can Find in Your Aula Global The Readings Needed (For Example, "Article X", Etc.)

UTIL

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12 views4 pages

Universitat Pompeu Problem Set 4: You Can Find in Your Aula Global The Readings Needed (For Example, "Article X", Etc.)

UTIL

Uploaded by

Carlota Goula
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Universitat Pompeu Fabra Macroeconomics I (2023-24) Professor: Priit Jeenas

Problem Set 4
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Instructions: You can find in your Aula global the readings needed (for example, “Article X”, etc.).
You do not have to submit the problem set but you need to know the solution and be able to
explain it in class. For math questions, clearly indicate the main steps needed to get your answer.
-----------------------------------------------------------------------------------------------------------------------------

1. Consider an economy represented by the following IS-LM model


C = 300 + 0.3(Y-T)
I = 400 + 0.2Y - 2000i
G = 400
T = 200
i = 0.05
1.1 Derive the IS equation. Obtain an expression of Y as a function of all other variables.
Represent the equation in a graph. Add in the graph the LM equation. Label the axes correctly.

1.2 Solve for the equilibrium values of Y, C, and I. And denote the value of Y in the graph.

1.3 What is the level of real money supply when the interest rate is 5%? To answer this question,
consider that the demand for real money balances is equal to 2Y-3000i, and that the economy
is in equilibrium in the money market as well as in the goods market.

1.4 Now suppose that the central bank increases the interest rate to 10%. How does this change
the LM curve? Solve for Y, I and C, and describe in words the effects of this policy. What is the
new equilibrium level for the real money supply M/P? Use a graph to go along with your
explanation.

1.5 With this new monetary policy i = 0.1, design a fiscal policy that by changing G would take
the economy back to the original equilibrium output obtained in question 1.2 above. Will the
values for C and I be the same now as in question 1.2?

2. The following statements are false. Explain why.

2.1 Based on our assumptions in the IS-LM model, the main determinants of investment are the
level of sales and taxes.

2.2 The IS curve is downward sloping because goods market equilibrium implies that an increase
in taxes leads to a lower level of output.

2.3 The real money supply is constant along the flat LM curve.

2.4 If the nominal money supply rises from €400 billion to €420 billion and the price level rises
from an index value of 100 to 102, the real money supply falls.
3. Consider the following IS-LM model:
𝐶 = 𝑐0 + 𝑐1 (𝑌 − 𝑇)
𝐼 = 𝑏0 + 𝑏1 𝑌 − 𝑏2 𝑖
𝑍 = 𝐶+𝐼+𝐺
𝑖 = 𝑖̂, where 𝑖̂ is a constant interest rate target chosen by the central bank

3.1 Solve for equilibrium output (find 𝑌) when the interest rate is 𝑖̂. Assume 𝑐1 + 𝑏1 < 1.

3.2 Focusing only on the goods market equilibrium, what is the value of the multiplier in this
economy. How does this value depend on the parameter 𝑏1 ? Explain.

3.3 Solve for the equilibrium level of investment (find 𝐼) as a function of 𝑖̂.

3.4 Let’s analyze the investment function obtained in 3.3. Explain how a decrease in the
sensitiveness of investment to changes in the interest rate (a decrease in the behavioral
parameter 𝑏2) affects the investment function. How does that change affect the IS function, will
it be steeper or flatter?

3.5 Now, instead explain how a decrease in the sensitiveness of investment to changes in sales
(a decrease in the behavioral parameter 𝑏1 ) affects the investment function. How does that
change affect the IS function, will it be steeper or flatter?

4.1 Use an IS-LM model diagram exactly as seen in class to show the effects on output of an
increase in government spending. Can you tell what happens to investment? Why?

4.2 In class, we have discussed that equilibrium in the goods market requires that investment
equals private plus public saving. That is, goods market equilibrium requires:
𝐼 = 𝑆 + (𝑇 − 𝐺)
If G decreases while T stays unchanged and thus public saving increases, how can it be possible
that I decreases as a result? Explain in words.

4.3 Provide a mathematical proof for the validity of your answer to 1.2 by considering the simple
IS-LM model:
𝐶 = 𝑐0 + 𝑐1 (𝑌 − 𝑇)
𝐼 = 𝑏0 + 𝑏1 𝑌 − 𝑏2 𝑖
𝑍 = 𝐶+𝐼+𝐺
𝑖 = 𝑖̂, where 𝑖̂ is a constant interest rate
Assume c1+b1<1, and b1>0 and derive the equilibrium effect of a 1 unit change in G on private
saving S=Y-T-C.

Often, people have in mind the intuition that if public saving increases, this should “leave more
savings available for investment and therefore higher public saving increases investment”. Such
logic is correct if, for example, the central bank moves the interest rate i down to exactly keep
output constant after the fiscal consolidation.

4.4 By how many units would investment I change if G decreased by 1 unit and the central bank
lowered the interest rate i to exactly keep output constant at the initial level?

4.5 By how much would the central bank need to decrease i in the above fiscal consolidation
scenario to keep output constant at the initial level?
A

3
4
.

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