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02 Macroeconomics: Problem Set 3

Gabriel Teixeira
Friday February 26, 2016
Problem 1. How do Central Banks Implement Monetary Policy?
(a) The IS and LM curves plotted on the interest rate-output plane look like this

with the intersection of the two curves corresponding to the equilibrium interest rate and equilibrium output.
We now consider the scenario where the Central Bank implements monetary
policy in the form of changing the money supply M. First we consider the
case where the Central Bank increase the money supply. When plotting
interest rate versus real money, the money supply is represented by a vertical
line, and the money demand is downward sloping. Therefore, when the
money supply is increased, the money supply curve will shift to the right
this. Assuming that the money demand curve hasnt changed, the interest
rate will go down and the demand for money will go up. We see that
increasing the money supply is an expansionary monetary policy. This in
turn will shift the LM curve downward, leading to an increase in output.
This makes sense because a decrease in interest rates increases investment,
in turn increasing equilibrium output.
We now look at the case where the Central Bank decreases the money
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supply, a contractionary monetary policy. As opposed to before, the money

supply curve shifts to the left, creating an increase in interest rates. This
creates a decrease in investment, and therefore an overall decrease in output.
This can be corroborated by thinking about what would happen on the ISLM curves. The increase in interest rates will shift the LM curve inward,
reflecting an increase in interest rates and a decrease in output.
(b) We assume that consumption is given by C(YD ) = c0 + c1 (Y T ) and
that c0 increases. This corresponds to fiscal expansion, or an increase in
output equilibrium; therefore, this causes a shift in the IS curve to the
right. This change in consumption does not cause any change in the LM
curve. Therefore, this corresponds to an increase in both interest rates and
output.
In order to offset the increase in output caused by the positive autonomous
increase in consumer spending, the LM curve must be shifted inward until
it reaches the original output, albeit at a higher interest rate. To shift the
LM curve inward, the Central Bank must employ contractionary monetary
policies, which correspond to an increase in interest rates, which is in turn
caused by a decrease in the money supply, M S .
(c) Upon targeting some arbitrary interest rate i , the Central Bank will employ either expansionary or contractionary monetary policy by inceasing or
decreasing the supply of money, respectively, thus causing a shift in the LM
curve either outward or inward, respectively. Below, we show a graph of
the equilibrium in the case of contractionary monetary policy, causing an
outward shift in LM and thus reaching the lower targeted interest rate i .

(d) As we noted in part (b), a positive autonomous increase in consumer spending will shift the IS curve outwards, resulting in an increase in both interest
rates and output. Since the Central Bank wishes to offset the change in

output, it must do so through contractionary monetary policy, which will

shift the LM curve inward, decreasing output and increasing interest rates.
Therefore, the interest rate i that the Central Bank shoots for must be
higher than the equilibrium output after the positive autonomous increase
in consumer spending c0 . This contractionary policy will be achieved by
the Central Bank by decreasing the supply of money.
Problem 2. Solving the IS-LM model analytically
(a) We are given that
C = c0 + c1 (Y T )
Plugging this into the equilibrium equation with I, G, and T fixed, we get
the relation
Y = c0 + c1 (Y T ) + I + G
which upon rearranging gives the equilibrium output
Y =

1
(c0 c1 T + I + G)
1 c1

From the equilibrium output, we differentiate to find the government spending multiplier
dY
1
=
dG
1 c1
(b) We now consider the case where investment is given by
I = b0 + b1 Y b2 i
Plugging this into the equilibrium relation along with our previous expression for consumption, we get the expression
Y = c0 + c1 (Y T ) + b0 + b1 Y b2 i + G
which upon rearranging gives the new equilibrium output
Y =

1
(c0 c1 T + b0 b2 i + G)
1 (c1 + b1 )

In part (a), the effect of a change in autonomous spending on output was

1
dY
=
dc0
1 c1
Given that we are working at a given interest rate, we find that this value
changes in part (b) to
dY
1
=
dc0
1 (c1 + b1 )
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Since we are assuming that c1 + b1 < 1, we can see that

than it was in part (a).

