PROBLEM SET 1 (Solutions)

(MACROECONOMICS cl. 15)

Exercise 1 – Calculating GDP

In an economic system there are two sectors, A and B. The sector A:

- produces value added for a value of 50;
- pays wages for a value of 30;
- sells intermediate goods to sector B for a value of 15.
In the same year, sector B:
- purchases intermediate goods from sector A for 15 and from abroad for a value of 10:
- pays wages for a value of 20;
- sells final goods for a value of 40, of which 10 goes abroad;
- sells investment goods for a value of 10, of which 5 goes abroad.
Compute the GDP of this economic system, by describing and explaining the possible definitions that can be
employed.

With the information we have, we can compute GDP by using the following definitions:
1. As the sum of each sector’s value added:
V.A. A = 50; V.A. B = (40 + 10) – (15 + 10) = 25
GDP = 50 + 25 = 75
2. As the sum of incomes distributed inside the economic system:
Profits A = revenues – intermediate goods’ purchases – wages – taxes
=values added - wages
= 50 – 30 = 20;
Profits B = (40 + 10) – (15 + 10) – 20 = 5
Wages A = 30 ;
Wages B = 20;
Taxes = 0
GDP = 20 + 5 + 30 + 20 + 0 = 75

Exercise 2 – The paradox of saving

Consider the following model:

Y =C +G+ I
C = c 0 + c1Yd
T = 50 , G = 150 , I = 100
with c0=10 and c1=0.5.
a) Compute equilibrium income, consumption and savings.
b) Suppose the government asks consumers to save more. The consumers abide and reduce c0 by 5. What
happens to equilibrium income, consumption and saving? Explain the intuition.

a) The equilibrium short term production is derived by solving:

⎧Z = C + I + G
⎨
⎩Y = Z .
Following the same steps as in previous exercise
Y = 10 + 0,5(Y – 50) + 150 + 100
Y = 10 + 0,5Y -25 +250
0,5 Y = 235
Y = 470
C = 10 + 0,5 (470 – 50) = 220
S = Y – T – C = 470 – 50 – 220 = 200
OR
Y=
1
1 − c1
(c0 + I + G − c1 T ) Y=
1
[10 + 100 + 150 − (0.5 × 50)] = 2 × 235 = 470
⇒ 1 − 0.5 ,
and by substitution
C = 10 + 0,5 × (470 − 50 ) = 220 ,
S = Y − T − C = 470 − 50 − 220 = 200 .

b) The government request entails a reduction in autonomous expenditure equal to the variation in
autonomous consumption:
∆A = ∆c0 = −5 . Therefore the new values of Y, C, and S are:
1
Y'= [5 + 100 + 150 − (0.5 × 50)] = 2 × 230 = 460
1 − 0.5 ,
C ' = 5 + 0.5 × (460 − 50 ) = 210 ,
S ' = 460 − 50 − 210 = 200 .
Savings remain constant since from the relation
S = Y −T −C
we know that ↓ C ⇒↑ S .
Nevertheless we also know that
↓ C ⇒↓ Z ⇒↓ Y ⇒↓Y d ⇒↓ S .

Therefore, at first sight the net effect is ambiguous. However, knowing that the relation S = I + (G − T )
holds and since I, G and T, are unchanged, the two effects must cancel out (savings paradox).
N.B. Since production is a linear function of autonomous expenditure, its variation could also have been
calculated using partial derivatives:
∆Y 1 1
= ∆Y = ∆A = 2 × (−5) = −10
∆A 1 − 0.5 ⇒ 1 − 0.5 ⇒ Y ' = Y + ∆Y = 470 − 10 = 460 .

Exercise 3 - The money market

In country A the quantity of money (M) in the year 2000 was equal to 450 billion euro. In the same year the
ratio of money held in currency (c) and the ratio of reserves/deposits (θ) took on the following values: c =
0.2 and θ =0.4.
a) Compute the supply of central bank money in 2000.
b) What is the money multiplier?
c) Suppose the central bank can perfectly control the value of the ratio reserves/deposits (θ). If in 2001 the
central bank wanted to increase the money supply to 675 billion euro, by how much must θ vary if H and
c remain constant at their 2000 levels?

a) The relation between central bank money and the overall money supply is:
H = M [c + θ (1 − c)]
Substituting the values we have:
H = 450 × [0.2 + 0.4 × (1 − 0.2)]
H = 450 × 0.52
H = 234

b) The money multiplier is

1 1 1
= = ≈ 1.923
[c + θ (1 − c)] [0.2 + 0.4 × (1 − 0.2)] 0.52
c) To determine the variation in the reserve/deposit ratio (θ) coherent with the objectives of the central
bank, we use the equation that relates central bank money and the overall money supply:
1
675 = × 234
[0.2 + θ ′(1 − 0.2)]
675 × [0.2 + 0.8θ ′] = 234
135 + 540θ ′ = 234
234 − 135
θ′ = = 0.183 ≈ 0.18
540
Hence, the needed variation is
∆θ = θ ′ − θ ≈ 0.18 − 0.4 = −0.22

