Universitat Pompeu Fabra

Introduction to Macroeconomics 2020-21

Problem set 3

Question 1. Read the article of The Economist “Governments can borrow more than was once believed”,
published on September 10th, 2020 and uploaded in aula global.
a) In discussing Keynes’ ideas, the first part of the article states “Recessions come about when the
economy is hit by a sudden rise in the desire to save…such desires lead to lower spending, which leads
to more unemployment, which leads to yet less spending, and so on”. How can you represent a sudden
increase in the desire for savings in the model of consumption used in class? Use the IS-LM model to
derive the macroeconomic effects of such an increase in savings. Show also how an increase in public
spending could be helpful in such a case.
In the model of consumption used in class (C = c0 + c1(Y-T)) a sudden increase in the desire for savings
would correspond to a sudden drop in c1 i.e. the marginal propensity to consume. In the IS-LM model the
drop in c1 corresponds to a steepening of the IS curve, resulting in a reduction in output (Y). In such a
situation an increase in government spending (G) can shift the IS curve out, bringing us closer to the
original equilibrium.

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b) The article points that, in the 70s, there was a shift in the perception of public spending and its effects.
In particular, Robert Barro argued that “a fiscal stimulus paid for by borrowing would see households
spend less and save more, because they would know that tax rises were coming”. How do the effects of
a fiscal stimulus change if they bring about an increase in household savings? Use the IS-LM model to
illustrate your answer.
An increase in household savings will dampen, or potentially completely eliminate, the effect of the fiscal
stimulus. The fiscal stimulus shifts the IS curve to the right but the increase in household savings steepens
the IS curve leading to a smaller increase in output than otherwise.

c) According to the article, what has changed in recent years to raise the appeal of fiscal stimuli as
macroeconomic policy tools?
In recent years, despite of high borrowing levels, interest rates have remained substantially low. Some
countries are even experiencing negative interest rates, which means that the amount to repay will be
actually lower than the amount borrowed. As a consequence, the notion of borrowing for financing
fiscal stimulus started to be attractive, particularly when GDP grows at a faster rate than the interest
rate.

d) What, according to the article, are two key points that should be taken into account by governments
seeking to raise spending?

Government borrowing is badly needed to deal with many of the world’s current woes. But this
consensus should ideally include two additional planks: that the quality of deficit-spending still matters,
and that governments should prepare for the possibility of an eventual change in the global interest-rate
environment—much as 2020 has shown that you should prepare for any low-probability disaster.

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1. The government should take care that public investment does not “crowd out” private investment. Such
“crowding out” happens when government borrowing increases the demand for loanable funds by so
much that the interest rate (price of borrowing) increases significantly, which leads to a reduction in
private sector borrowing for investment. The article concludes that this does not seem to be a serious
concern at the moment. Although returns to private investment are still higher than returns to public
investment, this fact is more likely to reflect either obstacles to private investment, or monopoly power
of private firms, rather than private firms’ investment being better for society than the governments’
investment. Thus governments should currently be investing more.
2. Rather than continuously borrowing to stimulate a weak economy (increasing G), governments should
perhaps be considering what they could do to fix the fundamental reasons behind insufficient demand by
households and firms (i.e. persistently low I and C). The problem is that economists do not know why
private demand has been so weak for so long. The article lists some potential reasons: (1) it could that
technological progress is not contributing to GDP and thus to income (but rather to free services like
social media); (2) widening income inequality means economic growth mostly benefits the rich who do
not consume as much as the poor; (3) households and firms are saving rather than consuming/investing
since they are afraid of the next financial crash; (4) the population is getting older on average, and older
people spend less than younger ones. Only some of these problems can be addressed by government
action – for example, there are no humane solutions for making the population younger.

