Mario Catalan SAIS

Macroeconomic Theory Johns Hopkins University

Part 1-Due November 14th, 2001.

Part 2-Due November 29th, 2001.

Answer Key - Homework #3 - Fall 2001

This homework consists of two parts. The first part includes Questions
1-4 and the second part consists of Questions 5-6.

Question 1-A Permanent Reduction in the Rate of Growth of the Money

Supply-Flexible Prices (20 Points)
Motivation: In many historical episodes, governments implemented anti-inflationary
policies aimed at reducing the long-run inflation rates of their economies. In the stylized
and so-called money-based stabilization plans, governments promise to reduce the rate of
money growth. We analyze the effects of this policy in an economy characterized by
flexible prices (as an approximate description of economies characterized by high
inflation). Throughout the analysis, we will be (explicitly) assuming that the change in
monetary policy is fully credible. In reality, the “credibility problem” can severely
jeopardize the success of the stabilization plan. When credibility is an important issue, the
money-based stabilization plans are usually launched in conjunction with additional
measures to enhance credibility, for instance, the announcement of more autonomy of
central bank authorities (independence).
Analyze the effects of a permanent reduction in the rate of growth of the (nominal) money
supply. The government (central bank) announces at t=0 that the money supply will grow
at a lower rate each period, starting at t=0. Observe that there is a permanent change in the
“rate of growth” of the money supply. This policy exercise differs from the case in which
there is a permanent change in the “level” of the money supply.
A) Assume that the real output level of the economy is constant and show the effects
of the new monetary policy on variables related to the money market. Use graphs
to trace the time path of the following variables: nominal money supply, real
money supply, price level, inflation rate and the nominal interest rate. (15 Points)
B) Explain (in detail) the long-run equilibrium of the money market. Specifically,
justify the long-run level of the inflation rate, nominal interest rate, output and the
price level. (5 Points)

Answer A and B:
The following equalities and facts characterize the equilibrium of the money market in the
long run (the economy is in the “long-run” at t=0, immediately after the policy shock,
because prices are fully flexible).
1) The rate of money growth is equal to the inflation rate (long-run money
neutrality),
2) The Fisher equation holds, i.e. the actual rate of inflation plus the real rate of
interest equal the nominal interest rate,
3) The real rate of interest is equal to the marginal productivity of physical capital
(see chapter 3-Mankiw)
4) The real output level is the full employment output level,
 Mario Catalan SAIS
Macroeconomic Theory Johns Hopkins University
5) The money market must be in equilibrium, i.e. the real money supply must be
equal to the real money demand, which is a decreasing function of the nominal
interest rate and an increasing function of the real output level. This is true because
all prices are fully flexible and they adjust to clear all markets (supply equals
demand in all markets)

Ms Md
= = L( R, YFE )
P P

Graph 1 Graph 2
Log
Ms
π

0 t 0 t

R Graph 3 M/P Graph 4

0 t 0 t

Log
P Graph 5

0 t
Mario Catalan SAIS
Macroeconomic Theory Johns Hopkins University

Graph 1 shows the level of the money supply (its logarithm). Observe that the government
announces at t=0 that it will print money at a lower rate per period from then on. Observe
also that the government does not change the level of the money supply at t=0, i.e. there is
no jump in the path of the money supply.
From Graph 1 and 1) we obtain Graph 2.
From Graph 2 and 2) and 3) we obtain Graph 3.
From Graph 3 and 4) and 5) we obtain Graph 4.
From Graphs 1 and 4 we obtain Graph 5.
Why does the path for the equilibrium real money balances jumps up at t=0? There is no
jump in the level of the nominal money supply. The real money supply jumps up because
the price level drops on impact (at t=0) in anticipation of lower future inflation and
nominal interest rates. Observe that even though the government has not changes the level
of money yet at t=0, prices fall because of the credible announcement that future inflation
will be lower.

Question 2-Fighting Business Cycles-The Policy Lessons of the Standard

IS-LM Model (30 Points)
What are the lessons of the IS-LM model? How should the country apply fiscal and
monetary policies to try to dampen economic fluctuations? What policy mix must be
implemented to help an economy recover from a recession? What policy mix must be
implemented in an “over-heated” economy that is at (or above) full employment?