dY
dc0

is bigger now

This occurs because in an economy with fixed I, an increase in c0 will

proportionally increase output, which in turn increases disposable income,
leading to an increase in consumption and thus an ultimate increase in
output proportional to
1
.
1 c1
However, we now have an economy where investment is dependent on output, I = b0 + b1 Y b2 i. In such an economy, we have the same effect as
before with the MPC causing a multiplier effect in the change of output.
However, we also now have the added effect that when c0 initially increases
and causes a proportional rise in output, this increase in Y thus causes an
increase in investment up to some proportionality constant b1 . This in turn
increases output, ultimately resulting in another multiplier effect. The two
effects described together create a multiplier of
1
1 (c1 + b1 )
Thus, we see that there are two different multiplier effects acting on output, resulting in the bigger effect than a change in c0 has on output when
investment is dependent on sales.
(c) We have the LM relation
M
= d1 Y d2 i
P
which we rearrange to find an expression for the interest rate.
i=

d1
1 M
Y
d2
d2 P

We then plug the interest rate into our equilibrium output from part (b), assuming once again that consumption is C = c0 + c1 (Y T ) and investment
is I = b0 + b1 Y b2 i.



1
d1
1 M
Y =
c0 + b0 c1 T + G b2
Y
1 (c1 + b1 )
d2
d2 P
which we rearrange to find the new equilibrium output in terms of the real
money supply.
Y =

1
1 (c1 + b1 ) + b2 dd21


c0 + b0 c1 T + G +

1 M
d2 P

We now find the magnitude of the multiplier effect of a change of one unit
in autonomous spending on output to be
1
dY
=
dc0
1 (c1 + b1 ) + b2 dd12
(d) Whether the multiplier found in part (c) is smaller or larger than the multiplier derived in part (a) is dependent on the parameters c1 , b1 , b2 , d1 , and
d2 . The two such cases are as follows. The multiplier in part (c) will be
smaller than that in part (a) if the relation
b1 b2

d1
<0
d2

holds. Conversely, the multiplier in part (c) will be larger than that in part
(a) if the relation
d1
b1 b2
>0
d2
holds.
Problem 3. Understanding Money Demand We suppose that a persons
yearly income $Y is $60,000, and that their demand function is given by
M d = $Y (.35 i)
(a) We wish to calculate this persons demand for money at various interest
rates. First, we consider the case where the interest rates are 5%, i = 0.05.
Plugging this value for i into the demand function given above, we find that
at a 5% interest rate, this persons demand for money is
M d (i = 5%) = $60, 000 (0.35 0.05) = $18, 000
Similarly, we find that this persons demand for money at an interest rate
of 10% is
M d (i = 10%) = $60, 000 (0.35 0.1) = $15, 000
(b) A given person has a choice between holding their assets in money or bonds.
Bonds accrue interest but are not readily accessible. On the other hand,
money is readily accessible but does not accrue any interest. Therefore, the
proportion of assets that a person decides to hold in bonds will depend on
the possible interest that they may accumulate it versus the accessibility of
money. Thus, when interest rates increase, this will increase the amount of
interest that can be accrued by bonds, so a person is more likely to keep a
higher fraction of their assets in bonds as opposed to money. We saw this in
part (a): when the interest rate went up from 5% to 10%, the demand for
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money decreased because the person could ultimately gain more money from
keeping assets in bonds as opposed to the gains they would have obtained
from the ease of not needing a broker or having to pay transaction fees on
the buying and selling of bonds.
(c) Given that the interest rate is 10%, we can write this persons money demand function for that given interest rate as
M d = $Y (0.35 0.1) = 0.25$Y
We now suppose that her yearly income is reduced by 50%, which we can
model as $Y 0 = 0.5$Y . Plugging this into the equation above, we find that
her new demand for money is
M 0d = 0.25$Y 0 = 0.125$Y
Thus, we find that the percent change in her demand for money is
M 0d M d
0.125$Y 0.25$Y
=
= 0.5
Md
0.25$Y
In other words, a 50% reduction in her yearly income will cause a proportional decrease of 50% in her demand for money, given that the interest rate
is 10%.
(d) We now wish to repeat the calculation done in part (c), but given that the
interest rate is now 5%. At this interest rate, we write this persons money
demand function as
M d = $Y (0.35 0.05) = 0.3$Y
We now once again suppose that her yearly income is reduced by 50%, which
we once again model as $Y 0 = 0.5$Y . Plugging this into the money demand
function above, we find that her demand for money after the reduction in
yearly income is
M 0d = 0.3$Y 0 = 0.15$Y
Thus, we find that the percent change in her demand for money is
M 0d M d
0.15$Y 0.3$Y
=
= 0.5
Md
0.3$Y
(e) In parts (c) and (d), we computed the percent change in money demand
caused by a reduction in yearly income of 50% at two different interest
rates. We found that in both cases, the percent change in money demand
was equal to the percent change in yearly income. Therefore, we conclude
that the percentage effect of income on money demand is independent of
the interest rate. We note that the absolute effect of income on money
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demand is also contrastingly dependent on the interest, therfore this effect

