Professional Documents
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GIUSEPPE FERRAGUTO is Associate Professor of Economics at Bocconi Universi- Problems and questions
ty, and director of the course on Macroeconomics offered at the same institution.
6th EDITION
MyBook http://mybook.egeaonline.it
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MACROECONOMICS
Problems and questions
6th EDITION
ISBN 978-88-7534-196-1
Introduction VII
V
Introduction
This exercises and solutions manual includes the exam questions for recent edi-
tions (from the Spring semester 2010 onwards) of the course ‘Introduction to
Economics − Macroeconomics’ offered at Bocconi University. In addition to
those questions, it also presents an updated, and sometimes drastically revised,
version of some of the exercises and problems discussed during the tutorials
for the same course in recent, and not so recent, years.
VII
Macroeconomics. Problems and Questions
The questions and problems in the following pages aim not only at familiariz-
ing readers with the subject matter of Macroeconomics, but also at deterring
students from a mechanical approach to the discipline and to the test. Their
main objective is to help readers grasp the economic reasoning and intuition
underlying the results derived in class – the aspect of Macroeconomics, and
more in general of Economics, that at first students find the most difficult to
master, but that will turn out to be the most useful and rewarding in their fu-
ture, academic and extra-academic, careers.
The manual is divided into two parts. In the first one, readers are encouraged
to work out on their own problems having exactly the same format as those
included in the final exam (a great training for the test!); the second part pro-
vides students with solutions and answers, thus giving them a sense of what
they ought to know.
This sixth edition also includes some questions − those marked with an aster-
isk − that are more difficult than those typically included in a final examina-
tion. While students are encouraged to arrive on their own to an answer, even
just a partial one, to those questions, they are also invited to read very careful-
ly the solutions to these more difficult, or longer, problems which are con-
tained in the second part of the book. The concepts discussed there, often not
covered by the textbook, are in fact needed to answer some of the other ques-
tions presented in this manual, as well as possible exam questions for the
course.
Although this book is being published to my name, the list of people entitled
to be regarded as its co-authors is very long; at the very least, it should include
the many colleagues responsible for each of the twenty or so classes of Bocconi
undergraduates to which the course on Macroeconomics has been taught in
recent years. I am especially grateful to Angelo Porta and Donato Mascianda-
ro, my immediate predecessors in the role of course director, who have con-
tributed in important ways to the process that has led to the current structure
and contents of the final examinations, and therefore of this manual; to Elisa
Borghi, Maria Giovanna Bosco, Michela Braga, Daniela Grieco, Antonella
Mori and Francesco Scervini, the instructors that, during my tenure as direc-
tor of the course, have acted as referees of the exam questions I have been
writing, before they were submitted to our students; and, last but not least, to
Patrice De Micco, Elisa Facchetti, Marcella Nicolini and, once again, to Maria
Giovanna Bosco, Marco Mantovani, Antonella Mori and Francesco Scervini,
who have read preliminary drafts of the manuscript and helped me improve it
VIII
Introduction
greatly. Needless to say, all the remaining weaknesses and errors are my own
responsibility.
The list of debts I have incurred would not be complete without an explicit
mention of the many students who, after sitting the exam, found the time to
give (in writing, during my office hours, or in other ways) their feedback –
sometimes positive, sometimes negative – on the questions it included. Their
suggestions have always been taken seriously, although not always followed; in
any case, all of them have helped make our course better. Finally, a special
thanks goes to Laura Vaini for what she has done in the recent past, and to
Alessandra Startari for what she is currently doing, for the students and the
instructors of the course on Macroeconomics.
Giuseppe Ferraguto
http://mybook.egeaonline.it.
IX
Part I
Problems and Questions
Chapter 1 - The goods and financial markets
Macroeconomics. Problems and Questions
Question 1
In the economy there are only two firms, firm A and firm B. Their operations
in a given year can be summarized as follows (all figures are in thousands of
Euros):
Firm A
Costs Revenues
Wages Sales to B
170 300
Indirect taxes
30
Firm B
Costs Revenues
Wages Sales to A
230 50
Compute the economy’s Gross Domestic Product (GDP) using all the defini-
tions of this variable that it is possible to employ in this case.
4
The goods and financial markets
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5
Macroeconomics. Problems and Questions
Question 2
a. What is meant by ‘GDP deflator’? How is the GDP deflator computed, and
how is it used?
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6
The goods and financial markets
b. Compared to the previous year (𝑡𝑡 − 1), in year 𝑡𝑡 the economy’s GDP
deflator has gone down by 1% and the real GDP growth rate has been
equal to −2%.
b.1 Compute the growth rate of nominal GDP for this economy in year 𝑡𝑡.
b.2 What is the rate at which the economy under consideration has been
growing in year 𝑡𝑡 ?
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7
Macroeconomics. Problems and Questions
Question 3
The economy of a country in which only the goods market exists is described
by the following system of equations,
𝐶𝐶 = 𝑐𝑐0
𝐼𝐼 = 𝐼𝐼 ̅
𝐺𝐺 = 𝐺𝐺̅
𝑇𝑇 = 𝑇𝑇� + 𝑡𝑡𝑡𝑡
where, as always, the positive constant 𝑐𝑐0 is autonomous consumption, 𝑡𝑡 (a
constant between zero and one) is the tax rate, 𝑇𝑇� (> 0) is the portion of net
taxes that does not depend on income, and the other symbols have the usual
meaning.
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8
The goods and financial markets
b. Suppose that the government cuts 𝑇𝑇� (that, as you will remember, is the
fraction of net taxes independent of income), so that ∆𝑇𝑇� < 0. Show in the
graph the effects of this change and, using the results derived when an-
swering the previous point of this question, derive the analytical expres-
sions of the changes in equilibrium production, private saving, govern-
ment saving and national saving caused by this decrease in 𝑇𝑇�.
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9
Macroeconomics. Problems and Questions
Question 4
The economy of a country in which only the goods market exists is described
by the following system of equations:
𝐶𝐶 = 𝑐𝑐0
𝐼𝐼 = 𝐼𝐼 ̅ + 𝑑𝑑1 𝑌𝑌
𝐺𝐺 = 𝐺𝐺̅ − 𝑔𝑔1 𝑌𝑌
𝑇𝑇 = 𝑇𝑇� + 𝑡𝑡𝑡𝑡
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10
The goods and financial markets
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b. Suppose that the government raises, at the same time and by the same
amount, both 𝐺𝐺̅ and 𝑇𝑇�, so that ∆𝐺𝐺̅ = ∆𝑇𝑇� > 0. Show in the graph the ef-
fects of these changes and, using the results derived when answering
the previous point of this question, derive the analytical expressions of
the changes in equilibrium production, private saving, government sav-
ing and national saving caused by the increases in 𝐺𝐺̅ and in 𝑇𝑇�. In your
answer, make sure to discuss in each case why reaching a definite con-
clusion about the direction in which those variables will change is pos-
sible, or not possible.
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11
Macroeconomics. Problems and Questions
Question 5
a. Derive the expression for the equilibrium level of income and that of
the multiplier for this economy.
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12
The goods and financial markets
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13
Macroeconomics. Problems and Questions
Question 6
The economy of a country in which only the goods market exists is described
by the following system of equations:
𝐶𝐶 = 𝑐𝑐0 + 𝑐𝑐1 (𝑌𝑌 − 𝑇𝑇)
𝐼𝐼 = 𝐼𝐼 ̅
𝐺𝐺 = 𝐺𝐺̅
𝑇𝑇 = 𝑇𝑇�
where the various symbols have the usual meaning.
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14
The goods and financial markets
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15
Macroeconomics. Problems and Questions
Question 7
The economy of a country in which only the goods market exists is described
by the following system of equations,
𝐶𝐶 = 𝑐𝑐0
𝐼𝐼 = 𝐼𝐼 ̅
𝐺𝐺 = 𝐺𝐺̅ − 𝑔𝑔𝑔𝑔
𝑇𝑇 = 𝑇𝑇� + 𝑡𝑡𝑡𝑡
where, as always, the positive constant 𝑐𝑐0 is autonomous consumption, 𝑡𝑡 (a
constant between zero and one) is the tax rate, 𝑔𝑔 (> 0) is the sensitivity to in-
come of government spending on goods and services, and the other symbols
have the usual meaning.
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16
The goods and financial markets
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17
Macroeconomics. Problems and Questions
Question 8
where the parameter 𝑡𝑡 (the tax rate) is positive, but smaller than one, 𝑑𝑑1 (> 0)
is the sensitivity of investment to income, 𝑐𝑐1 + 𝑑𝑑1 < 1, and the other symbols
have the usual meaning.
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18
The goods and financial markets
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19
Macroeconomics. Problems and Questions
Question 9
Country Macro, where only the good market exists and prices are constant, is
described by the following model:
�������
𝐶𝐶 = 𝑐𝑐0 + 𝑐𝑐1 (𝑌𝑌 − 𝑇𝑇) + 𝑎𝑎 𝑊𝑊𝑊𝑊𝑊𝑊
𝑇𝑇 = 𝑇𝑇�
𝐼𝐼 = 𝐼𝐼 ̅ + 𝑑𝑑1 𝑌𝑌
𝐺𝐺 = 𝐺𝐺̅
𝑌𝑌 = 𝐶𝐶 + 𝐼𝐼 + 𝐺𝐺.
In the equations above, 0 < 𝑐𝑐1 < 1, 𝑑𝑑1 > 0, 0 < 𝑐𝑐1 + 𝑑𝑑1 < 1, the parameter
𝑎𝑎 (> 0) is the sensitivity of consumption to the financial and housing wealth
𝑊𝑊𝑊𝑊𝑊𝑊 (assumed to be exogenous, so that 𝑊𝑊𝑊𝑊𝑊𝑊 = 𝑊𝑊𝑊𝑊𝑊𝑊������� ), and the other
symbols have the usual meaning.
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20
The goods and financial markets
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21
Macroeconomics. Problems and Questions
Question 10
where the parameters 𝑐𝑐1 and 𝑡𝑡 are positive but smaller than one. In this coun-
try, autonomous consumption 𝑐𝑐0 is therefore equal to zero, government pur-
chases of goods and services and investment are entirely exogenous, and net
taxes depend on consumption – as they include not just an exogenous compo-
nent (𝑇𝑇�), but also a portion that is increasing in consumption (𝑡𝑡𝑡𝑡).
a. Plugging the expression for net taxes given by the second equation into
the first one, and solving for 𝐶𝐶, derive the expression that the consump-
tion function takes on in this economy. Next, using the definition of (pri-
vate) saving and the consumption function you have just derived, write
down the (private) saving function. In this economy, is private saving still
increasing in income, 𝑌𝑌, as it is in the standard case? Why, or why not?
Explain.
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22
The goods and financial markets
b. Using the results derived when answering the previous point, write
down the expression of the government deficit (𝐷𝐷𝐷𝐷𝐷𝐷) for this economy.
Is the country’s government deficit increasing or decreasing in the level
of income, 𝑌𝑌? Why? Provide the economic intuition for your answer.
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23
Macroeconomics. Problems and Questions
Question 11
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24
The goods and financial markets
b. Consider now a different country, one in which there is only a goods market
described by the same set of equations specified above. Write down the goods
market equilibrium condition as an equality between national (private plus
public) saving and investment, and assume that the country’s government de-
cides to raise net taxes, 𝑇𝑇�. In the new equilibrium, national and private saving
will be larger or smaller than before? [Hint: you are NOT being asked to com-
pute the expressions for the change in private and national saving, but just to
provide the economic intuition that helps determine the direction in which they
will change].
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25
Macroeconomics. Problems and Questions
* Question 12
[Equilibrium in the money market and equilibrium in the market for the
monetary base]
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26
The goods and financial markets
b. Using the diagram below, show how the same changes just considered (de-
crease in 𝐻𝐻; rise in 𝑐𝑐 or 𝜃𝜃) will affect the money market equilibrium. Based
on the results of your analysis, what can you conclude about the relation-
ship between the value of the interest rate for which the market for the
monetary base is in equilibrium, and the value of the interest rate for
which the money market is in equilibrium?
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27
Macroeconomics. Problems and Questions
* Question 13
[Endogenous money supply]
a. Write down the money market equilibrium condition. Assuming that mon-
ey demand, 𝑀𝑀𝑑𝑑 , is increasing in the general price level 𝑃𝑃 and in real income
𝑌𝑌, and decreasing in the interest rate 𝑖𝑖, represent in the graph below a posi-
tion of equilibrium in the money market, denoting by 𝚤𝚤̅ the value that the
interest rate takes on in that equilibrium.
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28
The goods and financial markets
b. Suppose that the central bank aims at keeping the interest rate constant at
the level 𝑖𝑖 = 𝚤𝚤̅ and that, starting from an initial equilibrium like the one you
have just described, there is a rise in 𝑌𝑌, or in 𝑃𝑃. What should the central
bank do, to prevent such a change from leading to an equilibrium interest
rate different from 𝚤𝚤̅? Explain.
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29
Macroeconomics. Problems and Questions
Question 14
True or false?
Explain whether the following statements are true or false. Motivate your answer
in a brief but rigorous way, making explicit reference to the relevant theory.
Lack of proper explanations will result in zero points.
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30
The goods and financial markets
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31
Macroeconomics. Problems and Questions
Question 15
True or False?
Explain whether the following statements are true or false. Motivate your answer
in a brief but rigorous way, by making explicit reference to the relevant theory.
Lack of proper explanations will result in zero points.
a. “An increase in the price of bonds in the bond market makes bonds more
attractive and induces individuals to hold a smaller share of their financial
wealth in the form of money – the demand for money falls”.
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32
The goods and financial markets
b. In country Gamma, the central bank chooses, and wants to keep con-
stant at the chosen level, the interest rate, while in country Delta the
central bank chooses the money supply (and, once again, keeps it con-
stant at the level it has chosen). The figure below depicts the money
market equilibrium in the two countries. As you can see, in this initial
equilibrium position money supply is the same in both, and the same is
true about the money demand curve and the equilibrium interest rate.
Explain if you agree, or do not agree, with the following statement: “If,
in both countries, banks decide to decrease by the same amount the frac-
tion of deposits held as reserves, to keep the interest rate at the chosen
level the central bank of Gamma will have to increase the money supply,
while in Delta – whose central bank wants to prevent the money supply
from changing – the interest rate will fall”. [Hint: in the figure, denote
by 2γ and 2δ the new equilibria, if any, that will be reached by Gam-
ma and Delta, respectively].
𝑖𝑖
1
𝑀𝑀𝑑𝑑
𝑀𝑀 𝑀𝑀, 𝑀𝑀𝑑𝑑
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33
Macroeconomics. Problems and Questions
Question 16
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34
The goods and financial markets
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35
Chapter 2 - The IS-LM model
Macroeconomics. Problems and Questions
* Question 1
[An analytical version of the IS-LM model − (I) The standard case (endogenous
money supply)]
where 𝐼𝐼 ̅ is autonomous investment, the coefficients 𝑑𝑑1 and 𝑑𝑑2 , both positive,
have the interpretation of sensitivity of investment to income and to the inter-
est rate, respectively, and the other symbols have the usual meaning. Further-
more, assume that the sum 𝑐𝑐1 + 𝑑𝑑1 (the “propensity to spend”) is positive but
less than one, and that nominal money demand �𝑀𝑀𝑑𝑑 � depends positively on
the general price level (𝑃𝑃) and on real GDP (𝑌𝑌), and negatively on the interest
rate (𝑖𝑖), as implied by the following functional form:
In the previous equation, that we have met already when answering Question
13 of Chapter 1, the coefficients 𝑓𝑓1 and 𝑓𝑓2, both positive, have the interpreta-
tion of sensitivity of (real) money demand 𝑀𝑀𝑑𝑑 ⁄𝑃𝑃 to income and to the interest
rate, respectively. Finally, suppose that the central bank sets the money supply
so as to make sure that the interest rate always takes on the value 𝑖𝑖 = 𝚤𝚤̅.
a. Derive the analytical expression of the IS curve for this economy, and
draw the IS in the (𝑌𝑌, 𝑖𝑖) plane. What determines the slope of the curve?
And what causes parallel shifts of the IS curve in the plane? Explain, using
the graphs below and providing the economic intuition underlying your
answers.
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38
The IS-LM model
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39
Macroeconomics. Problems and Questions
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40
The IS-LM model
c. Derive the equilibrium values of 𝑌𝑌 and 𝑖𝑖. By how much will equilibri-
um output change if autonomous demand changes by 𝛥𝛥𝛥𝛥? And by how
much, following a change 𝛥𝛥𝚤𝚤̅ in the level of the interest rate chosen by
the central bank?
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41
Macroeconomics. Problems and Questions
* Question 2
[An analytical version of the IS-LM model − (II) Exogenous money supply]
Consider an economy different from the one studied in the previous question
only for the fact that, rather the interest rate, its central bank chooses a value
for the nominal money supply 𝑀𝑀, and then lets the interest rate take on any
value that turns out to be consistent with the macroeconomic equilibrium for
that given 𝑀𝑀.
a. Denoting by 𝑀𝑀 � the value of 𝑀𝑀 chosen by the central bank, derive the ana-
lytical expressions of the IS and LM curves for this economy.
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42
The IS-LM model
b. Draw the portion of the LM curve entirely lying in the first quadrant of the
(𝑌𝑌, 𝑖𝑖) plane (that is, the portion of the curve corresponding to positive val-
ues of both output and the interest rate). 1 What determines its slope?
Which are the causes of parallel shifts of the LM curve in that plane? Ex-
plain, using the following graphs and providing the economic intuition un-
derlying your results.
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1 The assumption that the nominal interest rate cannot take on negative values allows us to disregard
the portion of the LM curve lying in the second quadrant. We shall discuss later on the shape of the
LM curve when the nominal interest rate is zero (that is, when it is at its "zero lower bound") and − as
assumed in the present question − the central bank chooses the nominal money supply.
43
Macroeconomics. Problems and Questions
c. Derive the equilibrium values of 𝑌𝑌 and 𝑖𝑖. By how much will equilibrium
output change if autonomous demand changes by 𝛥𝛥𝛥𝛥? And by how much,
� in the nominal money supply?
following a change 𝛥𝛥𝑀𝑀
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44
The IS-LM model
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45
Macroeconomics. Problems and Questions
Question 3
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1
From now on, by "a standard IS-LM model" we shall mean a model like the one studied in Question
1 of this Chapter, and therefore based on the following assumptions:
• consumption function of disposable income, investment function of 𝑌𝑌 and 𝑖𝑖, nominal mon-
ey demand function of 𝑃𝑃, 𝑌𝑌 and 𝑖𝑖;
• 𝐺𝐺 and 𝑇𝑇 both exogenous;
• the central bank chooses a value 𝑖𝑖 = 𝚤𝚤̅ for the interest rate, and sets nominal money supply
to whatever level is consistent with the attainment of this target value for 𝑖𝑖;
• constant prices, and therefore current and future expected inflation rates equal to zero.
46
The IS-LM model
b. Consider now two different countries, Delta and Epsilon, whose IS curves
are drawn in the graphs below. Suppose that the different slopes of the two
curves only reflect differences in the value that the parameter 𝑑𝑑2 , the sensi-
tivity of investment to the interest rate, takes on in the two countries. All
the remaining parameters take on identical values in Delta and in Epsilon.
