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Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 2nd edition,

Instructor’s Manual on the Web

On the effectiveness of policy, it is possible to discuss the issue heuristically, as follows. For
example, consider an increase in government spending, and proceed in three steps.

i. For any given interest rate, the effect of fiscal policy on output will depend on the
multiplier, modified to include endogenous investment. The larger the multiplier, that is, the
greater the sensitivity of consumption and investment to output, the larger the initial
response of output.

ii. Because an increase in G will increase Y , it will also increase the quantity of money
demanded for any interest rate, and thus increase the interest rate, in order to maintain
money market equilibrium. The increase in the interest rate will be small to the extent that
money demand is not very sensitive to income, but is very sensitive to the interest rate.
If money demand is not very sensitive to income, then the excess demand for money created
by the increase in G will be small. If money demand is very sensitive to the interest rate,
the increase in the interest rate needed to restore equilibrium in the money market will be
small.

iii. Finally, the increase in the interest rate will tend to reduce investment and thus offset some
of the initial increase in output. This effect will be small to the extent that investment is not
very sensitive to the interest rate.
In sum, fiscal policy will have a greater effect on output to the extent that the multiplier is
large, money demand is not very sensitive to income, money demand is very sensitive to the
interest rate and investment is not very sensitive to the interest rate.
One could carry out the same exercise with respect to monetary policy. An increase in the
money supply affects output by reducing the interest rate and increasing investment. Thus,
an increase in the money supply will tend to have a large effect on output when it has a
large effect on the interest rate, which will be true when money demand is not very sensitive
to the interest rate. The interest rate will have a large effect on output when investment is
very sensitive to the interest rate, which calls forth the initial response of output, and, again,
when the multiplier is large. The increase in output increases the quantity of money
demanded for any interest rate and tends to increase the interest rate, offsetting some of the
initial effect of the increase in the money supply. This effect will be small when the demand
for money is not very sensitive to income.
In sum, monetary policy will have a greater effect on output to the extent that money
demand is not very sensitive to the interest rate, investment is very sensitive to the interest
rate, the multiplier is large and money demand is not very sensitive to income.
These exercises are relatively sophisticated despite the lack of an analytical model, and they
make clear the linkages between the goods market and the money market through the
interest rate.

Questions and Problems

1.

a. Uncertain. Investment depends primarily on the level of sales and the interest rate, but in
fact the formal investment relation considers the level of sales equal to the production and
the investment depends positively on Y and negatively on i.

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© Pearson Education Limited 2014
Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 2nd edition,
Instructor’s Manual on the Web

b. True. A decrease in the interest rate increases the demand for goods at any level of output,
leading to an increase in the equilibrium level of output.

c. False. The IS curve is downward-sloping because goods market equilibrium implies that an
increase in interest rates leads to a lower level of output.

d. False. An increase in taxes would shift the IS curve to the left, while an increase in
government spending would shift the curve to the right, but the effect on the output will not
1 − c1
be the same. Y will increase of 1 unit if both G and T will increase of 1 unit each, ∆Y =
1 − c1
the IS curve shift to the right. (See Chapter 3, Ex. 4).

e. False. The LM is upward-sloping because in equilibrium, an increase in the level of income


increases the demand for money and the interest rate.

f. Uncertain. An increase in government spending increases income and interest rate, so the
final effect on investment is ambiguous.

g. True. If a right mix of monetary and fiscal policy is used, the interest rate can remain the
same, or experience small variations.

2.

1
a. As seen in Chapter 3, the multiplier is .
1− c

1
b. The equilibrium output will be: Y = ( c0 − c1T + b0 − b2i + G ) . The effect of the
1 − b1 − c1
multiplier will be larger because ( b1 + c1 ) > c1 so the value of the new multiplier will be
higher.
M
d1Y −
c. From the LM relation, the interest rate is: = P . Call ( c0 − c1T + b0 + G ) autonomous
d2
spending, A . The output in equilibrium is:
1 M 1
Y* = + A
d2 P d1
(1 − b1 − c1 ) + d1 1 − b1 − c1 + b2
b2 d2

1
d. In answer a the multiplier was . To obtain the same result, d 2 and b2 must be equal to
1− c
1 and d1 and b1 = 0 . It means that if the investment depends only on the interest rate, and
also the money demand depends on the interest rate only, the multiplier does not change
from the case where variables are exogenous. The more investment and money demand
depends on Y, the more the multiplier increases its value. This is true if d 2 and b2 are very
small (close to zero) and d1 , b1 are close to 1.