Question 2. Use an IS-LM diagram to show the effects on output of an increase in government spending.
Can you tell what happens to investment? Why? Consider the two cases: a) upward slopping LM function;
b) flat LM function.
* Compare the two cases, a) and b), explain why the LM curves are different, and what differences you
see in the impact of an increase in G on the economy.
IS: Y = C + G + I + X – IM
Increase in G will shift the IS curve to the right (for every level of interest rate we have higher output).
As you can see in the figure.
In the new equilibrium we have higher output and higher interest rate. Investment has a positive relation
with output and a negative relation with interest rate I(Y,i). Because both have increased by an increase
in G we have 2 opposing effects on Investment and the outcome is ambiguous.

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Now let us consider a flat LM curve, we have
IS: Y = C + G + I + X – IM
LM: i = î (Red line)

An increase in G will shift the IS curve to the right. In this case the interest rate is chosen fixed by the
central bank, so we do not see any change in the interest rate as a result of the fiscal expansion. In the
new equilibrium we have higher output. Investment has a positive relation with output I(Y,i). So we will
see an increase in investment due to the fiscal expansion, as output increases and interest rate does not
change.
To keep the interest rate constant the Central Bank will increase Money Supply, to meet the new money
demand that will have increased as a result of the increase in output.
Please note: compared to the upward sloping LM the increase in output is higher as it is shown in the
graph by the green upward LM. This is because the interest rate does not increase, so the negative impact
on investment is not present anymore.

Question 3. Consider the following model:

C=c0+ c1*(Y-T)
I=b0+b1*Y-b2*i

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 Z=C+I+G
i = î where î is a constant value.
a. Solve for (Find Y = ) equilibrium output when the interest rate is î. Assume c1+b1<1

Y = C + I + G (Assuming we are in the closed economy)

Y = c0+ c1*(Y-T) + b0+b1*Y-b2* î + G
Y (1 - c1 – b1) = c0 - c1*T + b0 – b2* î + G
Y = 1/(1 - c1 – b1 ) * (c0 - c1*T + b0 – b2* î + G)

b. Solve for (Find I= ) the equilibrium level of investment.

i= î
I=b0+b1*Y-b2* î = b0 -b2* î + b1/(1 - c1 – b1 ) * (c0 - c1*T + b0 – b2* î + G)

c. Let’s analyze the investment function obtained in b. Explain how an increase in the sensitiveness of
investment to changes in the interest rate (an increase in the behavioral parameter b2) affects the
investment function. How does that change affect the IS function, will it be steeper or flatter?

The higher is b2, the larger will be the reaction of investment to changes in the interest rate. An increase
in the interest rate will be followed by a large reduction in investment, while a decrease in the interest
rate will be followed by a larger increase in investment. The IS curve in this case is flatter. Monetary
policy will have more impact on the equilibrium output of the economy the larger is b2.
These can be seen in the graph below, with a b2 larger on the left than on the right.

d. Let’s go behind the scenes in the money market. Use the equilibrium in the money market:

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M/P=d1*Y-d2*i to solve for the equilibrium level of the real money supply when i = î . How does the real
money supply vary with a decrease in taxes? Explain your result. Show your results with a graph in both
the money market and the IS-LM framework.

i= î
M/P = d1*[1/(1 - c1 – b1 ) * (c0 - c1*T + b0 – b2* î + G)] – d2* î
d(M/P)/dT =[ d1 / /(1 - c1 – b1 )](-c1) which is negative if d1>0. If the tax change is negative, the impact
on real money supply is positive.
When taxes decrease, there is a shift of the IS to the right, with a new equilibrium of output larger than
before. This new output will trigger a higher demand for nominal money, and given the price level fixed,
a higher demand of real money. To keep the interest rate constant at î, the Central Bank will have to
increase the real money supply.

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Question 4. Consider an economy represented by the following IS-LM model
C=150+0. 5(Y-T)
I= 250+0.25Y -500i
G=400
T=100
î = 0.15
a. Derive the IS equation. Obtain an expression of Y as a function of all other variables. Represent the
equation in a graph. Add in the graph the LM equation. Label the axis correctly.