Explain what is meant by “monetary policy multiplier”,
𝛥𝛥𝑌𝑌� 𝑑𝑑2
=−
𝛥𝛥𝚤𝚤̅ (1 − 𝑐𝑐1 − 𝑑𝑑1 )
and, making explicit reference to this concept (discussed in the answer to
Question 1 of this Chapter), discuss if the central bank's decision of chang-
ing the interest rate by the same 𝛥𝛥𝚤𝚤̅ in the two countries will change equilib-
rium output more in Delta or in Epsilon.
𝑖𝑖 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑖𝑖 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
𝐼𝐼𝐼𝐼𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷
𝐼𝐼𝐼𝐼𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
𝑌𝑌 𝑌𝑌
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47
Macroeconomics. Problems and Questions
Question 4
48
The IS-LM model
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b. Suppose now that Macro’s central bank intends to bring back equilibrium
income to its initial level, 𝑌𝑌0 . To achieve its goal, should it raise or lower
the interest rate? Show in the graph the new equilibrium that will be
reached following the monetary policy intervention that you are propos-
ing, denoting it by ‘2’. Finally, compare the composition of aggregate de-
mand at ‘2’ with that prevailing in the initial equilibrium ‘0’.
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49
Macroeconomics. Problems and Questions
Question 5
True or false?
Explain whether the following statements are true or false. Motivate your answer
in a brief but rigorous way, making explicit reference to the relevant theory.
Lack of proper explanations will result in zero points.
a. “In an IS-LM model that departs from the standard case only for the fact
that, rather than the interest rate, the central bank chooses the nominal
money supply, keeping it constant at the level 𝑀𝑀 = 𝑀𝑀 � , the higher the sensi-
tivity of investment to the interest rate, the larger the increase in equilibri-
um income caused by an expansionary fiscal policy”.
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50
The IS-LM model
b. “In a standard IS-LM model, in which the central bank chooses the inter-
est rate and keeps it constant at the level deemed appropriate given the
state of the economy (for instance, at 𝑖𝑖 = 𝚤𝚤̅), the higher the sensitivity of in-
vestment to the interest rate, the larger the increase in equilibrium income
caused by an expansionary fiscal policy”.
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51
Macroeconomics. Problems and Questions
Question 6
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52
The IS-LM model
b. Consider now country Delta. The only difference between Gamma and
Delta lies in the policy rule followed by their central banks. While, as
we already know from the first part of this question, Gamma's central
bank chooses a level for the interest rate, Delta's central bank chooses
a level for the nominal supply of money 𝑀𝑀 and, given that level, lets
the interest rate take on any value turns out to be consistent with the
macroeconomic equilibrium. Suppose now that, when the two coun-
tries are in an initial equilibrium with identical values of 𝑌𝑌 and 𝑖𝑖, Delta
experiences the same increase in 𝑐𝑐0 discussed in the previous point of
this question. Compared with what happened in Gamma, will income
change more or less in Delta? Represent graphically, and explain.
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53
Macroeconomics. Problems and Questions
Question 7
a.2 Assuming that all the other behavioral functions (investment, money de-
mand, etc.) are standard, explain if and why, following an expansionary
monetary policy, when ℎ2 > 0 equilibrium income increases more or less
than in the standard case (ℎ2 = 0) [Hint: no formal derivation of the IS
and LM curves is required – just provide the economic intuition underlying
your answer].
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54
The IS-LM model
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55
Macroeconomics. Problems and Questions
Question 8
True or false?
Explain whether the following statements are true or false. Motivate your answer
in a brief but rigorous way, making explicit reference to the relevant theory.
Lack of proper explanations will result in zero points.
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56
The IS-LM model
b. “When the economy is in a liquidity trap, with the nominal interest rate at
its ‘zero lower bound’, an expansionary fiscal policy cannot influence the
equilibrium level of output”.
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57
Macroeconomics. Problems and Questions
Question 9
58
The IS-LM model
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b. Suppose now that the central bank of the country attempts to return
income to the initial level, 𝑌𝑌1 , by implementing a conventional mone-
tary policy − for instance, an open market operation. Show in the
graph the equilibrium that will prevail after the central bank’s inter-
vention. Explain.
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59
Macroeconomics. Problems and Questions
Question 10
True or false?
Explain whether the following statements are true or false. Motivate your answer
in a brief but rigorous way, making explicit reference to the relevant theory.
Lack of proper explanations will result in zero points.
Define the concept of real interest rate (𝑟𝑟), and write the equation that shows
how 𝑟𝑟 and nominal interest rate (𝑖𝑖) are related to one another. Use this equa-
tion to explain if you agree, or do not agree, with the following statements:
a. “If individuals expect positive inflation, then the real interest rate will be
greater than the nominal one.”
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60
The IS-LM model
b. “The zero lower bound for the nominal interest rate implies that the real interest
rate cannot be greater than minus the expected inflation rate, −𝜋𝜋 𝑒𝑒 ”.
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61
Macroeconomics. Problems and Questions
Question 11
62
The IS-LM model
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b. To return equilibrium output to the initial level (that is, the one pre-
vailing at point ′0′), what kind of monetary policy intervention should
the central bank implement? In the graph, denote by ′2′ the equilibri-
um that will be reached following the monetary policy you are suggest-
ing, and compare the composition of aggregate demand at point ′2′
with that prevailing in the initial equilibrium (point ′0′).
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63
Macroeconomics. Problems and Questions
Question 12
Consider a country described by an ‘extended’ IS-LM that differs from the one
described in the previous question only for the fact that consumption takes on
the following functional form:
������� .
𝐶𝐶 = 𝑐𝑐0 + 𝑐𝑐1 (𝑌𝑌 − 𝑇𝑇�) + 𝑎𝑎 𝑊𝑊𝑊𝑊𝑊𝑊
In the equation above, 𝑊𝑊𝑊𝑊𝑊𝑊 is the individuals’ financial and housing wealth,
assumed to be exogenous, and the parameter 𝑎𝑎 is greater than zero.
a. In this economy, will the slope of the IS curve differ from that
prevailing in the standard case, where consumption is a function of
disposable income only (𝑎𝑎 = 0)? If so, will the IS curve be steeper or
flatter than in the standard case? If not, why? Explain. [Hint: you are
not being asked to derive the analytical expression of the IS curve and of
its slope, but just to discuss whether this slope will be different from the
one prevailing in the standard case, and to provide the economic intuition
underlying your answer.]
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64
The IS-LM model
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65
Chapter 3 - The labor market, the IS-LM-PC
model, and inflation
Macroeconomics. Problems and Questions
Question 1
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68
The labor market, the IS-LM-PC model, and inflation
b. Realizing that the law just passed has an impact on employment, but still
determined to provide income support for those who lose their job, the
government implements measures aiming at increasing the degree of com-
petition in the goods market. Assuming that such measures succeed in re-
turning the unemployment rate to the natural level − that is, to the level
prevailing before the increase in unemployment benefits −, show the ef-
fects of this second policy intervention in the same graph used to answer
the previous point of this question.
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69
Macroeconomics. Problems and Questions
Question 2
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70
The labor market, the IS-LM-PC model, and inflation
b. Explain if and why you agree or disagree with the following statement:
“In order to increase the natural level of production 𝑌𝑌𝑛𝑛 , policy-makers can
follow two alternative strategies: (i) they can try to increase the demand for
goods permanently, for example by opting for a permanent increase in ei-
ther the money supply or in government purchases of goods and services,
or (ii) they can decide to implement ‘supply-side’ policies, such as those
leading to an increase in the degree of competition in the goods market.
The difference between the two strategies above is that the first one will
lead not just to an increase in 𝑌𝑌𝑛𝑛 , but also to a permanently higher level of
prices, while the second strategy will push the economy towards an equilib-
rium characterized by a higher 𝑌𝑌𝑛𝑛 and a lower general price level.”
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71
Macroeconomics. Problems and Questions
Question 3
True or False?
Explain whether the following statements are true or false. Motivate your answer
in a brief but rigorous way, by making explicit reference to the relevant theory.
Lack of proper explanations will result in zero points.
a. “The zero lower bound for the nominal interest rate implies that the real
interest rate cannot be smaller than minus the expected inflation rate,
−𝜋𝜋 𝑒𝑒 ”.
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73
Macroeconomics. Problems and Questions
Question 4
True or False?
Explain whether the following statements are true or false. Motivate your answer
in a brief but rigorous way, by making explicit reference to the relevant theory.
Lack of proper explanations will result in zero points.
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74
The labor market, the IS-LM-PC model, and inflation
b. The smaller the fraction of wages indexed to the inflation rate, the larger
the increase in inflation associated with any given decrease in the rate of
unemployment.
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75
Macroeconomics. Problems and Questions
Question 5
True or False?
Explain whether the following statements are true or false. Motivate your answer
in a brief but rigorous way, by making explicit reference to the relevant theory.
Lack of proper explanations will result in zero points.
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77
Macroeconomics. Problems and Questions
Question 6
True or False?
Explain whether the following statements are true or false. Motivate your answer
in a brief but rigorous way, by making explicit reference to the relevant theory.
Lack of proper explanations will result in zero points.
a. “In country Alpha 𝜋𝜋𝑡𝑡𝑒𝑒 = 𝜋𝜋𝑡𝑡 , while in country Beta 𝜋𝜋𝑡𝑡𝑒𝑒 = 2%. It follows
that, to keep the rate of unemployment at the natural level (𝑢𝑢𝑡𝑡 = 𝑢𝑢𝑛𝑛 for
each time 𝑡𝑡), the rate of inflation must remain constant in Alpha, and in-
crease at a rate greater than 2% in Beta”.
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The labor market, the IS-LM-PC model, and inflation
b. “In country Gamma 𝜋𝜋𝑡𝑡𝑒𝑒 = 3%, while in country Delta 𝜋𝜋𝑡𝑡𝑒𝑒 = 𝜋𝜋𝑡𝑡−1 . It fol-
lows that, to keep the rate of unemployment at the natural level (𝑢𝑢𝑡𝑡 = 𝑢𝑢𝑛𝑛
for each time 𝑡𝑡), in both countries the rate of inflation must remain con-
stant over time ”.
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79
Macroeconomics. Problems and Questions
* Question 7
[The natural rate of interest - Monetary policy and fiscal policy in the medium-
run]
a. Define the concept of natural rate of interest, 𝑟𝑟𝑛𝑛 , and discuss its deter-
minants using a graph in which the real rate 𝑟𝑟 is measured along the
vertical axis, and goods' supply and demand along the horizontal one.
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81
Macroeconomics. Problems and Questions
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83
Macroeconomics. Problems and Questions
* Question 8
where, as usual, the positive constant 𝑐𝑐0 is autonomous consumption, 𝑐𝑐1 − the
marginal propensity to consume − is between zero and one, and the other
symbols have the usual meaning.
84
The labor market, the IS-LM-PC model, and inflation
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b. How should the central bank intervene if, in the short-run, it intends to
keep the policy rate at 𝑟𝑟𝑛𝑛 ? Do you think that 𝑟𝑟 can be kept at this level
indefinitely? If not, at what value should the policy rate be allowed to
converge? Motivate your answer by making explicit reference both to
the graph you have just drawn and to the one used to answer Question
7 of this Chapter.
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85
Macroeconomics. Problems and Questions
Question 9
a. To reduce a budget deficit deemed too high, the government of Eta de-
cides to raise taxes. At the same time, the central bank decides to resort to
an open market operation, aimed at preventing the fiscal policy just men-
tioned from changing the inflation rate, π. In an IS-LM-PC diagram, de-
note the initial medium-run equilibrium by ‘1’ and represent the new me-
dium-run equilibrium to which Eta will converge after the implementation
of the policy-mix described above. In particular, describe the type of open
market operation (purchase; sale) that the central bank should implement
to reach its objective.
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The labor market, the IS-LM-PC model, and inflation
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87
Macroeconomics. Problems and Questions
Question 10
a. Having explained if, in the (𝑌𝑌, 𝑟𝑟) space, the slope of the IS curve is in this
case negative, zero or positive, assume that the economy is initially in a
medium-run equilibrium, with 𝑌𝑌 = 𝑌𝑌𝑛𝑛 , 𝑟𝑟 = 𝑟𝑟𝑛𝑛 and 𝜋𝜋 − 𝜋𝜋−1 = 0. Show in
the graph, and discuss, the short-run effects of a permanent increase in the
financial markets participants’ degree of risk aversion, assuming that the
central bank keeps the policy rate constant at the initial level, 𝑟𝑟𝑛𝑛 . In the
move from the initial to the new short-run equilibrium, how will
consumption and investment change? Explain.
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The labor market, the IS-LM-PC model, and inflation
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b. Suppose that, once the economy has reached the short-run equilibrium
described in the answer to the previous point, the government decides to
return output to the natural level by changing 𝐺𝐺̅ . To achieve its goal,
should the government raise or lower 𝐺𝐺̅ ? Compare the levels of invest-
ment, consumption, private saving, public saving and national saving in
the new medium-run equilibrium that will be reached after the govern-
ment’s intervention to the levels of the same variables in the initial one
(that is, the medium-run equilibrium prevailing before the increases in the
degree of risk aversion and in 𝐺𝐺̅ ). Explain. [Hint: write down the (private)
saving function for this economy].
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89
Macroeconomics. Problems and Questions
Question 11
90
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b. Suppose that, once the economy has reached the short run equilibrium
you have described when answering the previous point, the central bank
decides to bring income back to the natural level by implementing an
open market operation. To achieve its aim, should it buy or sell bonds in
the open market? Show in the graph the new equilibrium that will be
reached following the central bank’s intervention you consider appropri-
ate. In this new equilibrium, how will the levels of investment, consump-
tion, private saving, public saving and national saving compare to the lev-
els of the same variables in the initial medium-run equilibrium (that is, the
equilibrium prevailing before the changes in autonomous consumption
and the fiscal and monetary policy interventions described above)?
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91
Macroeconomics. Problems and Questions
Question 12
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93
Macroeconomics. Problems and Questions
Question 13
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94
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95
Macroeconomics. Problems and Questions
Question 14
96
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b. In the same graph, show the adjustment process from the new short-run
equilibrium 1′ to the new medium-run equilibrium, denoting this latter by
2. Explain in detail how 2 will be reached, with special emphasis on the
reason for the changes in the interest rate and output taking place during
the transition. Finally, explain if and how the levels of consumption and
investment will have changed in the new medium-run equilibrium (2),
compared to the levels these variables were taking on in the initial medi-
um-run equilibrium (point 1).
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97
Macroeconomics. Problems and Questions
Question 15
a. To understand the cause of the fall in the real interest rate, the govern-
ment of the country consults two economists, Harry and Ginny. Accord-
ing to Harry, the fact that the inflation rate has remained constant allows
one to conclude that the economy must have been hit by an adverse de-
mand shock, one to which the central bank has reacted by bringing 𝑟𝑟 to
the new, lower medium run equilibrium level. The reduction in the real
rate therefore reflects, without any doubt, a decrease in its natural level,
𝑟𝑟𝑛𝑛 . Ginny instead thinks that, to be able to conclude that the economy has
been experiencing a fall in 𝑟𝑟𝑛𝑛 , rather than a decision of the central bank to
bring the real rate below an unchanged natural level, further information
is needed. In particular, one needs to know whether, over the past two
years, the inflation rate has remained constant at 2%, or at a level greater
than 2%. Represent in the graph below the medium run equilibrium pre-
vailing in Macro two years ago (𝑟𝑟𝑛𝑛 = 3%), denoting it by ‘1’. In the same
graph, denote by ‘2’ the equilibrium, associated with a real rate of 1%,
that would prevail if the fall in 𝑟𝑟 is due to a decrease in the natural, medi-
um run, real rate, and by ‘3’ that which would instead prevail if the de-
crease of the real rate to 1% is the outcome of the decision of the central
bank to bring 𝑟𝑟 below an unchanged natural level. Which of the two eco-
nomists is right? Why? Explain.
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b. Say you are now told that, in Macro, rather than an inflation rate con-
stant at 2%, individuals always expect an inflation rate equal to that ob-
served in the previous period, so that 𝜋𝜋 𝑒𝑒 = 𝜋𝜋−1 . Which of the two econo-
mists is right, in this case? Why? Explain.
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99
Macroeconomics. Problems and Questions
Question 16
A country in which expected inflation for the current year equals the inflation
rate prevailing in the previous year, 𝜋𝜋 𝑒𝑒 = 𝜋𝜋−1 , and in which 𝑖𝑖 ≥ 0, is initially in
a medium run equilibrium, with 𝑌𝑌 = 𝑌𝑌𝑛𝑛 , 𝑟𝑟𝑛𝑛 = 0 and 𝜋𝜋 𝑒𝑒 = 𝜋𝜋−1 = 0.
a. Assuming that the central bank chooses the interest rate, represent in the
two-panel IS-LM-PC diagram the initial medium run equilibrium, denot-
ing it by 1. Having explained which value the nominal interest rate, 𝑖𝑖, will
necessarily take on in this initial equilibrium, suppose that the government
launches an ambitious program of liberalizations, leading to an increase in
the degree of competition in the country’s goods markets. In the two pan-
els of the graph below, denote by 2 the new short run equilibrium that the
economy will reach. In the move from 1 to 2, how will have income
changed? And what about the rate of inflation? Why? Explain. [Hint:
when answering, assume that the position of the IS curve is not affected by
the change described above].
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b. If policy-makers do not intervene, how will the real interest rate and in-
come change next period? Why? Show in the graph, denoting by 3 the
new short run equilibrium that, absent any policy intervention, the econ-
omy would attain. To make sure that, rather than from 1 to 2, from 2 to
3, etc., the economy goes immediately from the initial medium run equi-
librium 1 to the new medium run equilibrium that you will denote by 4 in
the graph, the implementation of the liberalization program should be
combined with a fiscal policy intervention, or with a monetary policy one?
And, once the kind of economic policy most appropriate to go directly
from the equilibrium 1 to the equilibrium 4 has been detected, the pro-
posed policy should be a restrictive or an expansionary one? Show in the
graph the effects of the policy intervention you suggest, and comment.
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101
Macroeconomics. Problems and Questions
* Question 17
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b. If, in the medium run, inflation depends on the rate of money growth cho-
sen by the central bank, and if inflation is a 'bad', why the world's major
central banks target an inflation rate that, rather than zero, is positive (al-
beit 'small')? Mention two factors that help explain this choice.
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103
Chapter 4 - Expectations, financial markets,
and economic policies
Macroeconomics. Problems and Questions
Question 1
We are at time 𝑡𝑡. In country Tau, only one-year and two-year bonds exist. The
time-𝑡𝑡 price of two year bonds issued in that time period is €𝑃𝑃2𝑡𝑡 = €94. In ad-
𝑒𝑒
dition, 𝑖𝑖1𝑡𝑡+1 − the yield that market participants expect on one-year bonds
that, issued at 𝑡𝑡 + 1, will mature at 𝑡𝑡 + 2 − is 4%.
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106
Expectations, financial markets, and economic policies
b. Suppose now that you do not share the market’s expectations about
𝑒𝑒′
future short-term rates. In particular, you expect 𝑖𝑖1𝑡𝑡+1 = 5%, rather
𝑒𝑒
than 𝑖𝑖1𝑡𝑡+1 = 4%. If you are interested in how much you will have two
years from today, should you buy two-year bonds or a sequence of
one-year bonds? Or maybe you should be indifferent between the two
alternatives? Explain.