3.

a. Figure 5.8, but instead of ∆T > 0 we have ∆G < 0 . The effect is the same. The effect of a
fiscal contraction (or expansion) on investment is ambiguous. The decrease in spending
causes a decrease in output and a decrease in the interest rate. The investment depends

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© Pearson Education Limited 2014
Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 2nd edition,
Instructor’s Manual on the Web

positively on Y and negatively on i, so depending on how much investment is affected by


the output or the interest rate, it can decrease or increase.

b. See point 2.c


M
d1Y −
c. From the LM relation, the interest rate is: i = P . Substitute the value of the
d2
equilibrium interest rate Y * in the equation and find i * . The interest rate in equilibrium
will be:
1 M 1
i* = − + A
1+
b2 d1 P
b2 +
(1 − b1 − c1 ) d 2
1 − c1 − b1 d1

d. Substitute Y * and i * in the relation I = b0 + b1Y * −b2 i * . The investment in equilibrium will be:

b1 b2 M b1 b2
I = b0 + − + − A.
d 2 (1 − b1 − c1 ) b2 d1 P b2 d1 (1 − b1 − c1 ) d 2
+ d1 1 + (1 − b − c ) + b2 +
b2 (1 − b1 − c1 ) 1 1
d2 d1

e. If I depends only on and not on Y , the investment wil increase when G decrease: b2 = 1
and b1 = 0 .

f. The investment depends positively on Y and negatively on i . Depending on how much


investment is affected by Y or i , it can decrease or increase. If government spending
decreases, both output and interest rate will decrease. If investment depends only on the
interest rate, a decrease in G will increase investment for sure.

4.

a. ( )
Y = C Y − T + I + G . Substituting the values we obtain: Y = 2400 − 3000i .

M (Y − 1500 )
b. = YL ( i ) . Substituting the values we obtain: i = .
P 6000

c. The output in equilibrium is Y * = 2100 .

d. The interest rate in equilibrium is i* = 10% .

e. Consumption and investment in equilibrium are C* = 825; I * = 675 . We can verify that:
C * + I * +G* = 825 + 675 + 600 = 2100 = Y *

M
f. If increases to 4320, the new equilibrium values will be: Y ' = 2320 > Y * ; i ' = 0.027 < i * ;
P
C ' = 880 > C * ; I ' = 839.5 > I * . An expansion in monetary policy decreases the interest rate
and increases the output. The LM curve shifts down. Consumption increases because of the
higher disposable money and investment increases because of lower interest rates.

47
© Pearson Education Limited 2014
Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 2nd edition,
Instructor’s Manual on the Web

g. If government spending increases to G = 840 , Y '' = 2420 > Y * ; i '' = 0,153 > i * ;
C '' = 905 > C * . An expansionary fiscal policy increases consumption and output, the IS
curve shifts to the right. The increase in output causes the increase in interest rates.

5. Yes, the firm’s decision remains affected by the interest rates, also when the owner does not
need to borrow to finance his investment. In fact, the owner can consider more profitable an
investment on the financial market buying bonds than to invest buying new machinery for
production, if interest rates are sufficiently high.

6.

a. People want to hold currency. A negative interest rate means that people should pay to lend
his own money using bonds, because the return on the financial investment would be
negative.

b. See figure 5.11 a

c. See figure 5.11 b

d. The nominal interest rate will become zero and then remains zero. It will not be affected by
an increase in money supply.

e. No. After that i = 0 , an increase in money supply cannot increase output.

7.

a. First, a fiscal expansion (increasing G or decreasing T) will shift to the right the IS curve,
M
increasing both Y and i. Secondly, a monetary expansion (increase in ) will decrease the
P
interest rate to the original level and cause a further increase in Y.

b. To decrease the fiscal deficit maintaining Y unaffected, a fiscal consolidation (decrease G or


increase T) followed by a monetary expansion is needed. The interest rate will decrease
after the cut in spending, that causes a IS shift to the left, then it will further decrease after
the monetary expansion, that will cause a LM shift down. The investment will increase,
because Y is fixed and i is lower.

8.

a. Figure 5.8, but instead of ∆T > 0 (increase in taxes) there is ∆C < 0 (decrease in
consumption due to the decrease in consumers’ confidence). The effect on the IS curve is
the same (it shifts left).

b. A decrease in consumer confidence will cause a decrease in consumption. This will cause a
decrease in output and a decrease in interest rates. The effect on investment and saving is
ambiguous, because the decrease in output and interest rate has opposite effects on
investment. A decrease of Y will decrease investment, and a decrease in i will increase it.
Investment and saving are equal, so a decrease in consumption will not necessarily increase
saving, but it could only cause a decrease in output.

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© Pearson Education Limited 2014