Practice Problem Set #2 Solutions

EC202A1, Spring 2011, Jeremy Smith Chapter 4

2. a. i=0.05: money demand = $18,000. i=0.10: money demand = $15,000. (Just substitute the given nominal income level of $60,000 and the respective interest rate into the given money demand function.) b. Money demand decreases when the interest rate increases. This makes intuitive sense because bonds (which pay interest) become relatively more attractive to hold as the interest rate increases, so money (which doesnt pay interest) becomes relatively less attractive to hold. If nominal income starts at $60,000 and decreases by 50%, the new level of nominal income will be $30,000. Plugging the interest rate of 10% and nominal income level of $30,000 into the given money demand function gives Md=$30000(.25)=$7,500. This is half the money demand of $15,000 found in part a. for the same interest rate and the initial nominal income level. Therefore, the demand for money has fallen by 50%. The demand for money falls by 50% in this case too. (Plug $30,000 in for income and 5% in for the interest rate to find that money demand is $9,000. This is half of the $18,000 figure found in part a. for the 5% interest rate and the initial level of nominal income.) A 1% increase in income leads to a 1% increase in money demand. (Likewise, a 1% decrease in income will lead to a 1% decrease in money demand.) This effect is independent of the interest rate. Ms=Md $20=$100(.25-i) 100i=$25-$20 i=5/100=5%. (for equilibrium in the market for cash) (plugging in $100 for income and $20 for Ms, as given) (rearranging)

c.

d.

e.

4.

a.

b.

Instead of treating the money supply as a known number, treat it as an exogenous variable called M. Now, impose the condition for equilibrium in the market for cash: Ms=Md M=$100(.25-i) This gives an expression that must hold for the market for cash to be in equilibrium. One can insert any interest rate that is desired into this equation, and the resulting value for M will be the required money supply to support the desired interest rate as the equilibrium interest rate.

2 So if we want the equilibrium interest rate to be 2%, the money supply would have to be M=$100(.25-0.02)=$23; and if we want the equilibrium interest rate to be 12%, the money supply would have to be M=$100(.25-0.12)=$13; and, putting these two pieces of information together, if we want the equilibrium interest rate to increase by 10 percentage points from 2% to 12%, the money supply would have to decrease by $23-$13=$10. (In general, the equation tells us that any 10-percentage-point increase in i would require a $10 decrease in the money supply, regardless of the starting interest rate. As another example, note that the required money supply for the equilibrium interest rate to be 15% is $10; this interest rate is ten percentage points higher than the one found in part a., and the required money supply is $10 less than the money supply was in that part.) 5. a. Recall that when we think of the demand for cash, we assume that all individuals hold their wealth as either cash or bonds. The demand for bonds is therefore the part of wealth that is left over after the amount of cash held has been subtracted. W=Md+Bd Bd=W-Md (rearranging) Bd=50,000-60,000(.35-i) (substituting in the given information for W, Md and $Y) If the interest rate increases by 10 percentage points, bond demand increases by $6,000. (You should be able to see this by looking at the equation and reasoning to yourself. To prove it to yourself, choose an arbitrary number for the interest rate and calculate bond demand at that interest rate and again at an interest rate thats ten percentage points higher: if youve done the calculations correctly, you should find that the difference in bond demand is +$6,000.) b. An increase in wealth increases bond demand, but has no effect on money demand. (The demand for cash in our model depends only on the interest rate and on income, where the latter is a proxy for the amount of transactions.) An increase in income increases money demand, which hence decreases bond demand, since wealth is constant. (The increase in income does not lead to a change in the level of wealth within the same period.) First of all, the use of money in this statement is colloquial. Income should be substituted for money. (Theres a very good Focus Box near the beginning of Chapter 4 in the textbook called Semantic Traps on this point.) Second, when people earn more income, their wealth does not change right away. Thus, they increase their demand for money (in order to be able to complete the additional transactions they want to make), and as a result, in the short run their demand for bonds actually decreases.

c.

d.

Chapter 5
2. a. Y=Z (for equilibrium in the goods market, as usual) Y=C+I+G (substituting in the definition of Z)

