SESS1004 Introduction to Macroeconomics

Tutorial 5 (Week 24)

Part A: True/False/Uncertain Questions
Answer in full including justications for each and diagrams if necessary.
A1. Fiscal policy is more eective in changing GDP if investment is more sensitive to a
change in the interest rate.
False.
If investment is very sensitive to changes in the interest rate, a small decrease in interest
rate will cause a large increase in investment level. Thus, the IS curve will be relatively at
and scal policy is less eective. This is because the atter the IS curve, the smaller will be the
eect of a given shift in the IS on output.
I = I(Y
+
; i

)
I = d
1
Y d
2
i
d
1
: investment sensitivity
start at point A and let i #
if d
2
is large,then i #!I "
i #!I "!Z "
in equilibrium
! Y "
d
2
is large means for a given i, I is large and thus
Y is large. =)IS is atter
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A2. A monetary expansion is more eective in changing the interest rate when money
demand is very sensitive to the interest rate.
False.
The sensitivity of money demand to the interest rate is represented by the slope of the money
demand curve. The atter the curve is, the more sensitive the demand is since a small change
in the interest rate causes a big change in the amount of money demanded. When the money
demand curve is at, the same change in money supply has a smaller impact on the interest
rate than when the money demand curve is steep. Intuitively, the interest rate has to change
less to make money demand equal the new money supply since money demand is very sensitive
to the change in interest rate.
A3. Monetary contraction and scal expansion together lead to an increase equilibrium
output and interest rate..
Uncertain.
Monetary contraction: when the central bank decreases M
s
#! i "=) LM shifts to up
and left:
Fiscal expansion: G "!Z "!Y "
G "!Z "!Y "
at a given i the IS curve shifts up and right
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there are therefore three possible outcomes:
outcome 1: Y " and i " outcome 2: Y # and i " outcome 3: no Y and i "
A4. An increase in government spending leads to a decrease in investment.
Uncertain.
An increase in government spending leads to an increase in output (which tends to increase
investment), but also to an increase in the interest rate (which tends to reduce investment).
Part B: Problems and Essay Questions
B1. (revision) Suppose the goods and nancial markets are represented by the following:
Goods market: Financial market:
Goods demand: Z = C +I +G Money Supply:
_
M
P
_
s
= 5; 400
Consumption: C = 180 + 0:7 Y
D
Money Demand:
_
M
P
_
d
= 6 Y 120 i
Investment: I = 100 + 0:1 Y 18 i
Govern. Exp.: G = 400
Taxes: T = 400
a. Solve for the equilibrium level of output for the goods market (i.e. derive
the IS-relation)
In equilibrium on the goods market:
Y = Z
Y = 180 + 0:7 (Y 400) + 100 + 0:1 Y 18 i + 400
Y = 400 + 0:8 Y 18 i
Y = 2; 000 90 i
b. Briey explain what would happen to the IS curve as a result of
the following events:
- a reduction in the interest rate,
A lower interest rate causes an increase in I and an increase in Y - this explains the slope
of the IS curve and represents a movement along the IS curve. The IS curve does not shift
as i falls. See also graph from question A1.
- a reduction in c
0
from 180 to 100,
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This reduction in consumption will cause the IS curve to shift to the le: at any value of
i , the equilibrium level of output will be lower because of the drop in demand.
- an increase in taxes.
The same eect: it will cause a reduction in consumption and a leftward shift of the IS
curve.
c. Derive the LM relation.
Equilibrium on the money market:
_
M
P
_
s
=
_
M
P
_
d
5; 400 = 6 Y 120 i
i = 0:05 Y 45
d. Calculate i when Y = 1; 400. Assume that Y remains at 1; 400 and suppose
the real money supply falls to 5; 000. How much does i change?
i = 0:05 1; 400 45 = 25%
if
_
M
P
_
s0
= 5; 000 :
5; 000 = 6 Y 120 i
i = 0:05 Y 41:66 = 28:33%
so i increases by 3:33%:
e. Solve for equilibrium Y; i; C and I and graph the IS-LM diagram.
_
(IS) : Y = 2; 000 90 i
(LM) : i = 0:05 Y 45
Y = 2; 000 90 (0:05 Y 45)
Y = 2; 000 4:5 Y + 4; 050
5:5 Y = 6; 050