is not constant between interest rates. This can be seen by plugging some
numbers into the money demand equations in the previous two parts.
For instance, suppose that the interest rate is 10% and that this persons
yearly income drops by 50% from $100 to $50. Her money demand before
the reduction in income was
M d = 0.25 ($100) = $25
and after the reduction in income is
M 0d = 0.25 ($50) = $12.25
We see that the percent change in the money demand is a decrease of 50%,
but the absolute change in her money demand had a magnitude of $12.25.
Upon repeating the above calculations for an interest rate of 5% and the
same values for her income before and after the reduction, we find that
M d = $33.33 and M 0d = $16.67. This once again corresponds to a percent
change of -50%, but an absolute change of $16.66, which illustrates the claim
made above that percent change in money demand given a change in yearly
income is constant, but the absolute change is not.
Elasticity is defined in terms of percent changes. Therefore, we see that the
income elasticity of money demand for this equation will be constant, given
that the percent change in money demand given a change in yearly income
is constant and independent of the interest rate. For this specific demand
equation, we thus claim that the income elasticity of money demand is
=

% change in money demand

=1
% change in income

Problem 4. Banks Reserves and the Big Recession

(a) No response necessary.
(b) The balance sheet for the FED in 2007 and 2015 looked approximately as
follows (with units of billions of dollars).
Assets
Market Adjustment to Treasury and MBS Portfolio
Short-Term Lending to Financial Firms and Markets
Rescue Operations
Operations Focused on Longer-Term Conditions
Traditional Portfolio
Liabilities
Source Base
Traditional Liabilites and Capital Account
Treasury Financing Account
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2007
4.8
49
0
0
820.8
2007
801.4
73.2
0

2015
188.4
29.1
1.7
1,775.6
2,502.9
2015
3,676.7
820.9
0

We see that from 2007 to 2015, the FEDs balance sheet greatly expanded.
In order to bring about this expansion in its balance sheet, the FED conducted large-scale asset purchases (LSAPs) mainly consisting of mortgagebacked securities (MBS) and U.S. Treasury Securities. We see from the
balance sheet above that the most unusual change in assets from 2007 to
2015 is in the category of operations focused on longer-term conditions. In
the three rounds of LSAPs conducted, the FED bought largely the aforementioned MBS and U.S. Treasury Securities, but also federal agency debt
issued by Fannie Mae, Freddie Mac, and Ginnie Mae to fund the purchase
of mortgage loans.
(c) The large-scale asset purchases (LSAPs) conducted by the FED fall under
the category of buying bonds. When the FED buys bonds, it increases the
supply of money, driving interest rates down. This has no effect on the the
IS curve. Rather, the expansionary policy shifts the LM curve outward,
resulting in an increase in the equilibrium output.
(d) If the FED were to begin to unwind its balance sheet by selling bonds
and reducing the size of its balance sheet, the money supply will decrease,
increasing interest rates, and making the price of bonds go down. This
will be reflected on the FED balance sheet as a decrease in assets under
operations focused on longer-term conditions and an increase in shortterm lending to financial firms and markets.