Exercise 4 – Fiscal Policy

Consider the following numerical version of IS-LM model:

C = 400 + 0.5Yd
I = 700 – 4,000i + 0.1Y
G = 200
T = 200
Md/P = 0.5Y – 7,500i
Ms/P = 500

a) Calculate the equilibrium level of income and interest rate.

b) Suppose the government increases public spending to 300 (∆G =100). Compute the new
equilibrium values of income and interest rate.
c) Suppose the government decreases taxes to 100 (∆T = -100). Compute the new equilibrium
values of income and interest rate.
d) Compare the results you have found in (b) and (c). Provide an economic explanation for the
variation. If the government wants to finance the change in G by increasing T same amount
(∆T = 100), what happens to the economy?

a) It is necessary to have the equilibrium in both goods market and the money market.
Equilibrium condition for goods market is Y = C + I + G (IS)
Md Ms
Equilibrium condition for money market is =
P P
Goods market:
Y = 400 + 0,5Yd + 700 – 4000i + 0,1Y + 200
Y = 400 + 0,5(Y – 200) + 700 – 4000i + 0,1Y + 200
Y = 400 + 0,5Y – 100 + 700 – 4000i + 0,1Y +200
0,4Y = 1200 – 4000i
Y = 3000 – 10000i →IS
Money market:
0,5Y – 7500i = 500 → LM
We insert the IS equation we found above (Y = 3000 – 10000i) into the LM equation and
solve for i.
0,5(3000-10000i)- 7500i =500
1500 – 5000i – 7500i = 500
1000 = 12500i
i = 0,08 = 8%
Then we insert the equilibrium interest rate to the IS equation to be able to find the
equilibrium Y
 Y = 3000 – 10000(0,08)
Y = 2200

b)
f2
∆Y = ∆A (fiscal policy multiplier for Y)
f 2 (1 − c1 − d1 ) + d 2 f1
−
where A ≡ c0 + I + G − c1T is autonomous expenditure.
∆G = 100
7,500
∆Y = * 100 = 1.5 *100 = 150
7,500 × (1 − 0.5 − 0.1) + 4000 × 0.5
Y ′ = Y + ∆Y = 2200 + 150 = 2350

f1 f f2 f1
∆i = ∆Y = 1 ∆A = ∆A (fiscal policy multiplier for i)
f2 f 2 f 2 (1 − c1 − d 1 ) + d 2 f1 f 2 (1 − c1 − d1 ) + d 2 f1
0.5 0.5 1
∆i = × 100 = × 100 = × 100 = 0,01
7500 × (1 − 0,5 − 0,1) + 4000 × 0.5 5000 10000
∆i = 0,01 i’= i0 + ∆i = 0,08 + 0,01 = 0,09 = 9%.

OR

You can use the same methodology we used in point (a) and solve the equations again by inserting G=300
instead of G=200

An increase in G is an expansionary fiscal policy and it causes IS curve to shift right. As a result
equilibrium values for both Y and i increase.

c) ∆T = -100 -c1∆T = -(0,5)(-100 )=50

7,500
∆Y = * 50 = 1.5 * 50 = 75
7,500 × (1 − 0.5 − 0.1) + 4000 × 0.5
Y ′ = Y + ∆Y = 2200 + 75 = 2275
0.5 0.5 1
∆i = × 50 = × 50 = × 50 = 0,005
7500 × (1 − 0,5 − 0,1) + 4000 × 0.5 5000 10000
∆i = 0,005 i’= i0 + ∆i = 0,08 + 0,005 = 0,085 = 8,5%.

OR

You can use the same methodology we used in point (a) and solve the equations again by inserting T=100
instead of G=200

A decrease in T is again an expansionary fiscal policy and it cause IS curve to shift right. As a result
equilibrium values for both Y and i increase.

d) Both in point (b) and in point (c) we have an expansionary fiscal policy. In point (b) it is through
increasing public spending and in point (c) it is through a reduction in taxes. It can be observed that
although the amount of increase in G and decrease in T are same in absolute terms their impact on
equilibrium Y and i are different. An increase in public spending has higher impact on equilibrium
values than a reduction in taxes. This is due the fact that G enters the equation directly as an
autonomous expenditure while changes in taxes affect the equilibrium levels through the influence on
disposable income.
If the government wants to finance the change in G by increasing T same amount (∆T = 100),
increasing T by the same amount would not help to return to the initial equilibrium because of
the reason discussed above. Changes in T affect the equilibrium income through its impact on
disposable income, while changes in G have a direct impact. So if the government wants to
finance the change in G it should increase T more than the increase in G. In our example
c1=0,5 so the increase in T should be equal to:
∆G=c1∆T
100 = 0,5 ∆T
∆T = 200