Macroeconomic Theory

M. Finkler

Suggested Answers to Spring 2012 Midterm Examination #2

1. (25 points) Use the following version of Model 3.

Consumption: C = 1400 + .75*Yd + .08*(M/P)
Net Exports: NX= 400 - .25*Yd – 10*r
Taxes: T = -200 + .2*Y
Disposable Income: Yd = Y - T
Investment: I = 140 – 30*r
Governmental Purchases: G = 200 - .2*(Y – Yp) where Yp = potential GDP
Aggregate Demand: AD = C + I + G + NX
Goods Market Equilibrium Y = AD
Money Demand: Md/P = .25*Y – 50*r
Money Market Equilibrium M = Md

Endogenous Variables Exogenous Variables

C, Yd, NX, r,T,AD,Y,I,Md,G Yp,P,M

a. First plug T into Yd and then Yd into the C and NX terms, and then plug the
results and I and G into the AD equation to yield:

AD = 1400 +.75*(Y+200-.2*Y) + .08*(M/P) + 400 -.25*(Y+200-.2*Y) – 10*r + 140 –

30*r +200 - .2*(Y-Yp)

Set Y = AD and collect terms on the right hand side to yield =

Y=2,240 + .2*Y + .2*Yp + .08*(M/P) - 40*r and then solve for Y which yields:

IS: Y = (2,240 + .2*Yp + .08*(M/P) - 40*r)/ .8 with slope r/Y= -1/50

b. The LM curve comes from plugging money demand into the money market
equilibrium and then solving for r.

LM: M/P = .25*Y – 50*r can be solved for r to yield r = (.25*Y)/50 - (M/P)/50
Which has a slope r/Y =1/200.

c. Given M = 2,200, P = 1, and Yp = 4,000, determine the equilibrium value for Y.

First plug the LM curve into the IS curve to yield:

Y = (2240 + .2*Yp + .08*(M/P))/.8 – (.25*Y - M/P) which can be solved for Y to yield:
Y = (2,800 + .25Yp + 1.1*(M/P))/1.25
When we plug in the values for M, P, and Yp, we find that Y = 4,976

d. T = -200 + .2*(4,976) = 795.20 and G = 200 - .2*(4,976 – 4,000) = 4.80

The Government runs a surplus of 790.40.
e. Since Y > Yp, one might argue that model 3 does not apply. If Model 3 (as posed
in the exam and as I had originally intended) does apply, a change in the
autonomous portion of G can be used to bring GDP in line with potential GDP as
follows:

Return to part c and replace 2240 with 2040 + z, since 200 represents the autonomous
portion of G, to yield:
Y = (2,550 + 1.25*z + .25Yp + 1.1*(M/P))/1.25

Now, solve for z, given that Y = Yp = 4,000. The result would be z=-796.
Since the value for G determined in part d was 4.80, G= -800.80.

2. Divide both sides of the production function by H to yield

a. y = Y/H = k1/3 = (K/H)1/3

b. The steady state value of output per unit of human capital requires that physical
capital grow at the same rate as human capital; thus, k growth must equal E
growth + L growth. Based on Model 1g, this result can be written down as
follows:
y = ((n+g +δ)/s)*k
When this result is set equal to the production function to determine the steady
state level of output per unit of human capital, the result is:

y = (s/ (n+g +δ) raised to the (1/3)/(2/3) or ½.

This, of course is not very interesting as we would like to know about output per
laborer not per unit of human capital. Output per laborer Y/L would equal or y*E
which is a function of time and depends on the initial level of E.

c. Output per laborer can be determined from the production function. First
substitute E*L for H to yield:

Y = K 1/3 E 2/3 L 2/3 Based on this equation, growth rates can be determined by
taking logarithms of both sides and then the time derivative to yield

Ygr = (1/3)*Kgr + (2/3)*Egr + (2/3)*Lgr

To determine, growth in output per unit of labor, we need to subtract Lgr from
each side to yield

Ygr – Lgr = (1/3)*Kgr –(1/3)*Lgr + (2/3)*Egr

Since Kgr = Lgr + Egr in steady state, Kgr = n + g consequently,

Ygr = (1/3)*(n+g) – (1/3)*(n) + (2/3)*g = g per year.
d. When we plug s= .1, n=.01, g = .02, and δ=.05 into the result from part b, we find
y = [.1/(.01+.02+.05)]1/2 = (1.25)1/2 = 1.12 and (Y/L)t = 1.1Et
where Et = Eo*(1+.02)t

e. From part d, a doubling of the depreciation rate would reduce the value of y to
0.88. Output per unit of labor would also fall as Y/L = y*E and E is unaffected by
the change in the depreciation rate.

3. False. The statement should be modified to read “balance the cyclically adjusted
federal budget.” When the economy is booming (Y > Yp) , policy makers should
aim for a governmental budget surplus. When the economy is in a recession (Y <
Yp), policy makers should aim for a governmental budget deficit. Stated
differently, the structural (as opposed to cyclical portion of the budget deficit)
portion of the budget should be in balance. Alternatively, one could argue that
fiscal policy should be set to bring Y in line with Yp with the implications noted
above.

4. The BBM can be found from the equilibrium statement for GDP.

For Model 2 Y = a – b*T + G + I the BBM = ΔY/ΔG + ΔY/ΔT = 1/(1-b) – b/(1-b) = 1

1-b

For Model 3 Y = a – b*to + e + g + G + [(d+n)/h]*M/P so the balanced budget

1- b(1-t1) + m + (d+n)*k/h multiplier would be given by

ΔY/ΔG + ΔY/ΔT = (1-b) / [1- b(1-t1) + m + (d+n)*k/h]

which clearly is much smaller than 1

To make the two multipliers equivalent, all of the following must hold:
• The income tax rate (t1) must equal zero.
• The propensity to import out of income (m) must be zero.
• Either the sensitivity of investment to the interest rate (d) and the sensitivity of net
exports to the interest rate (n) must be zero or the sensitivity of money holding to
interest rate changes (h) must be very large.

b. Since some of the increase in AD resulting from the BBM would be absorbed by a
rise in the price level, the multiplier will be even smaller.

c. The existence of a liquidity trap means that h is very large. This effectively
eliminates the last term in the denominator and makes the BBM larger than in the
standard case in model 3.