Answer:
Scenario 1: If the economy is initially with high unemployment (due to price rigidity), the
government faces the following options.
1) Do nothing: it will take time for the economy to recover and reach the full employment
level again. The price level will have to fall (slowly because prices are sticky). As prices
fall the LM curve shifts downwards until the economy is at full employment. Prices fall
because the pool of unemployed workers will offer their labor services for lower wages,
thus enabling firms to reduce the prices of goods and services. The adjustment is slow
and painful because it requires deflation and a fall in wages. The government can do better
by implementing the appropriate fiscal and monetary policies.
LM

IS

YFE
Mario Catalan SAIS
Macroeconomic Theory Johns Hopkins University
2) Implement expansionary monetary and/or fiscal policies to increase the short-run output
level and prevent the deflation. These policies will increase the level of output and
employment immediately, moving the economy closer to full employment faster than the
alternative deflationary process, see graphs in Lecture notes.

Scenario 2: If the economy is initially over-heated, i.e. above full employment, the government
faces the following options.
1) Do nothing: there will be an upward (inflationary) pressure on prices. Thus, the
excessively high rate of expansion will eventually lead to inflation, which is
undesirable from the policymakers’ standpoint.
2) The government could combine restrictive monetary and fiscal policies to cool off the
economy until the unemployment rate converges to its natural (full employment)
level.

Question 3-Mankiw-Chapter 10-Questions 1 and 2 (10 Points)

1) (4 Points) Use the Keynesian cross to predict the impact of:
A- An increase in government purchases;
Answer: an increase in government purchases shifts the expenditure curve
upwards and causes an increase in the short-run output level for a given
level of interest rates (draw the graph with the Keynesian cross).
B- An increase in taxes;
Answer: an increase in taxes shifts the expenditure curve downwards and
decreases the short-run output for a given level of interest rates.
C- An equal increase in government purchases and taxes.
Answer: the government purchases multiplier in the Keynesian cross is
given by 1
1− b
The tax multiplier in the Keynesian cross is given by −b
1− b
They measure the response of the output level to unitary changes in
output and taxes, when the interest rates are kept constant. Suppose that
b=0.5, then the G-multiplier is 2 and the T-multiplier is –1. This means
that if G increases one unit, while T and R are constant, output increases 2
units (a multiple of the initial change in G). Similarly, if T increases one
unit, while G and R are constant, output falls one unit. Thus, an equal
increase in G and T cause an increase in the output level if R remains
unchanged. The balanced budget multiplier is 1 b
− =1
1− b 1− b
Therefore, if G and T both increase one unit, while R remains constant,
the output level increases one unit as well!!!
2) (6 Points) In the Keynesian cross, assume that the consumption function is given
by C=200+0.75(Y-T). Planned investment is 100; government purchases and taxes
are both 100.
A- Graph planned expenditure as a function of income;
Answer: E=C+I+G=200+0.75(Y-100)+100+100=325+0.75Y
Mario Catalan SAIS
Macroeconomic Theory Johns Hopkins University

45 Degree

E=325+0.75Y

YSR* Y

B- What is the equilibrium level of income?

Answer: observe that the slope of the expenditure curve is 0.75 (less than
one). It follows that the 45 degree line and the expenditure curve intersect
at some point. That point determines the short-run level of output in the
Keynesian cross (under the assumption that R is constant).
Mathematically, YSR* satisfies YSR*=325+0.75 YSR*. Solve for YSR* to
obtain YSR*=1,300.
C- If the government purchases increase to 125, what is the new equilibrium
income?
Answer: the new expenditure function is 350+0.75 Y. The new short run
output level is YSR*=1,400. Observe that an increase of G equal to 25 units
causes an increase in output that is equal to 100 units. This is the
Keynesian multiplier at work. The reason why the initial increase in
government purchases is multiplied is the following. An increase in G has
a first and initial effect on output. The increased output means a higher
level of disposable income for households. More disposable income
translates into increased consumption, which in turn increases output
even further. The multiplication is possible because output is demand
determined, and the demand is increasing in the output level.
D- What level of government purchases is needed to achieve an income of
1,600?
Answer: Solve for G in the following equation YSR*=1,600=200+0.75(1,600-
100)+100+G to obtain G=175.