3 Y=(c0+c1YD)+I+G (substituting in the given consumption function) Y=c0+c1(Y-T)+I+G (substituting in the usual definition of disposable income) Y(1-c1)=c0-c1T+I+G (isolating all terms containing Y on the left) Y*=[1/(1-c1)][c0-c1T+I+G]. (solving) The multiplier is 1/(1-c1). b. Y=Z Y=C+I+G Y=(c0+c1(Y-T))+(b0+b1Y-b2i)+G Y(1-b1-c1)=c0-c1T+G+b0-b2i Y=[1/(1-b1-c1)][c0-c1T+G +b0-b2i] This equation defines the IS relation. The multiplier for a given level of the interest rate is 1/(1-b1-c1). Since the multiplier is larger than the multiplier in part a. (because the denominator is smaller due to the presence of the -b1 term), the effect of a change in autonomous spending is bigger than in part a. An increase in autonomous spending now leads to an indirect increase in investment as well as in consumption. c. The question gives the LM relation, which results from setting the real money supply equal to the real demand for cash, and hence represents equilibrium in financial markets. However, it can be put in a more useful form than the question gives it in. So, the first thing to do is to rearrange the LM relation so that i is alone on the left. M/P=d1Y-d2i d2i= d1Y-M/P i=(d1/d2)Y-(1/d2)(M/P). To find equilibrium output, substitute the LM expression for the interest rate into the IS relation from part b.: Y= 1 (c -c T+G +b0-b2[(d1/d2)Y-(1/d2)(M/P)]) 1-b1-c1 0 1 b2(d1/d2) 1 = (c -c T+G +b0+b2(1/d2)(M/P)) 1-b1-c1 1-b1-c1 0 1

Y1 +

2 1-b1-c1+bdd1 2 = 1 (c -c T+G+b0+b2(1/d2)(M/P)) Y 1-b1-c1 1-b1-c1 0 1

1 Y*= 1-b -c +b2d1(c0-c1T+G+b0+(b2/d2)(M/P)). 1 1 d2 The multiplier is 1/(1-b1-c1+b2d1/d2).

4 d. Mechanically, the multiplier just found in part c. is greater than the multiplier in part a. if the extra terms make the denominator smaller, i.e. if (-b1+b2d1/d2) is less than zero. (It is always less than the multiplier from part b. because the term b2d1/d2 is always positive.) The multiplier from part c. measures the marginal effect of an increase in autonomous spending on equilibrium output, where this refers to simultaneous equilibrium in the goods market and in financial markets. As such, the multiplier embodies two composite effects: the first effect comprises the direct effect of the increase in autonomous expenditure plus the indirect positive effects of the induced higher income on consumption and investment; while the second effect comprises the indirect negative effect on investment from the interest rate, which is pushed higher because the higher income induces higher money demand. The first of these effects is equivalent to the horizontal shift of the IS curve. The relative size of the second of these effects depends on the slope of the LM curve (since the economy moves along the LM curve towards the new equilibrium in response to a shift of the IS curve) and on the sensitivity of investment to the interest rate. The first effect is captured by the 1-b1-c1 part of the multiplier. When b1 and c1 are large (that is, when consumption and investment respond strongly to increases in income), the multiplier will be large, as increases in autonomous expenditure will be strongly amplified by the much higher induced consumption and investment. The second effect is captured by the expression b2d1/d2. The ratio d1/d2 is the slope of the LM curve, and the parameter b2 measures the marginal (negative) effect of an increase in the interest rate on investment. If money demand jumps by a large degree in response to a small change in income and if investment drops by a large degree in response to changes in the interest rate, the multiplier will be small, as increases in autonomous expenditure will be mostly offset by the large crowding out of investment due to the much higher interest rate. When thinking about this graphically, note that shifts in the IS curve (caused, for example, by expansionary fiscal policy) get less and less effective at raising equilibrium output as the LM curve gets steeper and steeper. 3. a. The IS curve shifts left. Equilibrium output and the interest rate fall. The effect on investment is ambiguous because the output and interest rate effects work in opposite directions: the fall in output tends to reduce investment, but the fall in the interest rate tends to increase it.

Ive decided that the rest of this problem is too tedious in relation to the point that it tries to make. Getting through the following algebra is therefore not required, though it would be a good idea to think about the basic conclusion and try to follow the logic of the argument. Ill provide some brief and not altogether complete solutions for those who want to compare their own answers.