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107
Macroeconomics. Problems and Questions
Question 2
a. Alpha and Beta − two countries where only one, two and three-year bonds
exist – differ just for the expectations held by market participants about
the monetary policy that, in each of the two nations, will be implemented
in the future. The graph below shows the yield curve prevailing in the two
countries in the current period, time 𝑡𝑡 [N.B.: the yield curve prevailing in
Alpha (the bold, continuous line in the graph) and that observed in Beta (the
dashed, bold line) overlap for maturities up to two years; afterwards, Beta’s
yield curve declines faster than Alpha’s]. Which differences in individuals’
expectations about the future monetary policy that will be implemented in
each of the two countries can explain the observed differences in the two
yield curves? Using the data provided in the graph, compute the current
and future expected one-year rates 𝑖𝑖1𝑡𝑡 , 𝑖𝑖1𝑒𝑒 𝑡𝑡+1 and 𝑖𝑖1𝑒𝑒 𝑡𝑡+2 prevailing today
(time 𝑡𝑡) in each of the two countries.
Yield
to
maturity
7%
Alpha
6%
Beta
5%
1 2 3 Maturity
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Expectations, financial markets, and economic policies
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b. Consider now Gamma, a country where stock prices have recently soared.
To deflate what it thinks is a stock market bubble, Gamma’s central bank
decides to intervene to return stock prices to a level closer to fundamentals.
To achieve this goal, should the central bank implement an expansionary
or a restrictive monetary policy? Why? Motivate your answer by making
reference to the formula for stock prices, showing the determinants of the
value of these financial assets [Hint: when answering, assume that, in each
time period, the economy is described by a static IS-LM model, with con-
sumption and investment that depend on contemporaneous variables only].
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109
Macroeconomics. Problems and Questions
Question 3
a. In country Zeta, only one-year and two-year bonds exist. Investors, who
do care about risk, ask for a risk premium 𝑥𝑥 to hold the two-year bond
(which is risky, as they do not know the price at which they will be able to
sell it in a year). Use the arbitrage equation to derive the (approximate) re-
lation that will hold in this case among the yield to maturity of a two-year
𝑒𝑒
bond (𝑖𝑖2𝑡𝑡 ), the current (𝑖𝑖1𝑡𝑡 ) and future expected (𝑖𝑖1,𝑡𝑡+1 ) yields on one-year
bonds, and the risk premium (𝑥𝑥).
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110
Expectations, financial markets, and economic policies
b. Suppose that, in the current period (time 𝑡𝑡), Zeta’s yield curve is the one in
the figure below. Write on the axes the name of the variables measured
along each of them, and use your answer to the previous point of this ques-
tion to compute the numerical value that the risk premium 𝑥𝑥 takes on in
this economy, knowing that investors expect the future yield on one-year
𝑒𝑒
bonds to be the same as the current one (𝑖𝑖1𝑡𝑡 = 𝑖𝑖1,𝑡𝑡+1 ).
4%
1%
1 2
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111
Macroeconomics. Problems and Questions
Question 4
a. In country Zeta, only one-year and two-year bonds exist. Investors, who
do care about risk, ask for a risk premium 𝑥𝑥 to hold the two-year bond
(which is risky, as they do not know the price at which they will be able to
sell it in a year). Use the arbitrage equation to derive the (approximate) re-
lation that will hold in this case among the yield to maturity of a two-year
𝑒𝑒
bond (𝑖𝑖2𝑡𝑡 ), the current (𝑖𝑖1𝑡𝑡 ) and future expected (𝑖𝑖1,𝑡𝑡+1 ) yields on one-year
bonds, and the risk premium (𝑥𝑥).
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112
Expectations, financial markets, and economic policies
b. Suppose that, in the current period (time 𝑡𝑡), the yield curve in Zeta – a
country where the lower bound on the yield on one-year bonds is not zero,
but negative, equal to −1% - is the one in the figure below. Write on the
axes the name of the variables measured along each of them, and use your
answer to the previous point of this question to compute the numerical
value that the risk premium 𝑥𝑥 takes on in this economy, knowing that
𝑒𝑒
𝑖𝑖1𝑡𝑡+1 = −3𝑖𝑖1𝑡𝑡 .
0.2%
0%
1 2
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113
Macroeconomics. Problems and Questions
Question 5
a. We are at time t. Write down the expression defining the price (in nominal
terms) of a stock that has already paid the current dividend, and define
carefully all the variables entering it. From which principle/condition is
this expression derived? [Hint: you are not expected to derive the expression
for the nominal stock price formally; just describe in detail the considerations
on which its derivation is based].
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114
Expectations, financial markets, and economic policies
b. Explain if, and why, you agree, or do not agree, with the following
statements [Hint: when answering, assume that, in each time period, the
economy is described by a standard, static IS-LM model, with consump-
tion and investment that depend on contemporaneous variables only]:
b.2 if, at time 𝑡𝑡, individuals learn that from 𝑡𝑡 + 1 onwards fiscal
policy will become permanently more expansionary, and
monetary policy permanently more restrictive, then time 𝑡𝑡 stock
prices, €𝑄𝑄𝑡𝑡 , will unambiguously fall.
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115
Macroeconomics. Problems and Questions
Question 6
True or False?
Explain whether the following statements are true or false. Motivate your answer
in a brief but rigorous way, by making explicit reference to the relevant theory.
Lack of proper explanations will result in zero points.
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116
Expectations, financial markets, and economic policies
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117
Macroeconomics. Problems and Questions
* Question 7
[Intertemporal consumption choices – The microfoundations of the 'theory of the
very farsighted consumer']
There are only two time periods, 𝑡𝑡 (the 'present') and 𝑡𝑡 + 1 (the 'future'). Make
the following assumptions on the individuals populating the economy:
• their preferences are described by the utility function 𝑈𝑈(𝐶𝐶𝑡𝑡 , 𝐶𝐶𝑡𝑡+1 ), in-
creasing and concave in its two arguments – present consumption, 𝐶𝐶𝑡𝑡 ,
and future consumption, 𝐶𝐶𝑡𝑡+1 ;
• they have access to a credit market, where they can borrow and lend at
the real interest rate 𝑟𝑟;
• they earn a disposable (labor) income equal to (𝑌𝑌𝑡𝑡 − 𝑇𝑇𝑡𝑡 ) in the first pe-
𝑒𝑒 𝑒𝑒 )
riod, and expect to earn one equal to (𝑌𝑌𝑡𝑡+1 − 𝑇𝑇𝑡𝑡+1 in the second peri-
od.
a. Suppose that, at time 𝑡𝑡, the typical individual's financial wealth (stocks,
bonds, etc.) and housing wealth (apartments, commercial buildings, etc.)
are both zero. Write down the individual's budget constraints for each of
the two periods, combine them into a single 'intertemporal budget con-
straint' and represent in the (𝐶𝐶𝑡𝑡 , 𝐶𝐶𝑡𝑡+1 ) plane the problem the individual has
to solve in order to maximize his utility subject to such constraint. Where
is the optimal 'present consumption/future consumption' program located?
What determines whether, in the first period, the individual will be a bor-
rower, a lender, or rather consume exactly his disposable income?
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118
Expectations, financial markets, and economic policies
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b. Assuming that both 𝐶𝐶𝑡𝑡 and 𝐶𝐶𝑡𝑡+1 are 'normal goods', explain how the opti-
mal choice of present consumption will be affected by the following chang-
es:
• a transitory increase in current disposable income [𝛥𝛥(𝑌𝑌𝑡𝑡 − 𝑇𝑇𝑡𝑡 ) > 0 and
𝑒𝑒 𝑒𝑒 )
𝛥𝛥(𝑌𝑌𝑡𝑡+1 − 𝑇𝑇𝑡𝑡+1 = 0]
119
Macroeconomics. Problems and Questions
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Expectations, financial markets, and economic policies
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c. How does the consumption function you have just derived change if, at
time 𝑡𝑡, individuals have a positive − rather than zero, as assumed so far −
nonhuman wealth (𝑊𝑊𝑊𝑊𝑊𝑊), defined as the sum of financial and of housing
wealth?
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121
Macroeconomics. Problems and Questions
Question 8
There are only two periods, period 𝑡𝑡 (“the present”) and period 𝑡𝑡 + 1 (“the fu-
ture”). In the attempt to boost current economic activity, the government of
country Delta cuts by 100 the taxes each individual will have to pay in the cur-
rent period (time 𝑡𝑡). At the same time, the government however announces
that future taxes will be increased by the same amount. In other words, denot-
ing per-capita net taxes by 𝑇𝑇, the fiscal policy intervention just described can
𝑒𝑒
be summarized as follows: ∆𝑇𝑇𝑡𝑡 = −100, ∆𝑇𝑇𝑡𝑡+1 = ∆𝑇𝑇𝑡𝑡+1 = +100.
a. Suppose that all individuals are identical and that, at the beginning of
time 𝑡𝑡, their non-human wealth is zero. Moreover, assume that 𝑟𝑟 =
0, where 𝑟𝑟 is the real interest rate. Using the analysis of the intertemporal
consumption choices, evaluate ∆𝑐𝑐𝑡𝑡 and ∆𝑐𝑐𝑡𝑡+1 − that is, the changes in
current and future consumption levels of the typical inhabitant of country
Delta caused by the intertemporal reallocation of taxes implemented by
the government. Will the government be successful in its attempt to in-
crease consumption, and hence aggregate demand and equilibrium pro-
duction, at time 𝑡𝑡? If yes, indicate the fraction of the tax cut by which time
𝑡𝑡 consumption of the typical individual will rise. If no, why? In motivating
your answer, make explicit reference to the way in which savings by the
typical individual will change at time 𝑡𝑡.
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122
Expectations, financial markets, and economic policies
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123
Macroeconomics. Problems and Questions
Question 9
True or False?
Explain whether the following statements are true or false. Motivate your answer
in a brief but rigorous way, by making explicit reference to the relevant theory.
Lack of proper explanations will result in zero points.
a. Suppose that today (time 𝑡𝑡) there is a fall in house prices. The consumption
function based on the analysis of the intertemporal consumption decisions
implies that time 𝑡𝑡 consumption will rise – since houses are now less expen-
sive than before, individuals will need to save less to purchase one, and this
will allow them to consume more.
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124
Expectations, financial markets, and economic policies
b. Today (time 𝑡𝑡), stock prices fall. The consumption function based on the
analysis of the intertemporal consumption decisions implies that, at time 𝑡𝑡,
households will cut their consumption expenditures.
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125
Macroeconomics. Problems and Questions
Question 10
In country Macro, current and future expected inflation are equal to zero, so
that nominal and real interest rates are the same. At time 𝑡𝑡 + 1 (‘the future’),
consumption depends on 𝑡𝑡 + 1 disposable income only, while investment is en-
̅ . As for the current period, (𝑡𝑡, ‘the present’), con-
tirely exogenous, 𝐼𝐼𝑡𝑡+1 = 𝐼𝐼𝑡𝑡+1
sumption is increasing both in the current and in the future expected levels of
disposable income, 𝐶𝐶𝑡𝑡 = 𝐶𝐶(𝑌𝑌𝑡𝑡 − 𝑇𝑇�𝑡𝑡 , 𝑌𝑌𝑡𝑡+1
𝑒𝑒
− 𝑇𝑇�𝑡𝑡+1
𝑒𝑒
), investment is exogenous, 𝐼𝐼𝑡𝑡 =
𝐼𝐼𝑡𝑡̅ , 𝐺𝐺 and 𝑇𝑇 are as usual exogenous in both periods, and the central bank
chooses a level for the interest rate in both periods.
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126
Expectations, financial markets, and economic policies
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b. Suppose that only one-year bonds and two-year bonds exist and that,
before the announcement described above, at time 𝑡𝑡 the yield curve of
Macro was flat. Draw the new yield curve that, at time 𝑡𝑡, will prevail
in each of the following three cases: (i) the central bank has announced
that it will cut the future short-rate rate less than the current one; (ii) it
has announced that it will proceed to an equal cut in current and fu-
ture rates; (iii) it has announced that it will cut the future short-rate
rate more than the current one. Explain.
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127
Macroeconomics. Problems and Questions
Question 11
a. In country Macrolandia, there are only one-year and two-year bonds. The
current and the expected future inflation rates are both zero, so that the
real and the nominal interest rates are equal. In period 𝑡𝑡 + 1 (“the future”),
a standard IS-LM model describes the functioning of the economy. In par-
ticular, in the year 𝑡𝑡 + 1 consumption depends only on disposable income
at 𝑡𝑡 + 1, and investment on the interest rate and output at 𝑡𝑡 + 1 only.
Turning now to the current period (𝑡𝑡, “the present”), consumption is in-
creasing in both current and expected future disposable income, 𝐶𝐶𝑡𝑡 =
𝐶𝐶(𝑌𝑌𝑡𝑡 − 𝑇𝑇�𝑡𝑡 , 𝑌𝑌𝑡𝑡+1
𝑒𝑒
− 𝑇𝑇�𝑡𝑡+1
𝑒𝑒
), investment depend positively on current and ex-
pected future income levels, and negatively on the current and expected fu-
ture levels of short-term interest rates, the demand for money has the usual
functional form, and 𝐺𝐺 and 𝑇𝑇 are exogenous as usual. Starting from an ini-
tial equilibrium, at time 𝑡𝑡 the government of Macrolandia announces an
increase of its purchases of goods and services at time 𝑡𝑡 + 1, ∆𝐺𝐺𝑡𝑡+1 ̅ > 0. At
the same time, the central bank announces that it will adjust the policy rate
so as to prevent any change in equilibrium income that, at time 𝑡𝑡 and/or at
time 𝑡𝑡 + 1, could be caused by the fiscal policy just described. Explain how
these announcements, which are unexpected and credible, affect the time 𝑡𝑡
yield to maturity on the two-year bonds circulating in Macrolandia, 𝑖𝑖2𝑡𝑡 .
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128
Expectations, financial markets, and economic policies
b. Assume for simplicity that, in Macrolandia, at time 𝑡𝑡 the yield curve is ini-
tially horizontal. Explain how the position and the slope of this curve
change after the announcement studied above. Represent both curves, the
one “before” and the one “after” the announcement, in the graph below.
Clarify whether it is possible to determine the position and the slope of the
new yield curve unambiguously.
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129
Macroeconomics. Problems and Questions
Question 12
a. In country Macrolandia, there are only one-year and two-year bonds. The
current and the expected future inflation rates are both zero, so that the
real and the nominal interest rates are equal. In period 𝑡𝑡 + 1 (“the future”),
an IS-LM model describes the functioning of the economy. In particular,
in the year 𝑡𝑡 + 1 consumption depends only on disposable income at 𝑡𝑡 + 1,
and investment on the borrowing rate (the sum of the interest rate and the
risk premium 𝑥𝑥𝑡𝑡+1 ) and an output at 𝑡𝑡 + 1 only. Turning now to the cur-
rent period (𝑡𝑡, “the present”), consumption is increasing in both current
and expected future disposable income, 𝐶𝐶𝑡𝑡 = 𝐶𝐶(𝑌𝑌𝑡𝑡 − 𝑇𝑇�𝑡𝑡 , 𝑌𝑌𝑡𝑡+1
𝑒𝑒
− 𝑇𝑇�𝑡𝑡+1
𝑒𝑒
), in-
vestment depend positively on current and expected future income levels,
and negatively on the current and expected future borrowing rates, the
central bank chooses in each period the interest rate, and 𝐺𝐺 and 𝑇𝑇 are ex-
ogenous as usual. Starting from an initial equilibrium position in both pe-
riods, at time 𝑡𝑡 individuals start expecting a decrease in the risk premium
for time 𝑡𝑡 + 1, 𝛥𝛥𝑥𝑥𝑡𝑡+1 < 0. At the same time, the central bank announces
that it will adjust the policy rate so as to prevent any change in equilibrium
income that, at time 𝑡𝑡 (and at time 𝑡𝑡 only), could be caused by the change
in 𝑥𝑥𝑡𝑡+1 just described. Explain how these changes and announcements,
which are unexpected and credible, affect the time 𝑡𝑡 yield to maturity on
the two-year bonds circulating in Macrolandia, 𝑖𝑖2𝑡𝑡 .
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130
Expectations, financial markets, and economic policies
b. Assume for simplicity that, in Macrolandia, at time 𝑡𝑡 the yield curve is ini-
tially horizontal. Explain how the position and the slope of this curve
change after the change and the announcement studied above. Represent
both curves, the one “before” and the one “after”, in the graph below.
Clarify whether it is possible to determine the position and the slope of the
new yield curve unambiguously.
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131
Macroeconomics. Problems and Questions
Question 13
In country Gamma, current and future expected inflation rates coincide and
are equal to zero, so that the real and the nominal interest rates are equal. In
period 𝑡𝑡 + 1 (“the future”), consumption depends only on disposable income
at 𝑡𝑡 + 1, and investment is 𝐼𝐼𝑡𝑡+1 = 𝐼𝐼𝑡𝑡+1 ̅ + 𝑑𝑑1 𝑌𝑌𝑡𝑡+1 − 𝑑𝑑2 𝑖𝑖𝑡𝑡+1 , where symbols have
the usual meaning. Turning now to the current period (𝑡𝑡, “the present”), con-
sumption is increasing in both current and expected future disposable income,
𝐶𝐶𝑡𝑡 = 𝐶𝐶(𝑌𝑌𝑡𝑡 − 𝑇𝑇�𝑡𝑡 , 𝑌𝑌𝑡𝑡+1
𝑒𝑒
− 𝑇𝑇�𝑡𝑡+1
𝑒𝑒
), while investment is increasing in current and ex-
pected future income levels, and decreasing in the current and expected future
levels of short-term interest rates. Finally, 𝐺𝐺 and 𝑇𝑇 are exogenous in both peri-
ods.
a. At time 𝑡𝑡, individuals revise downwards their expectation about the value
that the autonomous component of investment will take on in the future.
More specifically, they start expecting that 𝐼𝐼𝑡𝑡+1 ̅ will drop to 𝐼𝐼 ′̅ 𝑡𝑡+1, with
̅ . At the same time, the central bank announces that, in the fu-
𝐼𝐼 ′̅ 𝑡𝑡+1 < 𝐼𝐼𝑡𝑡+1
ture, it will implement a monetary policy aimed at preventing any change
in time 𝑡𝑡 + 1 equilibrium output that could be caused by the expected
drop in autonomous investment in that period. To achieve its goal, what
kind of monetary policy (expansionary? restrictive?) should the central
bank implement? Describe, and represent in the graph below, the effects
of the two announcements on Gamma’s current (that is to say, time 𝑡𝑡) in-
come and interest rate equilibrium levels.
132
Expectations, financial markets, and economic policies
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b. Suppose that only one-year bonds and two-year bonds exist and that, be-
fore the announcements described above, at time 𝑡𝑡 the yield curve was
flat. What will be the effects of the two announcements on the position
and the slope of the yield curve of Gamma?
