Mid-term Review

Mid-term test format

• Multiple choice questions
• Short questions
• Problems (calculation, algebriac, diagramatic)
• Time
– 2 hours
 Content
• Aggregate variables
 Aggregate variables
• Definitions:
– GDP (compositions)
– Unemployment (Participation rate, labor force,
employment)
– Inflation (GDP deflator, CPI)
• Nominal vs Real variables
 Equilibrium Frameworks
• Goods market equilibrium (both prices and
nominal interest rates are fixed).
• Goods and financial market equilibrium (prices
are fixed but nominal interest rates can adjust).
– IS and LM model
• Labor, goods and financial market equilibrium.
– AS and AD model (short and medium run effects)
• Exogenous and endogenous variables.
Short run
 Goods market equilibrium (I)
• Prices are fixed.
• Nominal and real variables are the same.
• Equilibrium Y=Z (supply adjusts to demand).
• Compositions of Y.
• Equilibrium in Y-Z space (diagram).
• Effects of fiscal policy.
• Multiplier effect.
 Goods market equilibrium (II)
• Saving
• Private saving: S = Y - T – C.
• Public saving: T-G.
• National saving: Private+Public saving =
Investment.
• Paradox of saving:
– Increase the desire for saving reduces income and
has no effect on private saving.
 Financial market equilibrium
• Demand for money
– Transaction and liquidity (bond) demand
• Financial market equilibrium
– Equilibrium in M-i space
– Factors shift the demand function.
• Demand for CB money
– Reserve ratio/currency holding ratio
– Money multiplier
 IS-LM model (P fixed but i adjusts)
• IS curve (in Y-i space):
– downward sloping – high interest rates depress
investment
– Shifts of the IS curve induced by changes in fiscal
policy.
• LM curve (Real money supply = real money
demand)
– Shifts of the LM curve due to changes in monetary
policy.
 IS-LM model (II)
• Analysis using IS-LM
– Equilibrium: IS intersects LM
– Fiscal policy effect (compare with multiplier effect
in the goods market equilibrium)
– Monetary policy effect
Medium run
 Labor market equilibrium
• Wage setting relation (labor supply)
• Price setting relation (labor demand)
• Labor market equilibrium (real wages,
unemployment rates)
– Shifts to WS/PS
• “Natural rate” of unemployment
– Natural level of output
• AS relation: Y-P
Problems: IS-LM
Problems

Consider first the goods market model with constant

investment that we saw in Chapter 3. Consumption
is C  c0  c1 Y  T  I ,G, T
given by , and are given.

a. Solve for equilibrium output. What is the value of

the multiplier?
Answer: The goods market equilibrium condition
(the IS relation) is

Y  C Y  T   I  G

Y  c0  c1 Y  T   I  G

Solving for the equilibrium output, we obtain

1
Y c0  c1T  I  G 
1  c1

1
The multiplier is 1  c1
Now let investment depend on both sales and the
interest rate:

I  b0  b1Y  b2i b0  0, b1  0, b2  0

(b) Solve for equilibrium output. At a given interest

rate, is the effect of a change in autonomous
spending bigger than what it was in part (a)? Why?
(Assumec1  b1  1 .)
Answer:
The goods market equilibrium condition (the relation)
is
Y  C Y  T   I Y , i   G

Y  c0  c1 Y  T   b0  b1Y  b2i  G

Solving for the equilibrium output, we obtain

1
Y c0  c1T  b0  b2i  G 
1  c1  b1

1
The multiplier is 1  c1  b1
Since c1  b1  1 and b1  0 , the multiplier is larger than
the multiplier in part (a), the effect of a change in
autonomous spending is bigger than in part (a).