5 b. c. From the answer to 2c., Y*=[1/(1-c1-b1+b2d1/d2)][c0-c1T+b0+(b2/d2)(M/P)+G]. From the LM relation, i=Y(d1/d2)(M/P)/d2. To obtain a precise algebraic expression for the equilibrium interest rate, one would substitute Y* from part b. into the LM relation and proceed with some tedious simplification. I= b0+b1Y-b2i=b0+(b1-b2d1/d2)Y+(b2/d2)(M/P). The LM relation has been substituted in for i and the terms involving Y collected together. To obtain a precise algebraic expression for equilibrium investment, one would have to substitute Y* into this equation and simplify. The algebraic simplification that was skipped in the previous two parts is not required to satisfactorily answer this part. From part b., holding M/P constant, Y* decreases by [1/(1-c1-b1+b2d1/d2)] when G decreases by one unit. From part d., holding M/P constant, I* decreases by (b1- b2d1/d2)/(1-c1-b1+b2d1/d2) when G decreases by one unit (which is the amount by which equilibrium investment responds to changes in equilibrium output b1-b2d1/d2 multiplied by the amount by which output actually changes following the change in G). So, if G decreases by one unit, investment will increase if the numerator of this expression is negative, i.e. when b1<b2d1/d2. (You can see that this is closely related to the condition discussed in 2d., which should make sense if you think about it very carefully. Also see the extended discussion of 4g. below.) A fall in G leads to a fall in output (which tends to reduce investment) and to a fall in the interest rate (which tends to increase investment). For investment to increase on net, the output effect (b1) must be smaller than the interest rate effect (b2d1/d2). Note that the interest rate effect is the product of two factors: (i) d1/d2, the slope of the LM curve, which gives the effect of a one-unit change in equilibrium output on the interest rate; and (ii) b2, which gives the effect of a one-unit change in the equilibrium interest rate on investment. Y=Z Y=C+I+G Y=(200+.25(Y-200))+(150+.25Y-1000i)+250 Y-.25Y-.25Y=200-.25(200)+150-1000i+250 0.5Y=550-1000i Y=1100-2000i (IS curve) (M/P)s=(M/P)d 1600=2Y-8000i 8000i=2Y-1600 i=Y/4000-1/5 (LM curve) Substituting from part b. into part a. gives Y=1100-2000(Y/4000-1/5) Y+Y/2=1100+400 1.5Y=1500 Y*=1500/1.5=1000.

d.

e.

f.

4.

a.

b.

c.

6 d. Substituting from part c. into part b. gives i=(1000)/4000-1/5 i*=0.25-0.2=0.05=5%. Substitute the equilibrium output level and interest rate into the consumption and investment functions. You should get C=400; I=350; G=250 (given); so C+I+G=1000 (i.e. output equals demand, which we would expect, because this is the condition for equilibrium in the goods market that we imposed in deriving the IS curve). Derive the LM curve over again, with a real money supply of 1,840 rather than 1,600, then re-do parts c., d. and e. using this new LM curve and the same IS curve as before. You should get i=Y/4000-23/100 as your new LM curve; Y*=1040; i*=3%; C=410; I=380. A monetary expansion reduces the equilibrium interest rate and increases equilibrium output. Consumption increases (from 400 to 410 in this example) because output increases. Investment increases (from 350 to 380 in this example) because output increases and the interest rate decreases. Derive the IS curve over again, with government expenditure of 400 rather than 250, the re-do parts c., d. and e. using this new IS curve and the original LM curve from part b. You should get Y=1400-2000i as your new IS curve; Y*=1200; i*=10%; C=450; I=350. A fiscal expansion increases output and the interest rate. Consumption increases (from 400 to 450 in this example) because output increases. Investment is affected in two ways: the increase in output tends to increase investment, and the increase in the interest rate tends to reduce investment. In this very specific example, these two effects exactly offset one another, and investment does not change. (In 3e. it was found that investment would increase in response to a drop in government expenditure if b1<b2d1/d2. By the same token, investment will fall with an increase in government expenditure if this same condition holds, while investment will rise with an increase in government expenditure if the opposite condition holds, namely b1>b2d1/d2. In this specific example, b1=0.25 [from the investment function] and b2d1/d2=1000(2)/8000=0.25 [from the investment function and the real money demand function]. Only because we get the same number for both of these calculations does the interest rate effect on investment exactly offset the income effect, leading to zero net change in investment. Also note that the multiplier derived in 2c. and 3b. is, in this specific example, 1/(1-0.25-0.25+0.25)=1/0.75=4/3 [from the investment and money demand functions for the parameters already discussed, and from the consumption function for c1]. Since government expenditure changes by 400-250=+150, the change in equilibrium output should be the multiplier times this change, or 4/3(150)=200. This is exactly what we found above, since equilibrium output rose from 1000 to 1200 going from part c. to g., for a change of +200.) 8. Ill be brief here, since we discussed both parts in some detail in class.

e.

f.

g.

7 a. Increase G (or reduce T, or both), which shifts the IS curve to the right; then increase M, which shifts the LM curve down. Reduce G (or increase T, or both), which shifts the IS curve to the left; then increase M, which shifts the LM curve down. The interest rate falls (by a lot). Investment increases, since the interest rate falls while output remains constant. The IS curve shifts left. Equilibrium output and the interest rate fall. Consumption falls (because output has fallen). The change in investment is ambiguous: the fall in output tends to reduce investment, but the fall in the interest rate tends to increase investment. The change in private saving equals the change in investment (because investment equals total saving when the goods market is in equilibrium, and public saving has not changed because both G and T are being held constant). So, private saving could rise or fall in response to a fall in consumer confidence.

b.

9.

a. b.