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133
Macroeconomics. Problems and Questions
Question 14
a. In country Alpha, there are only one-year and two-year bonds. The cur-
rent and the expected future inflation rates are both zero, so that the real
and the nominal interest rates are equal. In period 𝑡𝑡 + 1 (“the future”), a
standard IS-LM model describes the functioning of the economy. In par-
ticular, in year 𝑡𝑡 + 1 consumption depends only on disposable income at
𝑡𝑡 + 1, and investment on the interest rate and output at 𝑡𝑡 + 1 only. Turn-
ing now to the current period (𝑡𝑡, “the present”), consumption is increasing
in both current and expected future disposable income levels, 𝐶𝐶𝑡𝑡 = 𝐶𝐶(𝑌𝑌𝑡𝑡 −
𝑇𝑇�𝑡𝑡 , 𝑌𝑌𝑡𝑡+1
𝑒𝑒
− 𝑇𝑇�𝑡𝑡+1
𝑒𝑒
), investment is exogenous, 𝐼𝐼𝑡𝑡 = 𝐼𝐼,̅ and the same is true
about 𝐺𝐺 and 𝑇𝑇. Rather than the interest rate, Alpha's central bank chooses
a value for the nominal money supply 𝑀𝑀 and, given this level at which 𝑀𝑀 is
set, lets the interest rate free to take on any value is consistent with the
macroeconomic equilibrium. It follows that, in the (𝑌𝑌, 𝑖𝑖) plane, the LM
curve of Alpha is the curve discussed in Question 2 − and, for the case of
an economy in a liquidity trap, in Question 10 − of Chapter 2. Finally, in
the initial equilibrium, time 𝑡𝑡 + 1 income and interest rates levels are both
positive, while at time 𝑡𝑡 the economy is in a liquidity trap. Suppose now
that, at time 𝑡𝑡, the central bank announces that it will decrease nominal
money supply at 𝑡𝑡 + 1. Explain how this announcement, which is unex-
pected and credible, affects the time 𝑡𝑡 yield to maturity on the two-year
bonds circulating in Alpha, 𝑖𝑖2𝑡𝑡 .
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134
Expectations, financial markets, and economic policies
b. Draw the yield curve prevailing at time 𝑡𝑡 before the central bank’s an-
nouncement, and explain how this latter will affect the yield curve of Al-
pha. In particular, draw the new yield curve in the same graph, and explain
if it is possible to determine without ambiguity how its slope and position
will compare to those of the original curve.
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135
Macroeconomics. Problems and Questions
Question 15
In countryABC, there are only one-year and two-year bonds. The current and
the expected future inflation rates are both zero, so that the real and the nomi-
nal interest rates are equal. In period 𝑡𝑡 + 1 (“the future”), investment is entire-
ly exogenous, while consumption depends only on disposable income at 𝑡𝑡 + 1.
Turning now to the current period (𝑡𝑡, “the present”), consumption is increas-
ing in both current and expected future disposable income, 𝐶𝐶𝑡𝑡 = 𝐶𝐶(𝑌𝑌𝑡𝑡 −
𝑇𝑇�𝑡𝑡 , 𝑌𝑌𝑡𝑡+1
𝑒𝑒
− 𝑇𝑇�𝑡𝑡+1
𝑒𝑒
), and investment is once again exogenous. In both periods, the
demand for money has the usual functional form, and 𝐺𝐺 and 𝑇𝑇 are exogenous
as usual. Starting from an initial equilibrium, at time 𝑡𝑡 the government of
Macrolandia announces an increase in net taxes for time 𝑡𝑡 + 1, ∆𝑇𝑇�𝑡𝑡+1 > 0.
a. Assuming that, in both periods, ABC’s central bank chooses the interest
rate, describe and represent in the two graphs below the effects of this fis-
cal policy announcement on income and the interest rate levels prevailing
at time 𝑡𝑡 and at time 𝑡𝑡 + 1. How will the time 𝑡𝑡 yield to maturity on the
two-year bonds circulating in Macrolandia, 𝑖𝑖2𝑡𝑡 , change? Why?
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136
Expectations, financial markets, and economic policies
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b. Repeat the same analysis carried out when answering the previous point
assuming that, rather than the interest rate, the central bank of the coun-
try chooses the money supply. Represent in the graphs below the effects of
the same fiscal policy announcement considered before and explain how
will 𝑖𝑖2𝑡𝑡 change in this case, and why.
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137
Chapter 5 - The open economy
Macroeconomics. Problems and Questions
Question 1
a. Country Iota’s Statistical Office announces that, between year 𝑡𝑡 and year
𝑡𝑡 + 1, gross investment has increased by €100bn, while public saving has
fallen by €50bn.
a.1 Knowing that Iota is a closed economy, by how much has private sav-
ing changed between the same two years?
a.2 How would your answer change, were Iota an economy open to trade
in goods, services and financial assets with the rest of the world?
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140
The open economy
b. Explain, briefly but rigorously, what is meant by J-curve [in your an-
swer, make explicit reference to the so-called ‘Marshall-Lerner condi-
tion’].
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141
Macroeconomics. Problems and Questions
Question 2
Consider an economy open to foreign trade, where only the goods market ex-
ists and prices are constant. Assume that foreign trade is initially balanced.
a. Suppose the government decides to cut net taxes, 𝑇𝑇�. In the two-
panel diagram that allows one to analyze simultaneously the deter-
mination of the goods market equilibrium and the trade balance as-
sociated with that equilibrium position, represent the effects of this
fiscal policy decision on equilibrium income and net exports. In the
graph, denote by 𝑌𝑌� the initial level of equilibrium income, and by 𝑌𝑌�′
its new level. Why do equilibrium income and net exports change?
Explain.
142
The open economy
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b. In the same graph used above, find the equilibrium level of income that
would have been reached had the same tax cut been implemented in a
closed economy. Denote this new, closed-economy equilibrium income by
𝑌𝑌�′′. Will 𝑌𝑌�′′ be less than, equal to, or greater than 𝑌𝑌�′? Why?
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143
Macroeconomics. Problems and Questions
Question 3
a. Consider a country that is open to trade in goods and services with the rest
of the world, where prices are fixed and in which only the goods market ex-
ists. Initially, the country is in goods market equilibrium with a trade sur-
plus. Draw in the two-panel diagram below the initial equilibrium posi-
tion, and show how it changes following a reduction in the domestic price
level, 𝑃𝑃 [Hint: assume that, after this reduction, 𝑃𝑃 remains forever constant
at its new, lower level, so that the economy is still described by a model with
fixed prices]. In particular, explain if and why income and net exports will
change in the new equilibrium.
144
The open economy
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b. How would your answer to the previous point of this question change, if
the quantities of goods and services exported and imported by the country
did not depend on the real exchange rate, but only on foreign and domestic
income levels, respectively? Explain.
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145
Macroeconomics. Problems and Questions
Question 4
Consider a country that is open to trade in goods and services with the rest of
the world, where the exchange rate and prices are fixed and in which only the
goods market exists. In the initial equilibrium, the country has a trade surplus.
146
The open economy
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b. Does the increase in investment change the level of output for which trade
is balanced? Why, or why not?
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147
Macroeconomics. Problems and Questions
Question 5
148
The open economy
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149
Macroeconomics. Problems and Questions
Question 6
a. Eta is initially in goods market equilibrium, with 𝐺𝐺̅ = 50, 𝑇𝑇� = 50, 𝑆𝑆 =
70, 𝐼𝐼 = 20, where 𝐺𝐺 is government spending on goods and services, 𝑇𝑇 net
taxes, 𝑆𝑆 private saving, and 𝐼𝐼 gross investment. Using this information,
represent the initial equilibrium of Eta in the two-panel diagram below
[Hint: you do not need to compute the equilibrium level of income; just
show clearly where the initial equilibrium position is located in each of the
two panels below, and explain why].
150
The open economy
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b. Suppose now that real exchange rate ε falls – a real depreciation. Assum-
ing that the Marshall-Lerner condition holds true, represent the effects of
this change in the graph above. In particular, explain if it will affect the
level of income at which Eta’s foreign trade is balanced, 𝑌𝑌𝑇𝑇𝑇𝑇 , and – if your
answer is positive – in what direction 𝑌𝑌𝑇𝑇𝑇𝑇 will change. Finally, explain if
and why the trade balance will vary.
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151
Macroeconomics. Problems and Questions
Question 7
Consider a country that is open to trade in goods and services with the rest of
the world, where prices are fixed and in which only the goods market exists.
Initially, the country is in goods market equilibrium, and trade is balanced.
a. Draw in the two-panel diagram below the initial equilibrium position and
show how it changes following a reduction in foreign output, 𝑌𝑌 ∗ . In par-
ticular, explain how and why net exports will have changed in the new
equilibrium.
152
The open economy
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153
Macroeconomics. Problems and Questions
Question 8
a. Consider a country that is open to trade in goods and services with the rest
of the world, where prices are fixed and in which only the goods market ex-
ists. Initially, the country is in goods market equilibrium, and trade is bal-
anced.
Draw in the two graphs below the initial equilibrium position, and show
how this equilibrium changes following an increase in 𝐸𝐸, the nominal ex-
change rate [Hint: assume that E will remain forever at the new, higher lev-
el, and that domestic and foreign prices do not change]. Finally, explain if
and why, in the new equilibrium, income and net exports will have
changed.
154
The open economy
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b. Consider now a different economy, where also financial markets exist and
under a flexible exchange rate regime. Show in the graph below, and dis-
cuss, how an increase in domestic money supply 𝑀𝑀 will affect the domestic
interest rate 𝑖𝑖, the country’s level of income and the exchange rate of its
currency, assuming that investment is exogenous, 𝐼𝐼 = 𝐼𝐼 ,̅ and therefore not
a function of 𝑖𝑖.
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155
Macroeconomics. Problems and Questions
Question 9
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156
The open economy
b. Write down the approximated version of the interest parity condition, and
check how good an approximation it is by repeating the computations you
carried out when answering the previous point of this question. Finally,
suggest two possible extensions that would likely increase the degree of re-
alism of the interest parity condition in its simplest form (be it approxi-
mated or not) considered in this question.
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157
Macroeconomics. Problems and Questions
Question 10
The one-year interest rate in Japan is 1%, and the nominal exchange rate be-
tween the yen and the euro (number of yen needed to purchase one euro) is
140. Finally, assume that financial markets participants expect the euro to ap-
preciate by 5% against the yen in the following year.
a. For a European investor, what is the expected return from holding one-
year Japanese assets?
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158
The open economy
b. Suppose that financial investors care only about the expected rate of re-
turn, and therefore want to hold only the assets with the highest expected
yield. Assuming that, in Europe, the one-year interest rate is 2%, would a
European investor purchase European assets or Japanese assets? In this
example, does the (uncovered) interest parity condition hold?
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159
Macroeconomics. Problems and Questions
Question 11
Consider an economy freely trading goods, services and financial assets with
the rest of the world, in a flexible exchange rate regime. Domestic and foreign
prices are constant, and equal to one (𝑃𝑃 = 𝑃𝑃 ∗ = 1).
a. Using the pair of graphs ‘open economy IS-LM – interest parity condi-
tion’, show the initial equilibrium of the country, denoting it by ‘1’ (hint:
assume that the economy is described by a standard open economy IS-LM
model, with a central bank the central bank that chooses the interest rate).
Suppose now that the government raises its purchases of goods and ser-
vices and that, to keep equilibrium income constant, the central bank var-
ies the interest rate by implementing an open market operation. To
achieve its aim, should the central bank buy or sell bonds? In the figure,
denote by 2 the new equilibrium that will prevail after the increase in 𝐺𝐺
and the central bank intervention. In the move from 1 to 2, how will the
interest rate, the exchange rate, investment and net exports change? Ex-
plain.
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160
The open economy
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161
Macroeconomics. Problems and Questions
Question 12
Consider Alpha, an open economy with a flexible exchange rate and in which
investment is a function of 𝑌𝑌 and of the borrowing rate 𝑟𝑟 + 𝑥𝑥. Aside from this,
the country is described by a standard ‘open economy IS-LM – interest parity’
model with constant domestic and foreign prices, so that 𝑖𝑖 = 𝑟𝑟.
a. Assuming that the central bank chooses the interest rate, represent the
initial equilibrium of the economy in an ‘open economy IS-LM – inter-
est parity’ diagram, denoting it by ‘1’, and by 𝑖𝑖1 , 𝑌𝑌1 and 𝐸𝐸1 the associ-
ated values of the interest rate, output and exchange rate. Suppose now
that the risk premium on which the borrowing rate depends, 𝑥𝑥, in-
creases. In the graph, denote by ‘2’ the new equilibrium that will be
reached. In the move from the initial equilibrium ‘1’ to the new one ‘2’,
how will production, consumption, investment, the exchange rate, net
exports and the country’s money supply and money demand change?
Explain.
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162
The open economy
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b. How would your answer to the previous point change, should Alpha’s
central bank decide to intervene in order to prevent the rise in 𝑥𝑥 from
affecting production, and therefore in order to keep 𝑌𝑌 at the same level
prevailing in the initial equilibrium (‘1’)? In the graph, denote by ‘3’
the equilibrium that would be reached in this case and explain if and
why, in the move from ‘1’ to ‘3’, consumption, investment, the ex-
change rate, net exports and the country’s money supply and money
demand will change.
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163
Macroeconomics. Problems and Questions
Question 13
Consider Zeta, an open economy with a fixed exchange rate and in which in-
vestment is a function of 𝑌𝑌 and of the borrowing rate 𝑟𝑟 + 𝑥𝑥. Aside from this,
the country is described by a standard ‘open economy IS-LM – interest parity’
model with constant domestic and foreign prices, so that 𝑖𝑖 = 𝑟𝑟, in wh ich th e
foreign interest rate is, as usual, denoted by 𝑖𝑖 ∗ , and where the value at which
the central bank keep the exchange rate constant is 𝐸𝐸� = 𝐸𝐸1 , with 𝐸𝐸� 𝑒𝑒 = 𝐸𝐸� = 𝐸𝐸1 .
a. Assuming that the central bank chooses the interest rate, represent the ini-
tial equilibrium of the economy in an ‘open economy IS-LM – interest
parity’ diagram, denoting it by ‘1’, and by 𝑖𝑖1 , 𝑌𝑌1 and 𝐸𝐸1 the associated val-
ues of the interest rate, output and exchange rate. Suppose now that the
risk premium on which the borrowing rate depends, 𝑥𝑥, decreases. In the
graph, denote by ‘2’ the new equilibrium that will be reached. In the move
from the initial equilibrium ‘1’ to the new one ‘2’, how will production,
consumption, investment, net exports and the country’s money supply
and money demand change? Explain.
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164
The open economy
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b. Suppose now that, to bring back income to the level prevailing before the
fall in 𝑥𝑥 (that is, to 𝑌𝑌1 ), Zeta’s central bank decides to change from 𝐸𝐸1 to
𝐸𝐸3 the value at which the exchange rate is kept fixed, and that individuals
revise accordingly the value of the exchange rate they expect to prevail in
the future, so that the new future expected exchange rate now becomes
� = 𝐸𝐸3 . Having explained if, to achieve the central bank’s aim, 𝐸𝐸3
𝐸𝐸� 𝑒𝑒′ = 𝐸𝐸′
will have to be greater or smaller than 𝐸𝐸1 , in the pair of graphs used before
denote by ‘3’ the new equilibrium the economy will reach. Comparing the
initial equilibrium (‘1’) to the final one (‘3’), how will consumption, in-
vestment, net exports and the country’s money supply and money demand
will change? Why? Explain.
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165
Macroeconomics. Problems and Questions
Question 14
Consider an economy freely trading goods, services and financial assets with
the rest of the world. Furthermore, assume that domestic and foreign prices
are constant, and equal to one (𝑃𝑃 = 𝑃𝑃∗ = 1).
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166
The open economy
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167
Macroeconomics. Problems and Questions
Question 15
a. The world economy consists of just two countries, Alpha and Beta. Inter-
national capital mobility is perfect, and the exchange rate between the cur-
rencies of the two countries is kept fixed at the level 𝐸𝐸� . Alpha has just en-
tered a recession. To revive its economy, would you recommend Alpha the
use of monetary policy or of fiscal policy? Explain your answer and illus-
trate graphically, using the pair of graphs 'open economy IS-LM'-'interest
parity condition'.
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168
The open economy
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b. Discuss the effects of the policy intervention you have just suggested on
the trade balance of Alpha and on that of Beta, always assuming a fixed
exchange rate.
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169
Macroeconomics. Problems and Questions
Question 16
Consider an economy that trades goods, services and financial assets with the
rest of the world, under a fixed exchange rate regime. Domestic and foreign
prices are constant and, for simplicity, both equal to 1 (𝑃𝑃 = 𝑃𝑃 ∗ = 1). In the
pair of graphs ‘open economy IS-LM’-‘interest parity condition’, show the ini-
tial equilibrium, denoting by 𝑖𝑖0 , 𝑌𝑌0 and 𝐸𝐸0 the values of the interest rate, out-
put and exchange rate in that equilibrium. Market participants expect that the
exchange rate will be kept fixed at the current level 𝐸𝐸0 also in the future, so
that 𝐸𝐸 𝑒𝑒 = 𝐸𝐸0 .
a. Suppose that there is a fall in the foreign interest rate, 𝑖𝑖 ∗ , while foreign
output 𝑌𝑌 ∗ and all the other exogenous variables remain constant. Assum-
ing that the country’s central bank keeps fixing the exchange rate at 𝐸𝐸0 ,
show in the graph, and explain carefully, the effects of this exogenous de-
crease in 𝑖𝑖 ∗ on equilibrium output, interest rate, money supply and net ex-
ports of the country, denoting by ‘1’ the new equilibrium that will be
reached.
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170
The open economy
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b. How would your answer have changed if, when 𝑖𝑖 ∗ falls, foreign output 𝑌𝑌 ∗
had also gone up, rather than remaining constant? In the same graph used
before, denote by ‘2’ the equilibrium that the economy would have
reached in this case (lower 𝑖𝑖 ∗ and higher 𝑌𝑌 ∗ ) and compare it to the
equilibrium (‘1’) where the economy settles when to vary is just the foreign
interest rate. Finally, explain in which of the two cases the intervention of
the central bank (consisting in a change in the money supply aimed at
keeping the exchange rate constant) will have to be quantitatively larger.
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171
Macroeconomics. Problems and Questions
Question 17
Consider an open economy under a fixed exchange rate regime. Domestic and
foreign prices are constant and, for simplicity, both equal to 1 (𝑃𝑃 = 𝑃𝑃∗ = 1).
In the pair of graphs ‘open economy IS-LM’-‘interest parity condition’, show
the initial equilibrium, denoting it by ‘0’, and by 𝑖𝑖0 , 𝑌𝑌0 and 𝐸𝐸0 the associated
values of the interest rate, output and the exchange rate. Market participants
expect that the exchange rate will be kept fixed at the current level 𝐸𝐸0 also in
the future, so that 𝐸𝐸 𝑒𝑒 = 𝐸𝐸0 .
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172
The open economy
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b. Suppose that, before the devaluation, both the domestic country and the
rest of the world were in a medium-run equilibrium, with income at its
natural level and zero inflation. In addition, assume that the inflation rate
is determined according to the following Phillips curve:
𝜋𝜋 = (𝛼𝛼/𝐿𝐿)(𝑌𝑌 − 𝑌𝑌𝑛𝑛 )
Once price adjustment − as implied by the previous equation − is taken
into account, do you think that a devaluation can permanently affect the
level of income of a country? Why, or why not? Discuss [Hint: no formal
analysis is required; just describe the likely dynamic adjustment of the
economy following a devaluation].
