CALIFORNIA STATE UNIVERSITY, SACRAMENTO ECN 100A: Intermediate Macroeconomic Theory Assignment #3 Answers Prof. Van Gaasbeck Question 1: IS/MP Model See graphs below.

a) Exogenous change: εMP↓ Effects: Y↑, r↓, C↑, I↑, CF↑

b) Exogenous changes: εMP↑ and G↓ Effects: Y↓, r ambiguous (depends on which policy is bigger), C↓, I and CF are ambiguous (depends on whether interest rates rise or fall).

c) Exogenous change: εMP↓ Effects: Y↑, r↓, C↑, I↑, CF↑

r

M/P

r

Y

L(r,Y1)

M1/P

M1/P

IS1

MP1

r1*

Y1*

M2/P

MP2

Y2*

L(r,Y2)r' r'

r1

*r2

*r2

1. Fed increas es the mo ney s upply to lo wer rea l inte res t ra te s .

3. Rea l mo ney demand increas es becaus e inco me increas es .

2. Real inte res t ra tes a re no w lo wer fo r any given leve l o f o utput. (εMP ↓)

AA

BB

1a)

r

M/P

r

Y

L(r,Y1)

M1/P

M1/P

IS1

MP1

r1*

Y1*

A Ar1*

1b)

IS2

M2/PMP2

Y2*L(r,Y2)

M2/P

B

B 1. Decreas e in G

2. Fed inc reas es εMP

1. Fed cuts M to increas e interes t ra tes

3. Real mo ney demand decreas es becaus e Y decreas es

r

M/P

r

Y

L(r,Y1)

M1/P

M1/P

IS1

MP1

r1*

Y1*

A Ar1*

1c)

IS2

M2/P

MP2

Y2*L(r,Y1)

BB

2. This is a dec reas e in εMP (lo wer r fo r a given Y)

1. P re fe rence fo r ho lding mo ney fa lls

3. Rea l mo ney demand increas es becaus e Y increas es

r' r'

L(r,Y2)

r2*

r2* r2*

CALIFORNIA STATE UNIVERSITY, SACRAMENTO ECN 100A: Intermediate Macroeconomic Theory Assignment #3 Answers Prof. Van Gaasbeck

d) This implies that any time output in the economy rises, the government offsets part of this increase by reducing government spending. This affects the slope of the IS curve, because now, G is a function of Y (much like consumption is a function of income). Specifically, the slope of the IS curve will be steeper (changes in interest rate r will be associated with smaller changes in Y)

e) This implies that the MP curve is steeper. Changes in output (Y) will be associated with larger changes in r (the Fed adjusts r by more when Y changes).

Question 2: IS/MP Model – Monetary Policy Strategy

a) The MP curve is flat. In other words, when output Y changes, the central bank does not change r. Changes in inflation will shift the MP curve up or down; changes in output will not affect interest rates.

b) The MP curve is vertical. The MP curve shifts only in response to output movements (it is determined strictly by where output is).

r

M/P

r

Y

L(r,Y1)

M1/P

M1/P

IS1

MP1r1*

Y1*

A Ar1*

2a)

Inte res t ra tes do no t vary with o utput, o nly infla tio n

Fed s till s hifts mo ney s upply to affec t interes tra tes . The Fed o nly do es this when infla tio nchanges .

r

M/P

r

Y

L(r,Y1)

M1/P

M1/P

IS1

MP1

r1*

Y1*

A Ar1*

2b)

Inte res t ra tes do no t vary with infla tio n, o nly o utput.

Fed s till s hifts mo ney s upply to a ffec t interes tra tes . The Fed o nly do es this when o utput changes .

CALIFORNIA STATE UNIVERSITY, SACRAMENTO ECN 100A: Intermediate Macroeconomic Theory Assignment #3 Answers Prof. Van Gaasbeck

c) This will lead to an upward shift in the MP curve. The central bank achieves this by decreasing the money supply.

Question 3: IS/MP/IA Model a) Exogenous change: εIS↑ Effects: Y↑, r ↑, π↑, C↑, I↓ and CF↓. b) Exogenous change: εIA↑ Effects: Y↓, r ↑, π↑, C↓, I↓ and CF↓.

IS2

π

Y

r

Y

AD1

IA1

IS1

MP1

π1*

Y1*

A

Ar1*

Y1*

AD2

π2*

Y'Y2*

Y2* Y'

MP2

B

B

r2*r'

3a)

π

Y

r

Y

AD1

IA1

IS1

MP1

π1*

Y1*

A

Ar1*

Y1*

IA2

π2*

Y2*

Y2*

MP2

B

B

r2*

3b)

1. Co ns umer co nfidence inc reas es , εIS increas es .

2. Inco me is higher, fo r a given ra te o f π.

3. π inc reas es , caus ing the Fed to increas e r (MP s hifts up).

2. π inc reas es , caus ing the Fed to inc reas e r (MP s hifts up).