Y = 1; 100
i = 0:05 1; 100 45 = 55 45 = 10%
C = 180 + 0:7 (1; 100 400) = 670
I = 100 + 0:1 1; 100 18 10 = 30
f. The government decides to increase its decit: G increases by 10.
Describe what happens in the economy. Find equilibrium Y; i; C, and I.
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Always be careful with this step because G needs to be changed in the original equation:
Y = 410 + 0:8 Y 18 i
Y = 2; 050 90 i
recall that this means the IS curve shifts to the right by 50, which is precisely G times
the multiplier of autonomous demand in the case that investment and not only consumption
depends on income:
G =
1
1 c
1
d
1
G
where c
1
and d
1
are the marginal propensity to consume and the sensitivity of investment to
income.
_
(IS) : Y = 2; 050 90 i
(LM) : i = 0:05 Y 45
Y = 2; 050 90 (0:05 Y 45)
Y = 2; 050 4:5 Y + 4; 050
5:5 Y = 6; 100
Y = 1; 109:1
i = 0:05 1; 109:1 45 = 55 45 = 10:46%
C = 180 + 0:7 (1; 109:1 400) = 676:4
I = 100 + 0:1 1; 109:1 18 10 = 22:6
Investment fell, meaning the positive eects of a higher income must have been oset by the
negative eects of a higher interest rate.
B2. According to the IS-LM model (short run perspectie) answer the following using also
appropriate graphs:
a. By what amount will the IS curve shift if the government increases
government purchases by G?
b.By what amount will the IS curve shift if the government increases taxes
by T?
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c. What happens if the government decreases the income tax rate? (recall
question B2 (c) from last weeks tutorial)?
[assume that money demand is very insensitive to changes in the interest rate.]
The IS relation becomes:
Y =
1
1 (1 t
1
) c
1
[c
0
+b
0
b
1
i +Gc
1
t
0
]
Lowering the income tax rate increases the multiplier. This results in a atter IS curve.
Since the LM curve is very steep, this is not an eective way to stimulate the economy, i.e. it
results in a small change in Y for a large change in i.
B3. We argued that investment depends negatively on the interest rate because an increase
in the cost of borrowing discourages investment. However, rms often nance their investment
projects using their own funds. In this case, why would higher interest rates discourage rms
from undertaking investment projects?
B4. (review money multiplier)
Checkable deposits: D
d
= $900 billion
Total money supply: M
s
= $1; 800 billion
Reserve ratio: = 0:2
Ration of (CU
d
=M
d
): c = 0:5
a. Find CU
d
, R
d
and D
d
. in equilibrium.
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M
d
= CU
d
+D
d
M
s
= M
d
_
=) 1800 = CU
d
+ 900
CU
d
= 900
R
d
= D
d
=) R
d
= 0:2 900
R
d
= 180
D
d
= 900
b. Find the money multiplier.
R
d
= D
d
D
d
= (1 c) M
d
H
d
= CU
d
+R
d
-
H
d
= c M
d
+ (1 c) M
d
H
d
= [c + (1 c)] M
d
R
d
= 0:2 900
H
d
=
1
c + (1 c)
. .
money
multiplier
M
d
=) mm =
1
c+(1c)
=
1
0:5+0:20:5
= 1:67
c. Describe two dierent ways the central bank can decrease money supply.
i. sell bonds via open market operations
ii. "
d. If the central bank wants to decrease the money supply by 500 million
(in order to raise i), what amount of bonds would it have to sell/buy?
$500 million
1:67
$300 million
Part C: Media Illustrations
C1. A major negative inuence on the U.S. economy has been the strong dollar. Its strength
causes excessive imports. The excess of imports over exports - more than $120 billion (US.) a
year - must be subtracted when calculating GDP.
a. How would a strong dollar be a negative inuence on the economy?
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The strong dollar makes US exports expensive to foreigners, so exports will go down. This
represents a fall in demand for domestically produced goods and services and sets a negative
multiplier eect in motion.
b. GDP measures the amount produced domestically. Imports are produced by
foreigners and so should be irrelevant for measuring GDP. Explain why this clipping
suggests that they be subtracted when calculating GDP.
GDP is calculated by adding up all sales of nal products, some of which are imports and
some of which have imported components. To calculate what has been produced domestically,
imports must be subtracted out.
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