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173
Macroeconomics. Problems and Questions
Question 18
Consider an open economy under a fixed exchange rate regime. Domestic and
foreign prices are constant and, for simplicity, both equal to 1 (𝑃𝑃 = 𝑃𝑃∗ = 1).
In the pair of graphs ‘open economy IS-LM’-‘interest parity condition’, show
the initial equilibrium, denoting it by ‘0’, and by 𝑖𝑖0 , 𝑌𝑌0 and 𝐸𝐸0 the associated
values of the interest rate, output and the exchange rate. Initially, market par-
ticipants expect that the exchange rate will be kept fixed at the current level 𝐸𝐸0
also in the future, so that 𝐸𝐸 𝑒𝑒 = 𝐸𝐸0 .
a. Suppose that, in the initial equilibrium, income is below its natural level.
Given that, as discussed in the answer to the previous question, a decision
to devalue leads a higher equilibrium output in a country under a fixed
exchange rate regime, individuals start expecting an impeding devalua-
tion. It follows that the future expected exchange rate decreases from
𝐸𝐸 𝑒𝑒 = 𝐸𝐸0 to 𝐸𝐸 𝑒𝑒′ = 𝐸𝐸1 , with 𝐸𝐸1 < 𝐸𝐸0 . Analyze in the graph the effects of
this downward revision in the expectations on the exchange rate that will
prevail in the future on the levels of domestic income and interest rate, as-
suming that the central bank intends to keep the exchange rate fixed at 𝐸𝐸0 .
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174
The open economy
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175
Macroeconomics. Problems and Questions
Question 19
True or False?
Explain whether the following statements are true or false. Motivate your answer
in a brief but rigorous way, by making explicit reference to the relevant theory.
Lack of proper explanations will result in zero points.
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176
The open economy
b. If financial investors only care about the expected rate of return, and
therefore want to hold only the assets with the highest expected rate of re-
turn, then from the interest parity condition it follows that, under fixed ex-
change rates, the domestic interest rate can only be equal to the foreign in-
terest rate, 𝑖𝑖 = 𝑖𝑖 ∗ .
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177
Macroeconomics. Problems and Questions
Question 20
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178
The open economy
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b. Suppose now that the government of Psi implements a fiscal policy aimed
at bringing equilibrium output back to the level it was taking on before the
decrease in θ. What happens to the trade balance in this case? Explain.
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179
Macroeconomics. Problems and Questions
Question 21
Consider an economy freely trading goods, services and financial assets with
the rest of the world, in a flexible exchange rate regime. Domestic and foreign
prices are constant, and equal to one (𝑃𝑃 = 𝑃𝑃 ∗ = 1).
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180
The open economy
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b. Suppose now that, rather than being independent of the real exchange
rate, net exports depend positively on ε – in other words, a real deprecia-
tion (appreciation) worsens (improves) the country’s trade balance. As-
suming that the remaining assumptions (exogeneity of investment, a flexi-
ble exchange rate, a central bank that chooses the interest rate, etc.) still
hold true, discuss the effects of the same monetary policy studied above
on the equilibrium levels of income, interest rate and exchange rate. Show
in the figure the new equilibrium that will be reached in this case, and ex-
plain.
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181
Macroeconomics. Problems and Questions
Question 22
Gamma is an economy that trades goods, services and financial assets with the
rest of the world, under a flexible exchange rate regime. In Gamma, changes in
the autonomous components of the demand for domestic goods are the main
cause of the observed fluctuations in real GDP. Starting from an initial equi-
librium like point ‘0’ in the graph, sometimes the level of autonomous demand
is high, leading to an 𝐼𝐼𝐼𝐼 curve such as 𝐼𝐼𝐼𝐼1 in the figure; sometimes it is however
low, so that the 𝐼𝐼𝐼𝐼 curve shifts to the left in the graph (𝐼𝐼𝐼𝐼2 ). Economists Jack
and Jill are asked which monetary policy rule − the one assumed in the 'stand-
ard' version of the IS-LM model, in which the central bank chooses a value for
the interest rate, or the alternative one, in which the central bank chooses the
nominal money supply − would, in their opinion, help minimize the variability
of output around its initial level, 𝑌𝑌0 , caused by such demand fluctuations. Jack
thinks that the best option is for the central bank to choose the interest rate,
and keep it at the chosen value; on the contrary, Jill suggests that the central
bank should choose a level for the money supply, and then let the interest rate
to take on any value that, given this choice of 𝑀𝑀, is consistent with the macroe-
conomic equilibrium.
a. In the pair of graphs ‘open economy IS-LM - interest parity condition’ be-
low, show the equilibrium levels of output that, under flexible exchange
rates, will prevail when the central bank chooses the interest rate and, fol-
lowing the fluctuations in demand just discussed, the IS curve shifts to the
right (𝐼𝐼𝐼𝐼1 ) or to the left (𝐼𝐼𝐼𝐼2 ). In the figure, make sure to denote the cor-
responding equilibrium levels of output by 𝑌𝑌1 and 𝑌𝑌2 , respectively.
𝐼𝐼𝐼𝐼1
𝑖𝑖 𝐼𝐼𝐼𝐼0 𝑖𝑖
𝐼𝐼𝐼𝐼2
0
●
𝑌𝑌0 𝑌𝑌 𝐸𝐸
182
The open economy
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b. In the same graph, denote by 𝑌𝑌1′ and 𝑌𝑌2′ the equilibrium levels of produc-
tion that, following the same changes in the autonomous components of
aggregate demand and the same shifts in the 𝐼𝐼𝐼𝐼 curve discussed before,
would prevail should the central bank choose the nominal money supply.
On the basis of your answers to this and to the previous point, do you
agree with Jack or with Jill? Provide the intuition for the lower output var-
iability in the central banks behaves in the way suggested by the economist
whose view you share.
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183
Macroeconomics. Problems and Questions
Question 23
a. We are at time 𝑡𝑡. Use the non-approximated form of the interest parity
condition to write the current period exchange rate, 𝐸𝐸𝑡𝑡 , as a function of the
current and future expected interest rates for each year over the next 𝑛𝑛
𝑒𝑒
years, as well as of the expected exchange rate for time 𝑡𝑡 + 𝑛𝑛 + 1, 𝐸𝐸𝑡𝑡+𝑛𝑛+1 .
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184
The open economy
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185
Chapter 6 - Government debt and economic growth
Macroeconomics. Problems and Questions
* Question 1
[A graphical analysis of the evolution of the debt-to-GDP ratio]
Write down the government budget constraint as an equation that, for given
values of the real interest rate (𝑟𝑟), of the growth rate of the economy (𝑔𝑔) and
of the primary deficit-to-GDP ratio (𝑑𝑑), relates the debt-to-GDP ratio (𝐵𝐵⁄𝑌𝑌)
at time 𝑡𝑡 to the value of the same ratio at time 𝑡𝑡 − 1. Use that equation to
graphically analyze the evolution of the ratio 𝐵𝐵⁄𝑌𝑌 in the following four cases,
providing the intuition underlying your conclusions:
𝐵𝐵𝑡𝑡 45°
𝑌𝑌𝑡𝑡
0 𝐵𝐵𝑡𝑡−1
𝑏𝑏𝑡𝑡−1
𝑌𝑌𝑡𝑡−1
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188
Government debt and economic growth
𝐵𝐵𝑡𝑡 45°
𝑌𝑌𝑡𝑡
0 𝐵𝐵𝑡𝑡−1
𝑏𝑏𝑡𝑡−1
𝑌𝑌𝑡𝑡−1
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189
Macroeconomics. Problems and Questions
𝐵𝐵𝑡𝑡 45°
𝑌𝑌𝑡𝑡
0 𝐵𝐵𝑡𝑡−1
𝑏𝑏𝑡𝑡−1
𝑌𝑌𝑡𝑡−1
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190
Government debt and economic growth
𝐵𝐵𝑡𝑡 45°
𝑌𝑌𝑡𝑡
0 𝐵𝐵𝑡𝑡−1
𝑏𝑏𝑡𝑡−1
𝑌𝑌𝑡𝑡−1
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191
Macroeconomics. Problems and Questions
Question 2
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192
Government debt and economic growth
b. Suppose now that the government intends to stabilize 𝑏𝑏 at the value ob-
served at 𝑡𝑡 = 0. In other words, the government wants 𝑏𝑏 to continue to
take on the value 1 both in period 𝑡𝑡 = 1 and in all subsequent periods. To
achieve this goal, the Government is considering the possibility of generat-
ing a permanent change in the ratio of the primary deficit to GDP. Com-
pute the value that this ratio should take on to stabilize 𝑏𝑏 at the value 1
forever, and explain whether it implies that the Government should im-
plement a restrictive or an expansionary fiscal policy.
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193
Macroeconomics. Problems and Questions
Question 3
At time 𝑡𝑡, a country inherits from the previous period a stock of government
0
debt greater than zero, corresponding to the debt-to-GDP ratio 𝑏𝑏𝑡𝑡−1 in the
graph below. Assuming that the real interest rate is smaller than the rate of
growth of the economy, and that the government runs a primary surplus,
a. show in the graph the steady state debt-to-GDP ratio in this economy and ex-
plain if, absent any intervention, the debt-to-GDP ratio of the country will
converge or not to this stationary level;
𝐵𝐵𝑡𝑡 45°
𝑌𝑌𝑡𝑡
0 𝐵𝐵𝑡𝑡−1
𝑏𝑏𝑡𝑡−1
𝑌𝑌𝑡𝑡−1
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194
Government debt and economic growth
b. show in the graph the change in the ratio between the primary balance
0
and GDP needed to stabilize the debt-to-GDP ratio at the value 𝑏𝑏𝑡𝑡−1
from time 𝑡𝑡 onwards. Explain.
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195
Macroeconomics. Problems and Questions
Question 4
debt/GDP line
𝐵𝐵𝑡𝑡 In the figure, the bold straight
45° line, that gives the time 𝑡𝑡
𝑌𝑌𝑡𝑡 debt/GDP ratio as a function of
the same ratio in the previous
period, is parallel to the 45° line
going through the origin.
In this economy, what is the
𝐵𝐵𝑡𝑡−1 relative size of the growth rate
0
𝑏𝑏𝑡𝑡−1 of real GDP and of the real in-
𝑌𝑌𝑡𝑡−1
terest rate? Is the government
running a primary deficit or a
primary surplus? Explain.
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196
Government debt and economic growth
0
b. Assuming that the debt-to-GDP ratio at time 𝑡𝑡 − 1 was 𝑏𝑏𝑡𝑡−1 , show in the
graph the values that this ratio will take on at times 𝑡𝑡 and 𝑡𝑡 + 1. Will the
debt-to-GDP ratio converge to a steady state value 𝑏𝑏�? If not, why? If yes,
show in the figure this steady state value and explain whether it is stable
(that is, if 𝑏𝑏 will converge to it independently of the value of the debt-to-
0
GDP ratio inherited from the past, 𝑏𝑏𝑡𝑡−1 ) or unstable (in which case, 𝑏𝑏 will
0
take on the steady state value if and only if 𝑏𝑏𝑡𝑡−1 = 𝑏𝑏�).
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197
Macroeconomics. Problems and Questions
Question 5
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198
Government debt and economic growth
b. Suppose now that, rather than a deficit, the same country runs a primary
surplus of 6% of GDP. How would your answer to the previous point of
this question change? Compute the debt ratio at times 𝑡𝑡 = 1 and 𝑡𝑡 = 2,
and its steady state value, 𝑏𝑏�. Will the debt ratio converge to 𝑏𝑏�? Explain, us-
ing the graph below to motivate your conclusions.
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199
Macroeconomics. Problems and Questions
Question 6
We are at time 𝑡𝑡. The economy inherits from the previous period a debt-to-
0
GDP ratio 𝑏𝑏𝑡𝑡−1 . Consider the following graph:
45°
𝐵𝐵𝑡𝑡
𝑌𝑌𝑡𝑡
Debt/GDP
line
𝑏𝑏� 0
𝑏𝑏𝑡𝑡−1 𝐵𝐵𝑡𝑡−1
𝑌𝑌𝑡𝑡−1
a. In this economy, is the GDP growth rate higher or lower than the real
interest rate? Is the government running a primary surplus or a prima-
ry deficit? Finally, is the debt ratio b� a stable or an unstable steady
state? Explain.
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200
Government debt and economic growth
b. Suppose now that, at time 𝑡𝑡, the Government intends to stabilize the
0
debt-to-GDP ratio at the level 𝑏𝑏𝑡𝑡−1 by changing the economy’s growth
rate. To achieve its aim, should it attempt to increase or to decrease
that growth rate? Show how your answer is going to affect the graph
used to answer the previous question, and discuss.
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201
Macroeconomics. Problems and Questions
* Question 7
a. Consider a country with a zero primary deficit-to-GDP ratio (𝑑𝑑 = 0), and
in which the real interest rate and the rate of growth of the economy are
constant and equal to 𝑟𝑟 = 𝑟𝑟̅ and 𝑔𝑔 = 𝑔𝑔̅ , respectively, with 𝑟𝑟̅ < 𝑔𝑔̅ and 1 +
𝑟𝑟̅ − 𝑔𝑔̅ > 0. Write down the equation that gives the dynamics of the debt-to-
GDP ratio for this economy (the government budget constraint) and de-
rive the steady state value of that ratio. Assuming that at time 𝑡𝑡 the econ-
0
omy inherits from the past a debt-to-GDP ratio equal to 𝑏𝑏𝑡𝑡−1 > 0, explain
if, and why, the economy will ever converge to that steady state. Use the
graph below to motivate your answer.
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202
Government debt and economic growth
b. Suppose now that the interest rate at which the government can borrow is
no longer equal to 𝑟𝑟̅ , but rather to 𝑟𝑟̅ + 𝑣𝑣𝑏𝑏𝑡𝑡−1 , where 𝑣𝑣 is a positive parame-
ter. In other words, the real interest rate is no longer constant, but increas-
ing in the debt-to-GDP ratio (𝑏𝑏) prevailing in the last period. The growth
rate of the economy is however stiIl constant and, as before, 𝑟𝑟̅ < 𝑔𝑔̅ and 1 +
𝑟𝑟̅ − 𝑔𝑔̅ > 0. Repeat the analysis carried out in order to answer the previous
point of this question. In particular, derive the expression of the steady
state debt-to-GDP ratio, explain if and why 𝑏𝑏 will converge to a steady
state, and represent graphically.
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203
Macroeconomics. Problems and Questions
Question 8
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204
Government debt and economic growth
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b. Assuming that the economy is initially in the steady state just described,
explain and represent graphically what happens to capital per worker,
output per worker and the growth rate of the economy following a reduc-
tion in the marginal propensity to consume.
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205
Macroeconomics. Problems and Questions
Question 9
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206
Government debt and economic growth
b. Assuming that the economy is initially in the steady state just described,
explain, and show in the graph, what happens to capital per worker, out-
put per worker and the growth rate of the economy following an increase
in the rate of depreciation, 𝛿𝛿.
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207
Macroeconomics. Problems and Questions
Question 10
a. Assuming that there is no technological progress and that both the private
saving rate and the population of the country are constant, show in the
graph below the impact of the emergence of a budget deficit (that is, of the
increase in 𝜌𝜌 from zero to a positive value) on output per worker and capi-
tal per worker in the Solow growth model. Explain.
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208
Government debt and economic growth
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b. Will the budget deficit permanently affect the growth rate of the econo-
my? Explain.
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209
Macroeconomics. Problems and Questions
Question 11
True or False?
Explain whether the following statements are true or false. Motivate your answer
in a brief but rigorous way, by making explicit reference to the relevant theory.
Lack of proper explanations will result in zero points.
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210
Government debt and economic growth
b.1 an increase in the saving rate 𝑠𝑠 will always raise steady state output
per worker;
b.2 an increase in the saving rate 𝑠𝑠 will always raise steady state con-
sumption per worker.
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211
Macroeconomics. Problems and Questions
Question 12
a. Using the Solow model with technological progress, and assuming the
economy was initially in a steady state equilibrium, study in the graph be-
low the effects of a decrease in the saving rate on capital and output per ef-
fective worker, briefly explaining the reasons for the observed changes in
these variables.
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212
Government debt and economic growth
b. How would capital and output per effective worker change following an
increase in the rate of technological progress?
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213
Macroeconomics. Problems and Questions
Question 13
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214
Government debt and ieconomic growth
b. Explain if and why you agree, or do not agree, with the following state-
ments:
b.2 the Solow model implies that, if the growth rate of population
𝑔𝑔𝑁𝑁 increases, the economy will reach a new steady state where
the growth rate of aggregate output 𝑌𝑌 is unchanged, and the
growth rate output per worker 𝑌𝑌⁄𝑁𝑁 is lower.
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215
Part II
Solutions
Chapter 1 - The goods and financial markets
Macroeconomics. Problems and Questions
Question 1
In the economy there are only two firms, firm A and firm B. Their operations
in a given year can be summarized as follows (all figures are in thousands of
Euros):
Firm A
Costs Revenues
Wages Sales to B
170 300
Indirect taxes
30
Firm B
Costs Revenues
Wages Sales to A
230 50
Compute the economy’s Gross Domestic Product (GDP) using all the defini-
tions of this variable that it is possible to employ in this case.
220
The goods and financial markets
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a. GDP is the value of the final goods and services produced in the economy:
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Value of final goods and services produced by firm A = 400 (sales to con-
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sumers);
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Value of final goods and services produced by firm B = 500 (sales to the
public) + 100 (exports, which are always a final use of the goods pro-
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duced in a country – why?) = 600
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GDP = 400 + 600 = 1000.
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1. An alternative, and fully equivalent, way of computing GDP is as the sum
of the value added (V.A.) by all the firms in the economy:.
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V.A. A = (300+ 400) – 50 = 650;
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V.A. B = (50 + 500+100) – 300 = 350;
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GDP = 650 + 350 = 1000.
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2. Finally, in this economy, GDP = Incomes + Indirect taxes, where incomes
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are in this case the sum of profits (revenues – costs) and wages.
Firm A’s profits = (300 + 400) – (170 + 50 + 30) = 450;
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Firm B’s profits = (50 + 500 + 100) – (230 + 300 + 20) =100;
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Wages paid by A = 170; Wages paid by B = 230.
In addition, indirect taxes = 30 + 20 = 50.
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It follows that GDP = 450 +100 + 170 + 230 + 50 = 1000.
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221
Macroeconomics. Problems and Questions
Question 2
a. What is meant by ‘GDP deflator’? How is the GDP deflator computed, and
how is it used?
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The GDP deflator for year 𝑡𝑡, 𝑃𝑃𝑡𝑡 , is computed by dividing nominal GDP by re-
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al GDP in year 𝑡𝑡:
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€𝑌𝑌𝑡𝑡
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𝑃𝑃𝑡𝑡 = ,
𝑌𝑌𝑡𝑡
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where €𝑌𝑌𝑡𝑡 and 𝑌𝑌𝑡𝑡 are year 𝑡𝑡 nominal GDP and real GDP, respectively.
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The GDP deflator is an index number with very wide coverage (it reflects the
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prices of all goods and services taken into account when measuring GDP –
that is, all the final goods and services produced in the economy). It takes on
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the value 1 in the base year, and its changes between consecutive years are
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one of the possible measures of the rate of inflation – the change over time in
the general price level.