Y = C + I + G = 150+0. 5(Y-100) + 250+0.25Y -500i + 400

Y = ( 1/( 1 – 0.25 – 0. 5) ) (750-500i)= 4 (750-500 i)

IS: Y = 4 (750-500 i)
LM: i=0.15

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b. What is the level of real money supply when the interest rate is 15%? To answer this question,
consider that the demand for real money balances is equal to 2Y-8000i, and that the economy is in
equilibrium in the money market as well as in the goods market.

M/P* = 2 Y* – 8000 i* = 2*2700 – 8000*0,15 = 4200

c. Solve for the equilibrium values of C, I and Y, and show them in the graph.

Y*=4 (750- 500 x 0.15)= 2700

i* = 0.15
C*= 150+0. 5(Y*-T)= 150 + 0.5 (2700 – 100) = 1450
I* = 250+0.25Y* -500i* = 250 + 0.25(2700) – 500*0.15 = 850

C* + I* + G = 1450 + 850 + 400 = 2700 = Y*

d. Now suppose that the central bank increases the interest rate to 25%. How does this change the LM
curve? Solve for Y, I and C, and describe in words the effects of this policy. What is the new
equilibrium for the real money supply M/P? Use a graph to go along with your explanation.

Y* = 4 (750-500 i*) = 4 ( 750 – 500*0,25 ) = 2500

C*= 150+0. 5(Y*-T)= 150 + 0.5 (2500 – 100) = 1350
I* = 250+0.25Y* -500i* = 300 + 0.25(2500) – 500*0,25 = 750

As we can see the effect of a contractionary monetary policy is a reduction in the output, consumption
and investment.
To reach the new interest rate, the Central Bank has decreased the money supply, selling bonds through
OMO. The real money supply is:
M/P* = 2 Y* – 8000 i* = 2*2500 – 8000*0,25 = 3000

e. With this new monetary policy î = 0.25, design a fiscal policy that by changing G would take the
economy back to the original equilibrium output obtained in question c above. Will the values for C
and I be the same now as in question c?

Y* = 4 (350-500 i* + Gnew )= 2700

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4 (350-500*0.25 + Gnew )= 2700

Gnew = 450. The government needs to follow an expansionary fiscal policy, increasing G by 50 to
recover the initial level of Y.

C*new = 150+0. 5(Y*-T)= 150 + 0.5 (2700 – 100) = 1450. Same as in part c. as it is not function of i

I*new = 250+0.25Y* -500i* = 250 + 0.25(2700) – 500*0.25 = 800

I* is Smaller than in part c. as the increase in interest rate reduces Investment for the same output. Note
that the decrease in I is equal to the increase in G.

f. Now return to the initial situation with the policy interest rate at 15%. Suppose that government
spending increases to 600 and taxes adjust so that the government has a balanced budget. How does
this change the IS curve? Solve for Y, I and C, and describe in words the effects of this policy.

G = T = 600. i*= î = 0.15

Y = C + I + G = 150+0. 5(Y-600) + 250+0.25Y -500i + 600

IS: Y=4 ( 700 – 500i )

LM: i=0.15

Y*= 2500
i*=0.15
Autonomous spending decreases by 50 units (from 750 to 700), a result of an increase of 200 in G and
an increase in taxes of 500 that multiplied by the marginal propensity to consume, 0. 5 decreases
autonomous spending by 250.

There is therefore a decrease in output of 200 units. (from 2700 to 2500)

C* = 150+0. 5(Y*-T) = 150+0. 5(2500 - 600)=1100

I* = 250+0.25Y* -500i* = 250 + 0.25 ( 2500 ) - 500*0.15 = 800
G = 600

C* + I* + G = 2500

There is a reduction in both C* and I*. The decrease in Y* and the increase in T reduces C*.
Investment is reduced due to the reduction in Y*.