1. εIA increas es , infla tio n inc reas es fo r a given Y.

r

M/P

r

Y

L(r,Y1)

M1/P

M1/P

IS1

MP1

r1*

Y1*

A Ar1*

2c)

IS2

M2/P MP2

Y2*

L(r,Y2)

M2/P

BB

2. Fed inc reas es εMP

1. Fed cuts M to inc reas e interes t ra te s

3. Rea l mo ney demand decreas es becaus e Y decreas es

r2*r' r'

r2*

CALIFORNIA STATE UNIVERSITY, SACRAMENTO ECN 100A: Intermediate Macroeconomic Theory Assignment #3 Answers Prof. Van Gaasbeck

c) Exogenous change: εMP↑ Effects: Y↓, r ↑, π↓, C↓, I↓ and CF↓. d) This makes the IS curve flatter, but does not necessarily affect the endogenous variables. What this

change means is that exogenous shocks to the economy will affect interest rates, output, and inflation differently.

π

Y

r

Y

AD1

IA1

IS1

MP1

π1*

Y1*

A

Ar1*

Y1*AD2

π2*

Y2*Y'

MP2

B

B

r2*r'

3c)

π

Y

r

Y

AD1

IA1

IS1

MP1

π1*

Y1*

A

Ar1*

Y1*

IA2

Y2*

3d)

MP'

Y'Y2*

IS2

2. Y decreas es fo r any given π, AD s hifts le ft.

3. π increas es , caus ing the Fed to increas e r (MP s hifts up).

1. Increas e in rea l mo ney demand leads to an inc reas e in r. εMP inc reas es , MP s hifts

1. If inves tment is le s s s ens itive to interes t ra tes , then an inc reas e in r will reduce Y by a s malle r amo unt (a lo ng the IS curve).

CALIFORNIA STATE UNIVERSITY, SACRAMENTO ECN 100A: Intermediate Macroeconomic Theory Assignment #3 Answers Prof. Van Gaasbeck

e) Exogenous changes: εIA↑ and εIS↓ Effects: Y↓, r and π ambiguous, C↓, I and CF ambiguous.

Question 4: IS/MP/IA Model – Fiscal and Monetary Policy Preview

a) IS curve shifts to the right. This causes an upward shift in the MP curve (when inflation rises) Exogenous change: T↓ Short Run Effects: Y↑, r ↑, π↑, C↑, I↓ and CF↓. Long Run Effects: Y no change, r ↑, π↑, C↑, I↓ and CF↓.

b) IS curve shifts to the left. This causes a downward shift in the MP curve (when inflation falls). This is

simply the reverse of the diagram 4a) above. Exogenous change: G↓ Short Run Effects: Y↓, r ↓, π↓, C↓, I↑ and CF↑. Long Run Effects: Y no change, r ↓, π↓, C no change, I↑ and CF↑.

c) IS curve shifts to the left. This is because the effects of the government spending cut are larger than those of the tax cut. Households only consume a fraction of the tax cut (marginal propensity to consume is less than one). This causes a downward shift in the MP curve (when inflation falls). The diagram is the same as 4a), except that the shifts would be smaller in magnitude.

IS2

π

Y

r

Y

AD1

IA1

IS1

MP1

π1*

Y1*

A

Ar1*

Y1*AD2

Y2*

Y2*

MP2

B

B

3e)

IA2

1. εIS decreas es

1. εIA increas es

2. πIA inc reas es , s o the Fed inc reas es r (MP s hifts up)

π

r

Y

AD1

IA1

IS1

MP1

π1*

Y1*

A

Ar1*

Y1*

π2*

Y'Y2*

Y2* Y'

MP2

B

B

r2*r'

4a)

4. As infla tio n adjus ts upward, the Fed further ra is es r.

2. Inco me is higher, fo r a given ra te o f π.

3. π increas es , caus ing the Fed to increas er (MP s hifts up).

IS2

MP3

C

IA3

r3*

π3*C

1. T decreas es , s o IS s hifts right.

CALIFORNIA STATE UNIVERSITY, SACRAMENTO ECN 100A: Intermediate Macroeconomic Theory Assignment #3 Answers Prof. Van Gaasbeck

Short Run Effects: Y↓, r ↓, π↓, C↓, I↑ and CF↑. Long Run Effects: Y no change, r ↓, π↓, C↓ (this is because Y is unchanged and I and CF increase), I↑ and CF↑.

d) A balanced budget amendment would force the government to decrease spending each time it cut taxes. However, the effects of these two policies are not the same in terms of output. This policy would actually reduce output in the short run. The policy is beneficial because it would reduce interest rates in the long run, leading to higher investment (and net exports).

e) MP curve shifts to the right. This causes an

upward shift in the MP curve (when inflation rises) Exogenous change: εMP↑ Short Run Effects: Y↓, r ↑, π↓, C↓, I↓ and CF↓. Long Run Effects: Y no change, r no change, π↓, C no change, I no change and CF no change.

f) The central bank would implement this policy to reduce inflation. Notice, there are no effects on real economic variables in the long run.

π

Y

r

Y

AD1

IA1

IS1

MP1

π1*

Y1*

A

Ar1*

Y1*AD2

π2*

Y2*Y'

MP2

B

B

r2*r'

4f)

MP'

Y'Y2*

2. Y decreas es fo r any given π, AD s hifts le ft.

3. π inc reas es , caus ing the Fed to inc reas e r (MP s hifts up).

1. Fed increas es inte res t ra te s fo r a given va lue o f Y and π. εMP increas es , MP s hifts up.

IA3

π3* C

4. π, decreas es as IA s hifts do wn to bring the eco no my to full emplo yment.

5. As π decreas es , the Fed to dec reas es r (MP s hifts do wn).

= C

= MP3