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222
The goods and financial markets
b. Compared to the previous year (𝑡𝑡 − 1), in year 𝑡𝑡 the economy’s GDP
deflator has gone down by 1% and the real GDP growth rate has been
equal to −2%.
b.1 Compute the growth rate of nominal GDP for this economy in year 𝑡𝑡.
b.2 What is the rate at which the economy under consideration has been
growing in year 𝑡𝑡 ?
b.1 The definition of GDP deflator given when answering the previous point
of this question implies that year 𝑡𝑡 nominal GDP, €𝑌𝑌𝑡𝑡 , can be written
as the product between the GDP deflator and real GDP for the same
year:
€𝑌𝑌𝑡𝑡 = 𝑃𝑃𝑡𝑡 · 𝑌𝑌𝑡𝑡 .
It follows that the rate of growth of nominal GDP is (approximately)
equal to the sum of the rate of change of the GDP deflator and the rate
of change of real GDP. In the economy we have been asked to consider,
the growth rate of nominal GDP in year 𝑡𝑡 therefore amounts to
(−1%) + (−2%) = −3%.
b.2 The ‘rate of growth of the economy’ is the rate of change of real GDP
between two consecutive years. It follows that, in year 𝑡𝑡, the economy
has been growing at a rate of −2%.
223
Macroeconomics. Problems and Questions
Question 3
The economy of a country in which only the goods market exists is described
by the following system of equations,
𝐶𝐶 = 𝑐𝑐0
𝐼𝐼 = 𝐼𝐼 ̅
𝐺𝐺 = 𝐺𝐺̅
𝑇𝑇 = 𝑇𝑇� + 𝑡𝑡𝑡𝑡
where, as always, the positive constant 𝑐𝑐0 is autonomous consumption, 𝑡𝑡 (a
constant between zero and one) is the tax rate, 𝑇𝑇� (> 0) is the portion of net
taxes that does not depend on income, and the other symbols have the usual
meaning.
45°
𝑍𝑍, 𝑌𝑌
𝑐𝑐0 + 𝐼𝐼 ̅ + 𝐺𝐺̅
𝑌𝑌� 𝑌𝑌
224
The goods and financial markets
b. Suppose that the government cuts 𝑇𝑇� (that, as you will remember, is the
fraction of net taxes independent of income), so that ∆𝑇𝑇� < 0. Show in the
graph the effects of this change and, using the results derived when an-
swering the previous point of this question, derive the analytical expres-
sions of the changes in equilibrium production, private saving, govern-
ment saving and national saving caused by this decrease in 𝑇𝑇�.
Since the demand for goods does not depend on 𝑇𝑇�, in the graph no curve will
shift, and equilibrium income will therefore remain unchanged. Being ∆𝑌𝑌� = 0,
private saving 𝑆𝑆̂𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 = �𝑌𝑌� − 𝑇𝑇� − 𝑡𝑡𝑌𝑌�� − 𝐶𝐶 = (1 − 𝑡𝑡)𝑌𝑌� − 𝑇𝑇� − 𝑐𝑐0 will rise by
∆𝑆𝑆̂𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 = −∆𝑇𝑇�, government saving 𝑆𝑆̂𝑔𝑔𝑔𝑔𝑔𝑔 = 𝑇𝑇 − 𝐺𝐺̅ = 𝑇𝑇� + 𝑡𝑡𝑌𝑌� − 𝐺𝐺̅ will fall by
∆𝑆𝑆̂𝑔𝑔𝑔𝑔𝑔𝑔 = ∆𝑇𝑇�, and national saving will not change, since ∆𝑆𝑆̂𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 + ∆𝑆𝑆̂𝑔𝑔𝑔𝑔𝑔𝑔 = 0.
225
Macroeconomics. Problems and Questions
Question 4
The economy of a country in which only the goods market exists is described
by the following system of equations:
𝐶𝐶 = 𝑐𝑐0
𝐼𝐼 = 𝐼𝐼 ̅ + 𝑑𝑑1 𝑌𝑌
𝐺𝐺 = 𝐺𝐺̅ − 𝑔𝑔1 𝑌𝑌
𝑇𝑇 = 𝑇𝑇� + 𝑡𝑡𝑡𝑡
45°
𝑍𝑍, 𝑌𝑌 𝑍𝑍′
2
𝑍𝑍
1
𝑐𝑐0 + 𝐼𝐼 ̅ + 𝐺𝐺̅
𝑌𝑌� 𝑌𝑌�′ 𝑌𝑌
226
The goods and financial markets
Writing down the goods market equilibrium condition, and solving for Y, one
gets the following expression for equilibrium income (the value of Y corre-
sponding to point 1 in the figure):
𝑐𝑐0 + 𝐼𝐼 ̅ + 𝐺𝐺̅
𝑌𝑌� = ,
1 − (𝑑𝑑1 − 𝑔𝑔1 )
from which it follows that the multiplier is
1
.
1 − (𝑑𝑑1 − 𝑔𝑔1 )
b. Suppose that the government raises, at the same time and by the same
amount, both 𝐺𝐺̅ and 𝑇𝑇�, so that ∆𝐺𝐺̅ = ∆𝑇𝑇� > 0. Show in the graph the effects
of these changes and, using the results derived when answering the previous
point of this question, derive the analytical expressions of the changes in
equilibrium production, private saving, government saving and national
saving caused by the increases in 𝐺𝐺̅ and in 𝑇𝑇�. In your answer, make sure to
discuss in each case why reaching a definite conclusion about the direction
in which those variables will change is possible, or not possible.
When ∆𝐺𝐺̅ = ∆𝑇𝑇� > 0, the aggregate demand curve in the figure shifts upwards
in a parallel fashion by ∆𝐺𝐺̅ , and the new equilibrium becomes point 2. From the
expression for 𝑌𝑌� just derived, it follows that equilibrium income goes up by
1
∆𝑌𝑌� = ∆𝐺𝐺̅ (> 0).
1 − (𝑑𝑑1 − 𝑔𝑔1 )
The change in private saving will be
(𝑑𝑑1 − 𝑔𝑔1 ) − 𝑡𝑡
∆𝑆𝑆̂𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 = ∆�𝑌𝑌� − 𝑇𝑇� − 𝑡𝑡𝑌𝑌�� = (1 − 𝑡𝑡)∆𝑌𝑌� − ∆𝐺𝐺̅ = ∆𝐺𝐺̅ ,
1 − (𝑑𝑑1 − 𝑔𝑔1 )
a quantity whose sign is uncertain, without further information on the relative
sizes of the parameters 𝑡𝑡, 𝑑𝑑1 and 𝑔𝑔1 , while government saving will rise for sure
by
𝑡𝑡 + 𝑔𝑔1
∆𝑆𝑆̂𝑔𝑔𝑔𝑔𝑔𝑔 = ∆𝑇𝑇� + 𝑡𝑡∆𝑌𝑌� − ∆𝐺𝐺̅ + 𝑔𝑔1 ∆𝑌𝑌� = ∆𝐺𝐺̅ (> 0).
1 − (𝑑𝑑1 − 𝑔𝑔1 )
Finally, and although without more information it is not possible to determine
the direction in which private saving will change, it is easy to conclude that
national saving will go up, since
𝑑𝑑1
∆𝑆𝑆̂𝑛𝑛𝑛𝑛𝑛𝑛 = ∆𝐼𝐼 = ∆𝐺𝐺̅ (> 0).
1 − (𝑑𝑑1 − 𝑔𝑔1 )
227
Macroeconomics. Problems and Questions
Question 5
a. Derive the expression for the equilibrium level of income and that of
the multiplier for this economy.
Using the first four equations into the last one, the goods market equilibrium
condition, and solving for 𝑌𝑌, one gets the following expression for the equilib-
rium level of income:
1
𝑌𝑌� = ⋅ [𝑐𝑐 − 𝑐𝑐1 𝑇𝑇� + 𝐼𝐼 ̅ + 𝐺𝐺̅ ] ,
1 − 𝑐𝑐1 (1 − 𝑡𝑡) 0
where the term in square brackets is autonomous spending, and the multiplier
is the ratio
1
.
1 − 𝑐𝑐1 (1 − 𝑡𝑡)
228
The goods and financial markets
229
Macroeconomics. Problems and Questions
Question 6
The economy of a country in which only the goods market exists is described
by the following system of equations:
𝐶𝐶 = 𝑐𝑐0 + 𝑐𝑐1 (𝑌𝑌 − 𝑇𝑇)
𝐼𝐼 = 𝐼𝐼 ̅
𝐺𝐺 = 𝐺𝐺̅
𝑇𝑇 = 𝑇𝑇�
where the various symbols have the usual meaning.
a. Derive the expressions of equilibrium income and of the multiplier for this
economy.
45°
𝑍𝑍, 𝑌𝑌 𝑍𝑍′
2
𝑍𝑍
1
𝐴𝐴
𝑌𝑌� 𝑌𝑌�′ 𝑌𝑌
230
The goods and financial markets
b. Suppose that, when the economy was in the equilibrium position de-
scribed above, investment rises, and that the Government cuts 𝑇𝑇� by the
same amount by which 𝐼𝐼 ̅ has gone up, so that ∆𝐼𝐼 ̅ = −∆𝑇𝑇� > 0. Show in the
graph the effects of these two contemporaneous changes and, using the re-
sults derived when answering the previous point, derive the analytical ex-
pressions of the changes in equilibrium production, private saving, gov-
ernment saving and national saving they will cause. In your answer, make
sure to discuss in each case why reaching a definite conclusion about the
direction in which those variables will vary is possible, or not possible.
When ∆𝐼𝐼 ̅ = −∆𝑇𝑇� > 0, the aggregate demand curve in the figure shifts up-
wards in a parallel fashion by (1 + 𝑐𝑐1 )∆𝐼𝐼 ,̅ and the new equilibrium becomes
point 2. From the expression for 𝑌𝑌� just derived, it follows that equilibrium
income goes up by
1 + 𝑐𝑐1
𝑌𝑌� = ∆𝐼𝐼 ̅ (> 0).
1 − 𝑐𝑐1
The change in equilibrium private saving 𝑆𝑆̂𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 = �𝑌𝑌� − 𝑇𝑇�� − 𝐶𝐶̂ will be
2∆𝐼𝐼 ̅
∆𝑆𝑆̂𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 = ∆�𝑌𝑌� − 𝑇𝑇�) − 𝑐𝑐1 ∆(𝑌𝑌� − 𝑇𝑇�� = (1 − 𝑐𝑐1 ) = 2∆𝐼𝐼 ,̅
1 − 𝑐𝑐1
a positive quantity. Since government saving, equal to the difference between
𝑇𝑇 and 𝐺𝐺, varies by ∆𝑇𝑇� = −∆𝐼𝐼 ̅ (< 0), national saving (the sum of private and
government saving) rises by ∆𝐼𝐼.̅ [Alternatively: since investment goes up by
∆𝐼𝐼,̅ in equilibrium national saving will have to rise by the same amount; given
that government saving falls by ∆𝐼𝐼,̅ it follows that private saving will increase
by 2∆𝐼𝐼]̅ .
231
Macroeconomics. Problems and Questions
Question 7
The economy of a country in which only the goods market exists is described
by the following system of equations,
𝐶𝐶 = 𝑐𝑐0
𝐼𝐼 = 𝐼𝐼 ̅
𝐺𝐺 = 𝐺𝐺̅ − 𝑔𝑔𝑔𝑔
𝑇𝑇 = 𝑇𝑇� + 𝑡𝑡𝑡𝑡
where, as always, the positive constant 𝑐𝑐𝑜𝑜 is autonomous consumption, 𝑡𝑡 (a
constant between zero and one) is the tax rate, 𝑔𝑔 (> 0) is the sensitivity to in-
come of government spending on goods and services, and the other symbols
have the usual meaning.
232
The goods and financial markets
When ∆𝐺𝐺̅ = ∆𝑇𝑇� < 0, in equilibrium the government deficit will change by
� = ∆𝐺𝐺̅ − 𝑔𝑔∆𝑌𝑌� − ∆𝑇𝑇� − 𝑡𝑡∆𝑌𝑌� = −(𝑔𝑔 + 𝑡𝑡)∆𝑌𝑌�.
∆𝐷𝐷𝐷𝐷𝐷𝐷
Plugging in this equation the expression for the change in equilibrium income
when ∆𝐺𝐺̅ = ∆𝑇𝑇� < 0, that is, ∆𝑌𝑌� = [1⁄(1 + 𝑔𝑔)] ∙ ∆𝐺𝐺̅ , yields
𝑔𝑔 + 𝑡𝑡
� =−
∆𝐷𝐷𝐷𝐷𝐷𝐷 ∙ ∆𝐺𝐺̅ .
1 + 𝑔𝑔
Since ∆𝐺𝐺̅ < 0, the government deficit will unambiguously rise, and this
independently of the relative size of the two parameters 𝑡𝑡 and 𝑔𝑔. The
intuition is as follows: if 𝐺𝐺 and 𝑇𝑇 did not depend on 𝑌𝑌 (in other words, if 𝑔𝑔 =
𝑡𝑡 = 0), cutting 𝐺𝐺̅ and 𝑇𝑇� by the same amount would not change the government
deficit; however, since ∆𝐺𝐺̅ < 0 decreases equilibrium income, and given that
when income goes down government outlays rise (remember that 𝑔𝑔 > 0), and
government revenues (net taxes) fall (since 𝑡𝑡 > 0), in this economy ∆𝐺𝐺̅ =
∆𝑇𝑇� < 0 will unambigously increase the government deficit, and this
independently of 𝑡𝑡 being greater, rather than smaller, than 𝑔𝑔.
233
Macroeconomics. Problems and Questions
Question 8
where the parameter 𝑡𝑡 (the tax rate) is positive, but smaller than one, 𝑑𝑑1 (> 0)
is the sensitivity of investment to income, 𝑐𝑐1 + 𝑑𝑑1 < 1, and the other symbols
have the usual meaning.
a. Derive the expressions of equilibrium income and of the multiplier for this
economy.
Equilibrium income, 𝑌𝑌�, is the value of Y that solves the goods market
equilibrium condition (the last equation of the model above). Using the first
four equations in the fifth one, and solving, one gets
𝑐𝑐0 − 𝑐𝑐1 𝑇𝑇� + 𝐼𝐼 ̅ + 𝐺𝐺̅
𝑌𝑌� = .
1 − 𝑐𝑐1 − 𝑑𝑑1 + 𝑡𝑡𝑐𝑐1
It follows that the multiplier is the ratio
1
.
1 − 𝑐𝑐1 − 𝑑𝑑1 + 𝑡𝑡𝑐𝑐1
234
The goods and financial markets
235
Macroeconomics. Problems and Questions
Question 9
Country Macro, where only the good market exists and prices are constant, is
described by the following model:
�������
𝐶𝐶 = 𝑐𝑐0 + 𝑐𝑐1 (𝑌𝑌 − 𝑇𝑇) + 𝑎𝑎 𝑊𝑊𝑊𝑊𝑊𝑊
𝑇𝑇 = 𝑇𝑇�
𝐼𝐼 = 𝐼𝐼 ̅ + 𝑑𝑑1 𝑌𝑌
𝐺𝐺 = 𝐺𝐺̅
𝑌𝑌 = 𝐶𝐶 + 𝐼𝐼 + 𝐺𝐺.
In the equations above, 0 < 𝑐𝑐1 < 1, 𝑑𝑑1 > 0, 0 < 𝑐𝑐1 + 𝑑𝑑1 < 1, the parameter
𝑎𝑎 (> 0) is the sensitivity of consumption to the financial and housing wealth
𝑊𝑊𝑊𝑊𝑊𝑊 (assumed to be exogenous, so that 𝑊𝑊𝑊𝑊𝑊𝑊 = 𝑊𝑊𝑊𝑊𝑊𝑊������� ), and the other
symbols have the usual meaning.
Equilibrium income, 𝑌𝑌�, is the value of Y that solves the goods market equilib-
rium condition (the last equation of the model above). Using the first four
equations in the fifth one, and solving, one gets
236
The goods and financial markets
Private saving is the portion of their disposable income individuals decide not
to consume, 𝑆𝑆 = (𝑌𝑌 − 𝑇𝑇) − 𝐶𝐶. Using in this expression the consumption
function for Macro (first equation of the model above), it follows that, in
equilibrium, private saving is 𝑆𝑆̂ = −𝑐𝑐0 + (1 − 𝑐𝑐1 )�𝑌𝑌� − 𝑇𝑇�� − 𝑎𝑎 �������
𝑊𝑊𝑊𝑊𝑊𝑊 . If indi-
������� > 0, equilibrium income
viduals’ financial and housing wealth rises by 𝛥𝛥𝑊𝑊𝑊𝑊𝑊𝑊
������� . It follows that, in equilibrium, pri-
will rise by the multiplier times 𝑎𝑎𝛥𝛥𝑊𝑊𝑊𝑊𝑊𝑊
vate saving will change by
�������
𝑎𝑎𝑎𝑎𝑊𝑊𝑊𝑊𝑊𝑊
𝛥𝛥𝑆𝑆̂ = (1 − 𝑐𝑐1 )𝛥𝛥𝑌𝑌� − 𝑎𝑎𝑎𝑎𝑊𝑊𝑊𝑊𝑊𝑊
������� = (1 − 𝑐𝑐1 ) · �������
− 𝑎𝑎𝛥𝛥𝑊𝑊𝑊𝑊𝑊𝑊
1 − (𝑐𝑐1 + 𝑑𝑑1 )
𝑑𝑑1
= ������� > 0.
· 𝑎𝑎 𝛥𝛥𝑊𝑊𝑊𝑊𝑊𝑊
1 − (𝑐𝑐1 + 𝑑𝑑1 )
Private saving will be higher. For a given disposable income, the increase in
𝑊𝑊𝑊𝑊𝑊𝑊 leads individuals to save less, and consume more. However, this increase
in consumption raises equilibrium income, and therefore saving. Although
these two forces push saving in opposite directions, to prevail must necessarily
be the second one, and private saving will go up, as made clear by the equation
above. An alternative, and fully equivalent, way to arrive to the same conclu-
sion is to recall that, in goods market equilibrium, investment and national
saving must be equal. Since the rise in wealth leads to more consumption and
a higher income, in the new equilibrium investment (which depends positively
on Y) will be higher. It follows that, in the new equilibrium, national saving
must be higher, too. Since government saving is unchanged, the increase in na-
tional saving can only follow from an increase in private saving.
237
Macroeconomics. Problems and Questions
Question 10
where the parameters 𝑐𝑐1 and 𝑡𝑡 are positive but smaller than one. In this coun-
try, autonomous consumption 𝑐𝑐0 is therefore equal to zero, government pur-
chases of goods and services and investment are entirely exogenous, and net
taxes depend on consumption – as they include not just an exogenous compo-
nent (𝑇𝑇�), but also a portion that is increasing in consumption (𝑡𝑡𝑡𝑡).
a. Plugging the expression for net taxes given by the second equation into
the first one, and solving for 𝐶𝐶, derive the expression that the consump-
tion function takes on in this economy. Next, using the definition of (pri-
vate) saving and the consumption function you have just derived, write
down the (private) saving function. In this economy, is private saving still
increasing in income, 𝑌𝑌, as it is in the standard case? Why, or why not?
Explain.
Plugging the expression for net taxes given by the second equation into the
first one, yields:
...........................................................................................................................
𝐶𝐶 = 𝑐𝑐1 𝑌𝑌 − 𝑐𝑐1 𝑇𝑇� − 𝑐𝑐1 𝑡𝑡𝑡𝑡.