The reason is that an increase in autonomous

spending now leads to an increase in investment as
well as consumption.
Next, write the LM relation as

M P  d1Y  d 2i

c. Solve for equilibrium output. (Hint: Eliminate the

interest rate from the and relations.) Derive the
multiplier.
To solve for equilibrium output, we rewrite (p.1),
implied by the goods market equilibrium condition,
as
1
i c0  c1T  b0  G  1  c1  b1 Y 
b2 (P.2)

Aside:ISNote that from


1  here
c1  b1 we can see that the
slope b2

of the curve is . b c1 ,b1 2

The slope of the IS curve depends on and

If b2 is large, i.e., if investment is highly sensitive
to
the interest rate, then small changes in the interest
rate lead to large changes in income: the IS curve is
b2
relatively flat. Conversely, if is small, i.e. if
investment is not very sensitive to the interest rate,
then large changes in interest rates lead to small
changes in income: the IS curve is relatively steep.

c ,b
If 1 1 is large, they will lead to a large multiplier.
The larger the multiplier, the larger the impact of a
change in investment or government spending, etc.
on income and the flatter the IS curve.
End of the Aside
Substituting (P.2) into the LM relation to eliminate i ,
we have
M 1
 d1Y  d 2 c0  c1T  b0  G  1  c1  b2 Y 
P b2
Solving for , we obtain
Y
1  b2 M 
Y  c0  c1T  b0  G  
b2 d1  d P
1  c1  b1   2 
d2
The multiplier is
1
1  c1  b1   b2d1
d2
d. Is the multiplier you obtained in part (c) smaller
or
larger than the multiplier you derived in part (a)?
Explain how your answer depends on the parameters
in the behavioral equations for consumption,
investment, and money demand.
Answer: The multiplier is greater (less) than the
multiplier in part (a) if b1  b2d1 d 2  is greater (less)
than zero.

The multiplier in part (c) measures the marginal

effect of an increase in autonomous spending on
equilibrium output. As such, the multiplier is the sum
of two effects:
(1) a direct effect of output on demand. The direct
effect is equivalent to the horizontal shift of the IS
curve. The direct effect is captured by the sum
c1  b1 , which measures the marginal effect of an
increase in output on the sum of consumption
and investment demand. As this sum increases,
the multiplier gets larger.

(2) an indirect effect of output on demand via the

interest rate. The indirect effect is captured by
b2 d1 d 2
the expression and tends to reduce the
size of the multiplier.
The indirect effect depends on the slope of the LM
curve,d1 d 2 , and the marginal effect of the interest
rate on investment, b2 .

Aside: To see that the slope of the LM curve is d1 d 2 ,

rewrite the LM relation as
M
i  d1 d 2 Y  1 d 2 
P

The slope of the LM curve depends on d1 and d 2 .

If d1 is small, i.e. if money demand is not very
sensitive to the level of income, then an increase in
income will cause a small increase in money demand
and only a small increase in the interest rate is
necessary to restore equilibrium in the money
market: the LM curve is relatively flat.

Similarly, if is small, i.e. if the quantity of money

demanded isd 2not very sensitive to the interest rate,
then an increase in income will increase money
demand and it requires a large increase in the
interest rate to restore equilibrium in the money
market: the LM curve is relatively steep.
end of the
Aside
8. The (less paradoxical) paradox of saving

A chapter problem at the end of Chapter 3

considered
the effect of a drop in consumer confidence on
private
saving and investment, when investment depended
on output but not on the interest rate. Here, we
consider the same experiment in the context of the
framework, in which investment depends on the
interest rate and output.
(a) Suppose households attempt to save more, so
that consumer confidence falls. In an diagram,
show the effect of the fall in consumer confidence
on output and the interest rate.

(b) How will the fall in consumer confidence affect

consumption, investment, and private saving?
Will the attempt to save more necessarily lead to
more saving? Will this attempt necessarily lead to
less saving?
Answer to (a): The IS curve shifts left. Output and
the interest rate fall.

Answer to (b): Consumption falls. The change in

investment is ambiguous: the fall in output tends to
reduce investment, but the fall in the interest rate
tends to increase investment. The change in private
saving equals the change in investment. So, private
saving could rise or fall in response to a fall in
consumer confidence.