Question 4-Multiple Choice. Select one option and explain using graphs
(20 Points)
1-A government implements an expansionary fiscal policy when taxes are increased
and/or government purchases are reduced. In the IS-LM model, an expansionary fiscal
policy shifts the LM curve upwards.
2-A government implements an expansionary fiscal policy when taxes are reduced and/or
government purchases are reduced. In the IS-LM model, an expansionary fiscal policy
shifts the IS curve upwards.
3-A government implements an expansionary fiscal policy when taxes are reduced and/or
government purchases are increased. In the IS-LM model, an expansionary fiscal policy
shifts the IS curve upwards.
Mario Catalan SAIS
Macroeconomic Theory Johns Hopkins University
4-A government implements an expansionary fiscal policy when taxes are reduced and/or
government purchases are increased. In the IS-LM model, an expansionary fiscal policy
shifts the LM curve downwards.
5-A government implements an expansionary fiscal policy when taxes are increased
and/or government purchases are increased. In the IS-LM model, an expansionary fiscal
policy shifts the IS curve downwards.
Answer: Expansionary fiscal policies are associated with increases in government
purchases and tax cuts. Moreover, only the IS curve is sensitive to changes in fiscal
policy. An expansionary fiscal policy shifts the IS curve upwards, increases the short-
run equilibrium output level and the interest rate. EXPLAIN IT GRAPHICALLY
AS WELL. Correct choice is 3.

Homework #3 - Fall 2001-Part 2

Question 5-Keynesian Cross (10 Points)

Consider the Keynesian cross depicted in the graph. Suppose that the initial "planned
expenditure" curve is E0. Suppose that government purchases increase, shifting the
"planned expenditure" curve to E1.
Using the information provided in the graph, compute:
A) The change in government purchases (G1-G0), (3 Points)
Answer: 10
B) The government-purchases multiplier in the keynesian cross, (4 Points)
Answer: 2= 20/10
C) The marginal propensity to consume (3 Points)
Answer: The government purchases multiplier in the Keynesian cross is equal to
1 where b is the marginal propensity to consume. Solve for b to obtain
2 =
1− b
b=0.5. Thus, for each extra dollar of disposable income, households consume $0.5
and save the rest.

Expenditure E 45 degree line

E1

E0
40

30

Income, Output Y

40 60
Mario Catalan SAIS
Macroeconomic Theory Johns Hopkins University
Question 6-IS-LM Model (10 Points)
Consider the following graph that shows the short-run equilibrium of an economy in the
IS-LM model. At the initial equilibrium, output is 100 and the interest rate is equal to
0.05. Suppose that the level of government purchases increases 15 units, shifting the IS
curve upwards to IS'. At the new equilibrium, output is 115. Additional information is
provided in the graph to help you to answer the questions. The consumption, investment
and real money demand functions are the following:

C = a + b(Y − T )
I =c−R
L( R, Y ) = Y − fR
These are the standard linear functional forms of the IS-LM model where d=1 and e=1.
Compute:
A) The marginal propensity to consume, i.e. compute the value of the parameter (b); (5
Points)
B) The sensitivity of real money demand to changes in the interest rate, i.e. compute the
value of the parameter (f) (5 Points).

R IS'
IS LM

0.05

Y
100 115 120

Answer: A) First, from the graph we see that the IS curve shifts rightwards 20 units
when the interest rate is kept constant at 0.05. Thus, the G-multiplier in the
Keynesian cross (the cross is not shown) is equal to the change in Y divided by the
change in G, i.e. 20/15=1.333. Second, we know that the G-multiplier in the
Keynesian cross is equal to 1 where b is the marginal propensity to
1 . 33 =
1− b
consume. Solve for b to obtain b=0.25.
C) First, from the graph we can compute the G-multiplier in the IS-LM model.
Equilibrium output increases 15 units when G increases 15 units. Thus, the
multiplier is 1. Second, we know the following:
The G –multiplier in the IS-LM model is
z f
1= ; z =
1− b de
f +
1− b
Plug d=1, e=1, b=0.25 into z and then solve for f to obtain the result.