...........................................................................................................................
Solving for 𝐶𝐶, the consumption function for this economy can be written as
...........................................................................................................................
𝑐𝑐1
𝐶𝐶 = (𝑌𝑌 − 𝑇𝑇�).
...........................................................................................................................
1 + 𝑐𝑐1 𝑡𝑡
Using this expression for 𝐶𝐶 and 𝑇𝑇 = 𝑇𝑇� + 𝑡𝑡𝑡𝑡 in the definition of private sav-
....................................
ing, 𝑆𝑆 = (𝑌𝑌 − 𝑇𝑇) − 𝐶𝐶, one gets:
1 − 𝑐𝑐1
𝑆𝑆 = � � (𝑌𝑌 − 𝑇𝑇�),
1 + 𝑐𝑐1 𝑡𝑡
a quantity that depends positively on 𝑌𝑌, since 𝑐𝑐1 , the marginal propensity to
consume out of disposable income, is less than one. As usual, also in this
economy private saving is therefore increasing in the level of income.
238
The goods and financial markets
b. Using the results derived when answering the previous point, write down
the expression of the government deficit (𝐷𝐷𝐷𝐷𝐷𝐷) for this economy. Is the
country’s government deficit increasing or decreasing in the level of in-
come, 𝑌𝑌? Why? Provide the economic intuition for your answer.
..................
From the results above, it follows that, in this economy,
𝑡𝑡𝑐𝑐1
𝐷𝐷𝐷𝐷𝐷𝐷 = 𝐺𝐺 − 𝑇𝑇 = 𝐺𝐺̅ − 𝑇𝑇� − (𝑌𝑌 − 𝑇𝑇�).
1 + 𝑐𝑐1 𝑡𝑡
The government deficit is therefore smaller the larger is the economy’s in-
come. This is so because an increase in 𝑌𝑌 does not change the government’s
purchases of goods and services, which are entirely exogenous; by raising con-
sumption, it however leads to an increase in net taxes (see the second equation
of the model describing this economy), and therefore in government revenues.
239
Macroeconomics. Problems and Questions
Question 11
...........................................................................................................................
The equilibrium level of output is the value of Y that solves the goods market
equilibrium condition (the last equation of the model above), that is
...........................................................................................................................
𝑐𝑐0 − 𝑐𝑐1 𝑇𝑇� + 𝐼𝐼 ̅ + 𝐺𝐺̅
...........................................................................................................................
𝑌𝑌� = .
1 − 𝑐𝑐1 − 𝑑𝑑1
...........................................................................................................................
Following a simultaneous change in 𝐺𝐺̅ and 𝑇𝑇�, in order to have 𝛥𝛥𝑌𝑌� = 0 it must
...........................................................................................................................
be the case that 𝛥𝛥𝐺𝐺̅ = 𝑐𝑐1 𝛥𝛥𝑇𝑇�. Using this result in 𝛥𝛥𝛥𝛥𝛥𝛥𝛥𝛥 = 𝛥𝛥𝐺𝐺̅ − 𝛥𝛥𝑇𝑇�, the
change in the government deficit can be written as 𝛥𝛥𝛥𝛥𝛥𝛥𝛥𝛥 = 𝑐𝑐1 𝛥𝛥𝑇𝑇� − 𝛥𝛥𝑇𝑇� =
...........................................................................................................................
(𝑐𝑐1 − 1)𝛥𝛥𝑇𝑇�, which is less than zero if 𝛥𝛥𝑇𝑇� > 0 (remember that 0 < 𝑐𝑐1 < 1).
...........................................................................................................................
It is easy to see that raising net taxes by 𝛥𝛥𝑇𝑇� and 𝐺𝐺̅ by 𝛥𝛥𝐺𝐺̅ = 𝑐𝑐1 𝛥𝛥𝑇𝑇� (< 𝛥𝛥𝑇𝑇�)
...........................................................................................................................
leads to a lower deficit. The reason why income does not change is that the
decision to increase net taxes by 𝛥𝛥𝑇𝑇� leads to an equal fall in disposable in-
...........................................................................................................................
come and, for a given 𝑌𝑌, lowers consumption by 𝑐𝑐1 𝛥𝛥𝑇𝑇�; however, this drop in
consumption is offset by the increase in 𝐺𝐺̅ by 𝑐𝑐1 𝛥𝛥𝑇𝑇� . Since aggregate demand
...........................................................................................................................
does not change, equilibrium income will not change either. Cher is right.
...........................................................................................................................
240
The goods and financial markets
b. Consider now a different country, one in which there is only a goods market
described by the same set of equations specified above. Write down the goods
market equilibrium condition as an equality between national (private plus
public) saving and investment, and assume that the country’s government de-
cides to raise net taxes, 𝑇𝑇�. In the new equilibrium, national and private saving
will be larger or smaller than before? [Hint: you are NOT being asked to com-
pute the expressions for the change in private and national saving, but just to
provide the economic intuition that helps determine the direction in which they
will change].
..........................................................................................................................
In goods market equilibrium, national saving (the sum of private saving and
...........................................................................................................................
government saving) must equal investment, 𝑆𝑆 + �𝑇𝑇 − 𝐺𝐺� = 𝐼𝐼. The increase in
...........................................................................................................................
net taxes lowers equilibrium income by
...........................................................................................................................
−𝑐𝑐1 𝛥𝛥𝑇𝑇�
𝛥𝛥𝑌𝑌� =
...........................................................................................................................
1 − 𝑐𝑐1 − 𝑑𝑑1
...........................................................................................................................
and thus leads to lower investment, since this latter variable is increasing in 𝑌𝑌.
It follows that national saving will have to fall by the same amount I has gone
...........................................................................................................................
down. Since public saving is greater than before (due to the increase in 𝑇𝑇�),
...........................................................................................................................
this requires a lower private saving. Private saving will fall because of the de-
crease in disposable income caused by the decrease in 𝑌𝑌� and the increase in 𝑇𝑇�.
...........................................................................................................................
241
Macroeconomics. Problems and Questions
* Question 12
[Equilibrium in the money market and equilibrium in the market for the
monetary base]
𝑖𝑖
2
1
𝚤𝚤̅
0
𝐻𝐻 𝑑𝑑 𝐻𝐻 𝑑𝑑 ′
𝐻𝐻’ 𝐻𝐻 𝐻𝐻 𝑠𝑠 , 𝐻𝐻 𝑑𝑑
...........................................................................................................................
...........................................................................................................................
The monetary base amounts to the central bank's overall liabilities − the sum of
...........................................................................................................................
bank reserves (𝑅𝑅) and currency (𝐶𝐶𝐶𝐶). The supply of monetary base, that in the
...........................................................................................................................
figure we assume to be initially given by 𝐻𝐻, is just the total amount of currency
...........................................................................................................................
and reserves outstanding at a given point in time, 𝐻𝐻 = 𝐶𝐶𝐶𝐶 + 𝑅𝑅. Since it has full
...........................................................................................................................
control over its liabilities, the supply of monetary base is under the control of
...........................................................................................................................
the central bank (for instance, through open market operations). It follows
...........................................................................................................................
that, in a diagram where the interest rate is measured on the vertical axis, it
...........................................................................................................................
will be represented by a vertical line at 𝐻𝐻 − the value of the monetary base cho-
sen by the central bank. The demand for monetary base, 𝐻𝐻 𝑑𝑑 , is the sum of the
individuals' demand for currency, 𝐶𝐶𝐶𝐶 𝑑𝑑 = 𝑐𝑐𝑀𝑀𝑑𝑑 , and of the banks' demand for
reserves, 𝑅𝑅 𝑑𝑑 = 𝜃𝜃(1 − 𝑐𝑐)𝑀𝑀𝑑𝑑 [the fraction 𝜃𝜃 of individuals' demand for depos-
its]. Since 𝐻𝐻 𝑑𝑑 = 𝐶𝐶𝐶𝐶 𝑑𝑑 + 𝑅𝑅 𝑑𝑑 = [𝑐𝑐 + 𝜃𝜃(1 − 𝑐𝑐)]𝑀𝑀𝑑𝑑 , and given that 𝑀𝑀𝑑𝑑 is decreasing
in the interest rate, the demand for monetary base is a negatively sloped curve
in the diagram above.
242
The goods and financial markets
A fall in 𝐻𝐻, due for instance to the fact that the central bank has decided to
sell bonds in the open market, shifts the supply curve to the left. The equilibri-
um position goes from point ′0′ to point ′1′, where the interest rate is higher
(the sale of bonds lowers their price, thus rising their yield). Finally, an in-
crease in 𝑐𝑐 and/or 𝜃𝜃 shifts the demand curve to the right, and the equilibrium
from point ′0′ to a point such as ′2′ in the figure. In this case, the interest rate
goes up for the reasons that will be discussed answering the next question.
b. Using the diagram below, show how the same changes just considered (de-
crease in 𝐻𝐻; rise in 𝑐𝑐 or 𝜃𝜃) will affect the money market equilibrium. Based
on the results of your analysis, what can you conclude about the relation-
ship between the value of the interest rate for which the market for the
monetary base is in equilibrium, and the value of the interest rate for
which the money market is in equilibrium?
𝐻𝐻
𝑐𝑐 + 𝜃𝜃(1 − 𝑐𝑐)
𝑖𝑖
𝚤𝚤̅ 0
𝑀𝑀’ 𝑀𝑀 𝑀𝑀 𝑠𝑠 , 𝑀𝑀𝑑𝑑
Let's start by writing down the equilibrium condition in the market for the
monetary base,
𝐻𝐻 = 𝐻𝐻 𝑑𝑑
= [𝑐𝑐 + 𝜃𝜃(1 − 𝑐𝑐)]𝑀𝑀𝑑𝑑 .
Dividing both sides by the term in squared brackets, the previous equation be-
comes:
243
Macroeconomics. Problems and Questions
𝐻𝐻
= 𝑀𝑀𝑑𝑑 .
𝑐𝑐 + 𝜃𝜃(1 − 𝑐𝑐)
On the right-hand side, we now have the demand for money. The term on the
left-hand side is − as you might have guessed, being the equation above an
equilibrium condition − the supply of money. When people hold both currency
and checkable deposits, one can in fact write 𝑀𝑀 as the ratio on the left-hand
side of the equilibrium condition above.1
It follows that, whenever the market for the monetary base is in equilibrium,
the money market, too, will be in equilibrium. One can therefore analyze the
determination of the interest rate with reference to either market, reaching
identical conclusions for the equilibrium value of this variable.
If, for instance, 𝐻𝐻 falls, maybe because the central bank has decided to sell
bonds
1 in the open market, the left-hand side of the above equation – the supply
of money – declines, leading to the same increase in 𝑖𝑖 we concluded will take
place when answering to point a. of this question.
The same will be true following an increase in 𝑐𝑐 and/or in 𝜃𝜃 – these changes,
too, will lower the supply of money, thus leading to the same increase in the
equilibrium interest rate that, by looking at the market for the monetary base,
we concluded will take place.
1
By definition, the supply of money is the sum of currency and deposits,
𝑀𝑀 = 𝐶𝐶𝐶𝐶 + 𝐷𝐷,
while the monetary base is the sum of currency and reserves,
𝐻𝐻 = 𝐶𝐶𝐶𝐶 + 𝑅𝑅.
Taking the ratio of the two previous equations, one gets:
𝑀𝑀 𝐶𝐶𝐶𝐶 + 𝐷𝐷 𝑐𝑐𝑐𝑐 + (1 − 𝑐𝑐)𝑀𝑀 1
= = =
𝐻𝐻 𝐶𝐶𝐶𝐶 + 𝑅𝑅 𝑐𝑐𝑐𝑐 + 𝜃𝜃(1 − 𝑐𝑐)𝑀𝑀 𝑐𝑐 + 𝜃𝜃(1 − 𝑐𝑐)
𝑑𝑑 𝑑𝑑
where we have used the fact that, in equilibrium, 𝐶𝐶𝐶𝐶 = 𝐶𝐶𝐶𝐶𝑑𝑑 = 𝑐𝑐𝑀𝑀 , 𝐷𝐷 = 𝐷𝐷𝑑𝑑 = (1 − 𝑐𝑐)𝑀𝑀 ,
𝑑𝑑
𝑅𝑅 = 𝑅𝑅𝑑𝑑 = 𝜃𝜃(1 − 𝑐𝑐)𝑀𝑀 , and 𝑀𝑀 = 𝑀𝑀𝑑𝑑 .
Finally, multiplying both sides of the previous equation by 𝐻𝐻 yields
𝐻𝐻
𝑀𝑀 = .
𝑐𝑐 + 𝜃𝜃(1 − 𝑐𝑐)
244
The goods and financial markets
245
Macroeconomics. Problems and Questions
* Question 13
[Endogenous money supply]
a. Write down the money market equilibrium condition. Assuming that mon-
ey demand, 𝑀𝑀𝑑𝑑 , is increasing in the general price level 𝑃𝑃 and in real income
𝑌𝑌, and decreasing in the interest rate 𝑖𝑖, represent in the graph below a posi-
tion of equilibrium in the money market, denoting by 𝚤𝚤̅ the value that the
interest rate takes on in that equilibrium.
𝑖𝑖
𝚤𝚤̅ 1
0
𝑀𝑀𝑑𝑑 𝑀𝑀𝑑𝑑 ′
𝑀𝑀 𝑀𝑀′ 𝑀𝑀 𝑠𝑠 , 𝑀𝑀𝑑𝑑
246
The goods and financial markets
in its determinants; for this reason, they both lead to conclusions that are, at
least qualitatively, identical about the way in which an equilibrium in the
money market is reached, and on how this equilibrium is affected by shocks.
For this reason, and the fact that this choice greatly simplifies the analysis of
the analytical version of the model that will be introduced in the next Chapter,
very often we shall assume that the demand for money takes on the functional
form (∗∗∗), rather than the one given by equation (∗∗); sometimes, we shall
also write the function 𝐿𝐿 (with 𝐿𝐿 = 𝑀𝑀𝑑𝑑 ⁄𝑃𝑃 = real money demand) as
𝐿𝐿(𝑌𝑌, 𝑖𝑖) = 𝑓𝑓1 𝑌𝑌 − 𝑓𝑓2 𝑖𝑖, so that
𝑀𝑀𝑑𝑑 = 𝑃𝑃(𝑓𝑓1 𝑌𝑌 − 𝑓𝑓2 𝑖𝑖).
In the above equation, 𝑓𝑓1 and 𝑓𝑓2 are positive parameters having the interpre-
tation of sensitivity of the demand for money to the level of income and to the
interest rate, respectively.
No matter the functional form − (∗∗) or (∗∗∗) – assumed for the demand for
money, this latter will be a negatively sloped curve in a diagram where the in-
terest rate is measured on the vertical axis; in the same diagram, money sup-
ply will be a line vertical at the value 𝑀𝑀 chosen by the central bank. In the fig-
ure, the initial equilibrium is at point ′0′, with 𝑖𝑖 = 𝚤𝚤̅.
b. Suppose that the central bank aims at keeping the interest rate constant at
the level 𝑖𝑖 = 𝚤𝚤̅ and that, starting from an initial equilibrium like the one you
have just described, there is a rise in 𝑌𝑌, or in 𝑃𝑃. What should the central
bank do, to prevent such a change from leading to an equilibrium interest
rate different from 𝚤𝚤̅? Explain.
247
Macroeconomics. Problems and Questions
Question 14
True or false?
Explain whether the following statements are true or false. Motivate your answer
in a brief but rigorous way, making explicit reference to the relevant theory.
Lack of proper explanations will result in zero points.
False. Both changes tend to lower money supply. In fact, an increase in c de-
creases bank deposits, while an increase in θ leads bank to lend out a smaller
fraction of the deposits received from their customers. It follows that, in the
case we are asked to analyze, bank will end up lending a smaller fraction of a
smaller volume of deposits. Bank loans will fall, thus leading to a further de-
crease in deposits, loans, deposits… and therefore in money supply.
248
The goods and financial markets
False. Other things the same, the rise in bank deposits caused by the fall in c
will allow banks to expand their loans, thus leading to new deposits, further
loans, new deposits, etc., in a process that will lead to an expansion of the
money supply − which is the sum of the currency and the bank deposits out-
standing.
249
Macroeconomics. Problems and Questions
Question 15
True or False?
Explain whether the following statements are true or false. Motivate your answer
in a brief but rigorous way, by making explicit reference to the relevant theory.
Lack of proper explanations will result in zero points.
a. “An increase in the price of bonds in the bond market makes bonds more
attractive and induces individuals to hold a smaller share of their financial
wealth in the form of money – the demand for money falls”.
False. If the price of bonds increases, their yield, the interest rate, will go
down. Other things the same, this fall in the interest foregone by holding
money rather than bonds will induce individuals to hold a larger fraction of
their financial wealth in the form of money. It follows that money demand will
rise.
250
The goods and financial markets
b. In country Gamma, the central bank chooses, and wants to keep constant
at the chosen level, the interest rate, while in country Delta the central
bank chooses the money supply (and, once again, keeps it constant at the
level it has chosen). The figure below depicts the money market equilibri-
um in the two countries. As you can see, in this initial equilibrium position
money supply is the same in both, and the same is true about the money
demand curve and the equilibrium interest rate. Explain if you agree, or
do not agree, with the following statement: “If, in both countries, banks de-
cide to decrease by the same amount the fraction of deposits held as reserves,
to keep the interest rate at the chosen level the central bank of Gamma will
have to increase the money supply, while in Delta – whose central bank
wants to prevent the money supply from changing – the interest rate will
fall”. [Hint: in the figure, denote by 2γ and 2δ the new equilibria, if any,
that will be reached by Gamma and Delta, respectively].
𝑖𝑖
1
𝑀𝑀𝑑𝑑
𝑀𝑀 𝑀𝑀, 𝑀𝑀𝑑𝑑
251
Macroeconomics. Problems and Questions
Question 16
...........................................................................................................................
a.1 Situation, typically associated with a zero (or, in any case, a very low)
interest rate, in which individuals are willing to hold more money (the
...........................................................................................................................
most ‘liquid’ asset) even if the interest rate doesn’t change. When the
...........................................................................................................................
economy is in a liquidity trap, monetary policy (or, at least, convention-
al monetary policy) is unable to affect the interest rate and the equilib-
...........................................................................................................................
rium position of the economy.
...........................................................................................................................
a.2 Sale of bonds by the central bank in the market for these financial as-
...........................................................................................................................
sets. It is a ‘contractionary’ policy intervention because it ends up reduc-
ing the supply of money (the central bank gets paid in currency or, more
...........................................................................................................................
frequently, with bank reserves; it follows that the monetary base, sum of
...........................................................................................................................
currency and reserves, decreases, and with it the money supply).
..............................................................................................
252
The goods and financial markets
...............................
Normally, an increase in money supply lowers the interest rate because, at the
initial income and interest rate levels, individuals have an incentive to use the
...........................................................................................................................
extra money injected in the economy to purchase bonds, assets with a rate of
...........................................................................................................................
return greater than the return on money. The ensuing increase in the demand
for bonds will raise bond prices and lower their yield, the interest rate. This
...........................................................................................................................
latter will keep dropping until it gets low enough to induce individuals to will-
ingly hold all the extra money now in the economy.
...........................................................................................................................
If, however, the economy is in a liquidity trap, with a zero (or, in any case, a
...........................................................................................................................
very low) interest rate, this process does not take place any longer. Individu-
...........................................................................................................................
als are holding more money, but they do not try to convert this extra money
into bonds, as the return on bonds is now very close to that on money, and
...........................................................................................................................
money has the extra advantage of being the most liquid asset. In this case,
...........................................................................................................................
even if money supply increases, the demand for bonds does not change, and
the interest rate therefore does not fall.
...........................................................................................................................
253
Chapter 2 - The IS-LM model
Macroeconomics. Problems and Questions
* Question 1
[An analytical version of the IS-LM model − (I) The standard case (endogenous
money supply)]
256
The IS-LM model
𝐴𝐴 1 − 𝑐𝑐1 − 𝑑𝑑1
𝑖𝑖 = − · 𝑌𝑌
𝑑𝑑2 𝑑𝑑2
where A ( = 𝑐𝑐0 − 𝑐𝑐1 𝑇𝑇� + 𝐼𝐼 ̅ + 𝐺𝐺̅ ) is autonomous demand (or spending) – the
sum of all the components of the aggregate demand for goods and services
that do not depend on 𝑌𝑌 or 𝑖𝑖. Since 𝑑𝑑2 > 0 and 0 < 𝑐𝑐1 + 𝑑𝑑1 < 1, in the (𝑌𝑌, 𝑖𝑖)
plane the IS curve for the economy under consideration is a straight line with
a positive vertical intercept (equal to 𝐴𝐴⁄𝑑𝑑2 ) and a negative slope
[− (1 − 𝑐𝑐1 − 𝑑𝑑1 )⁄𝑑𝑑2 ]. The above results have the following implications for
the slope and the position of the IS curve in the (𝑌𝑌, 𝑖𝑖) plane:
• The absolute value of the slope of the IS curve is greater (the IS is
steeper) the smaller are the propensity to spend (𝑐𝑐1 + 𝑑𝑑1 ) and the sensi-
tivity of investment to the interest rate (𝑑𝑑2 ).
Suppose, for instance, that we are dealing with an economy where 𝑑𝑑2 is
relatively small, and let's try to understand why this leads to a relatively
steep IS curve (to check your understanding of the properties of this
curve, make sure that you can explain why one can reach the same con-
clusion if to be relatively small are the values of 𝑐𝑐1 and/or 𝑑𝑑1 ). Let us as-
sume that, initially, the economy is at a point lying on the IS, and there-
fore in a goods market equilibrium position. If, for some reason, the inter-
est rate falls, investment will rise. It follows that demand and equilibrium
output will increase. For a given decrease in 𝑖𝑖, the rise in investment, de-
mand and output will be smaller the less sensitive is investment to changes
in the interest rate (that is, the smaller is 𝑑𝑑2 ). But if, for any given de-
crease in the interest rate, the increase in 𝑌𝑌 needed to return to a goods
market equilibrium position is small, the IS curve will be relatively steep.
In the limiting case in which investment does not depend on 𝑖𝑖 (𝑑𝑑2 = 0),
changes in the interest rate will not lead to changes in the aggregate de-
mand for goods and services, thus leaving equilibrium output unchanged.
In this case, the IS curve is a vertical line.
• Increases (decreases) in 𝑐𝑐0 , 𝐼𝐼 ,̅ 𝐺𝐺̅ and/or decreases (increases) in 𝑇𝑇� cause a
parallel rightward (leftward) shift of the IS curve.
In fact, and for any given level of the interest rate prevailing in the econo-
my, the changes mentioned above raise (lower) the demand for goods,
thus leading to an increase (decrease) in equilibrium output.
The next figures summarize the conclusions we have just reached about the
slope and the position of the IS curve in the (𝑌𝑌, 𝑖𝑖) plane.
257
Macroeconomics. Problems and Questions
𝐼𝐼𝐼𝐼
𝐼𝐼𝐼𝐼
𝑌𝑌 𝑌𝑌
𝑖𝑖 𝑖𝑖
↑𝑐𝑐0 , ↑𝐼𝐼 ̅ , ↑𝐺𝐺̅ , ↓𝑇𝑇�
𝑌𝑌 𝑌𝑌
The LM curve is the locus of all the pairs (𝑌𝑌, 𝑖𝑖) for which the money market is
in equilibrium − that is, for which the following equilibrium condition holds
true:
𝑀𝑀 = 𝑀𝑀𝑑𝑑 ,
where the term on the left-hand side is the money supply in nominal terms,
and that on the right-hand side nominal money demand. The same equilibrium
condition can be written in real terms by dividing both sides by the general
price level, 𝑃𝑃:
𝑀𝑀⁄𝑃𝑃 = 𝑀𝑀𝑑𝑑 ⁄𝑃𝑃.
Given the functional form that, by assumption, money demand takes on in this
economy, the previous equation becomes:
𝑀𝑀/𝑃𝑃 = (𝑓𝑓1 𝑌𝑌 − 𝑓𝑓2 𝑖𝑖).
To make sure that 𝑖𝑖 = 𝚤𝚤̅ always, the central bank will have to set 𝑀𝑀 =
𝑃𝑃(𝑓𝑓1 𝑌𝑌 − 𝑓𝑓2 𝚤𝚤̅), something that − as discussed in the answer to Question 14 of
Chapter 1 – guarantees that the interest rate will always be equal to 𝚤𝚤̅. Given
the way in which, in this economy, the central bank sets 𝑀𝑀, the equation of
the LM curve is 𝑖𝑖 = 𝚤𝚤̅ .
258
The IS-LM model
In the (𝑌𝑌, 𝑖𝑖) plane, the LM is therefore a horizontal line drawn at the value of
the interest rate chosen by the central bank, 𝚤𝚤̅.
𝑖𝑖
𝚤𝚤̅ 𝐿𝐿𝐿𝐿
𝑌𝑌
c. Derive the equilibrium values of 𝑌𝑌 and 𝑖𝑖. By how much will equilibri-
um output change if autonomous demand changes by 𝛥𝛥𝛥𝛥? And by how
much, following a change 𝛥𝛥𝚤𝚤̅ in the level of the interest rate chosen by
the central bank?
The equilibrium values of 𝑌𝑌 and 𝑖𝑖 are the solutions to the system of two equa-
tions given by the analytical expressions of the IS and the LM curves:
𝐴𝐴 1 − 𝑐𝑐1 − 𝑑𝑑1
𝑖𝑖 = − · 𝑌𝑌
𝑑𝑑2 𝑑𝑑2
𝑖𝑖 = 𝚤𝚤̅ .
Given our assumption about the behavior of the central bank, in equilibrium
the interest rate will always be equal to 𝚤𝚤̅. To find the equilibrium value of
output, 𝑌𝑌�, replace 𝑖𝑖 with 𝚤𝚤̅ in the first equation, the IS curve. Solving for 𝑌𝑌,
one gets:
1 𝑑𝑑2
𝑌𝑌� = · 𝐴𝐴 − · 𝚤𝚤̅ .
1 − 𝑐𝑐1 − 𝑑𝑑1 1 − 𝑐𝑐1 − 𝑑𝑑1
The change in equilibrium output 𝑌𝑌� caused by a change 𝛥𝛥𝛥𝛥 in the level of au-
tonomous demand is therefore 𝛥𝛥𝑌𝑌� = [1⁄(1 − 𝑐𝑐1 − 𝑑𝑑1 )] · 𝛥𝛥𝛥𝛥. The constant
1⁄(1 − 𝑐𝑐1 − 𝑑𝑑1 ) is sometimes referred to as “fiscal policy multiplier”, since
changes in 𝐺𝐺̅ and/or 𝑇𝑇� are among the possible causes of the changes in 𝐴𝐴
whose effects we are studying. When, like in this economy, the central bank
chooses a level for the interest rate, the fiscal policy multiplier is therefore
identical to the income, or keynesian, multiplier derived when studying the
goods market in isolation. Finally, when the change disturbing the equilibrium of
the economy is one in 𝚤𝚤̅, 𝛥𝛥𝑌𝑌�⁄𝛥𝛥 𝚤𝚤̅ = − 𝑑𝑑2 ⁄(1 − 𝑐𝑐1 − 𝑑𝑑1 ). Notice that this con-
stant – the “monetary policy multiplier” – equals zero if 𝑑𝑑2 = 0, that is, if no
component of aggregate demand depends on the interest rate.
259
Macroeconomics. Problems and Questions
* Question 2
[An analytical version of the IS-LM model − (II) Exogenous money supply]
Consider an economy different from the one studied in the previous question
only for the fact that, rather than the interest rate, its central bank chooses a
value for the nominal money supply 𝑀𝑀, and then lets the interest rate take on
any value that turns out to be consistent with the macroeconomic equilibrium
for that given 𝑀𝑀.
a. Denoting by 𝑀𝑀 � the value of 𝑀𝑀 chosen by the central bank, derive the ana-
lytical expressions of the IS and LM curves for this economy.
The analytical expression of the IS curve is identical to the one derived in the
answer to the previous question. Its slope and position in the (𝑌𝑌, 𝑖𝑖) plane will
therefore be determined by the same factors discussed before. As for the LM
curve, to derive its expression let us write down the money market equilibrium
condition,
𝑀𝑀
= (𝑓𝑓1 𝑌𝑌 − 𝑓𝑓2 𝑖𝑖)
𝑃𝑃
and set 𝑀𝑀 = 𝑀𝑀� (the constant level at which the central bank keeps the supply
of money) in this equation. Since, as usual, the LM curve will be drawn in a
plane in which the interest rate is measured on the vertical axis, it is conven-
ient to solve for 𝑖𝑖. This leads to the following expression of the LM curve:
�
1 𝑀𝑀 𝑓𝑓1
𝑖𝑖 = − � � · + � � · 𝑌𝑌.
𝑓𝑓2 𝑃𝑃 𝑓𝑓2
b. Draw the portion of the LM curve entirely lying in the first quadrant of the
(𝑌𝑌, 𝑖𝑖) plane (that is, the portion of the curve corresponding to positive val-
ues of both output and the interest rate). 1 What determines its slope?
Which are the causes of parallel shifts of the LM curve in that plane? Ex-
plain, using the following graphs and providing the economic intuition un-
derlying your results.
1 The assumption that the nominal interest rate cannot take on negative values allows us to disregard
the portion of the LM curve lying in the second quadrant. We shall discuss later on the shape of the
LM curve when the nominal interest rate is zero (that is, when it is at its "zero lower bound") and − as
assumed in the present question − the central bank chooses the nominal money supply.
260
The IS-LM model
Since 𝑓𝑓1 , 𝑓𝑓2 > 0, the LM curve for this economy is, in the (𝑌𝑌, 𝑖𝑖) plane, a
straight line with a negative vertical intercept equal to −(1⁄𝑓𝑓2 ) 𝑀𝑀 � ⁄𝑃𝑃, and
positive slope equal to the ratio 𝑓𝑓1⁄𝑓𝑓2 . The above results have the following
implications for the slope and the position of the LM curve in the (𝑌𝑌, 𝑖𝑖) plane:
• The slope of the LM curve is greater (the LM is steeper) the more sensi-
tive is money demand to income (that is, the larger is 𝑓𝑓1 ), and the less
sensitive it is to the interest rate (the smaller is 𝑓𝑓2 ).
First of all, to understand why the LM curve is, in this economy, positive-
ly sloped, let us assume that we are initially on the LM, and therefore in a
money market equilibrium position. If, for some reason, starting from this
initial position income goes up, money demand will rise. In the money
market, this change will lead to an excess demand for money over the
supply of money (recall that, in this economy, the central bank keeps
money supply constant at the chosen level 𝑀𝑀 � ). To return to a money mar-
ket equilibrium, the initial increase in Y must be matched by a rise in the
interest rate. This explains the positive slope of the LM. But by how much
will have the interest rate to go up? The increase in the interest rate need-
ed to return in equilibrium will be larger the greater is 𝑓𝑓1. If 𝑓𝑓1is very large
(that is, money demand very sensitive to income), for any given increase
in Y money demand will go up by a lot, the excess demand in the money
market will be large, and to eliminate it the interest rate will have to rise a
lot – the LM curve will therefore be relatively steep. To check your under-
standing of the properties of the LM curve in the case analyzed in the pre-
sent question, make sure that you can explain why, for a given 𝑓𝑓1, the
slope of the LM curve is decreasing in 𝑓𝑓2, the sensitivity of money demand
to the interest rate.
• Increases (decreases) in 𝑀𝑀� , and/or decreases (increases) in 𝑃𝑃 cause par-
allel rightward (leftward) shifts of the LM curve.
For any given level of income 𝑌𝑌, the changes metioned above raise (low-
er) real money supply, thus leading to a fall (rise) in the level of the in-
terest rate for which the money market is in equilibrium.
The next figures summarize the conclusions we have just reached about the
slope and the position of the LM curve in the (𝑌𝑌, 𝑖𝑖) plane for an economy in
which the central bank chooses the money supply.
261
Macroeconomics. Problems and Questions
𝑖𝑖 𝐿𝐿𝐿𝐿 𝑖𝑖
𝑓𝑓1 “small”,
𝑓𝑓1 “large”, 𝐿𝐿𝐿𝐿
and/or
and/or
𝑓𝑓2 “large”
𝑓𝑓2 “small”
𝑌𝑌 𝑌𝑌
𝑖𝑖 𝐿𝐿𝐿𝐿 𝑖𝑖 𝐿𝐿𝐿𝐿
� , ↑𝑃𝑃
↓𝑀𝑀
��� ↓𝑃𝑃
↑𝑀𝑀,
𝑌𝑌 𝑌𝑌
c. Derive the equilibrium values of 𝑌𝑌 and 𝑖𝑖. By how much will equilibrium
output change if autonomous demand changes by 𝛥𝛥𝛥𝛥? And by how much,
� in the nominal money supply?
following a change 𝛥𝛥𝑀𝑀
The equilibrium values of 𝑌𝑌 and 𝑖𝑖 are the solutions to the system of two equa-
tions given by the analytical expressions of the IS and the LM curves. For the
economy under consideration, the system is the following one:
𝐴𝐴 1 − 𝑐𝑐1 − 𝑑𝑑1
𝑖𝑖 = − 𝑌𝑌
𝑑𝑑2 𝑑𝑑2
�
1 𝑀𝑀 𝑓𝑓1
𝑖𝑖 = − � � + � � 𝑌𝑌 .
𝑓𝑓2 𝑃𝑃 𝑓𝑓2
Equating the right-hand sides of the two equations above, solving for 𝑌𝑌 and
then plugging the result in the first or in the second one, yields the following
expressions for the equilibrium values of 𝑌𝑌 and 𝑖𝑖:
1 𝑑𝑑2 �
𝑀𝑀
𝑌𝑌� = · 𝐴𝐴 + · (∗)
(𝑓𝑓1 𝑑𝑑2 ⁄𝑓𝑓2 ) + (1 − 𝑐𝑐1 − 𝑑𝑑1 ) 𝑓𝑓1 𝑑𝑑2 + 𝑓𝑓2 (1 − 𝑐𝑐1 − 𝑑𝑑1 ) 𝑃𝑃
𝑓𝑓1⁄𝑓𝑓2 (1 − 𝑐𝑐1 − 𝑑𝑑1 ) �
𝑀𝑀
𝚤𝚤̂ = · 𝐴𝐴 − · (∗∗)
(𝑓𝑓1 𝑑𝑑2 ⁄𝑓𝑓2 ) + (1 − 𝑐𝑐1 − 𝑑𝑑1 ) 𝑓𝑓1 𝑑𝑑2 + 𝑓𝑓2 (1 − 𝑐𝑐1 − 𝑑𝑑1 ) 𝑃𝑃
262
The IS-LM model
These expressions, that may look rather intimidating (however, bear in mind
that you are not supposed to memorize them, and that no exam question will
ask you to derive them) are useful because they allow one to understand why,
and by how much, policy interventions and other shocks hitting an economy in
which the central bank chooses the money supply will affect the macroeco-
nomic equilibrium. In particular, the question asks us to determine the change
in equilibrium output caused by a change 𝛥𝛥𝛥𝛥 in autonomous demand. From
the expression for 𝑌𝑌� we have just derived, it follows that
1
𝛥𝛥𝑌𝑌� = · 𝛥𝛥𝛥𝛥
(𝑓𝑓1 𝑑𝑑2 ⁄𝑓𝑓2 ) + (1 − 𝑐𝑐1 − 𝑑𝑑1 )
where the ratio multiplying 𝛥𝛥𝛥𝛥 on the right-hand side is the “fiscal policy
multiplier” − the constant by which one has to multiply any given change 𝛥𝛥𝛥𝛥
in autonomous spending in order to get the ensuing change in equilibrium out-
put – in an economy where the central bank chooses the level of 𝑀𝑀. Notice
that, being 𝑓𝑓1 , 𝑓𝑓2 , 𝑑𝑑2 > 0 by assumption, this multiplier will be always lower
than the fiscal policy multiplier prevailing when the central bank chooses a
value for 𝑖𝑖 and that, answering Question 1.c of this Chapter, we have conclud-
ed is given by 1⁄(1 − 𝑐𝑐1 − 𝑑𝑑1 ). Why this is necessarily the case will become
clear when answering some of the next questions.
Finally, the “monetary policy multiplier” (the constant by which one has to
multiply any given change in 𝛥𝛥𝑀𝑀 � /𝑃𝑃 in the real money supply, or – which is the
same, given the assumption of constant prices − in nominal money supply in
1
order to get the corresponding change in equilibrium output, 𝛥𝛥𝑌𝑌�) is the ratio
� ⁄𝑃𝑃 in equation (∗) above.1
that multiplies 𝑀𝑀
1
In Question 1 of this Chapter, where the central bank was choosing the interest rate, the monetary
policy multiplier measured the impact on 𝑌𝑌� of a change in the value chosen for 𝑖𝑖; in the economy
studied in the present question, where the central bank chooses 𝑀𝑀, that multiplier measures instead
� , the value of 𝑀𝑀 chosen by the central bank. Also in this latter case,
the impact on 𝑌𝑌� of a change in 𝑀𝑀
however, a change in money supply affects 𝑌𝑌� by changing 𝑖𝑖. Using equation (∗∗) above to compute
� needed to change 𝚤𝚤̂ by the same 𝛥𝛥𝚤𝚤̅ assumed in Question 1, one gets:
the change in 𝑀𝑀
�
𝛥𝛥𝑀𝑀 𝑓𝑓1 𝑑𝑑2 + 𝑓𝑓2 (1 − 𝑐𝑐1 − 𝑑𝑑1 )
=− · 𝛥𝛥𝑖𝑖.̅
𝑃𝑃 (1 − 𝑐𝑐1 − 𝑑𝑑1 )
� so determined into the relation between 𝛥𝛥𝑀𝑀
Plugging the expression for 𝛥𝛥𝑀𝑀 � e 𝛥𝛥𝑌𝑌� implied by equa-
tion (∗), it is straightforward to conclude that the impact on income of a monetary impulse is identical
in both cases [equal to 𝛥𝛥𝑌𝑌 � ⁄𝛥𝛥 𝚤𝚤̅ = − 𝑑𝑑2 ⁄(1 − 𝑐𝑐1 − 𝑑𝑑1 )], once such an impulse is expressed in a
comparable fashion.
263
Macroeconomics. Problems and Questions
Question 3
1
From now on, by "a standard IS-LM model" we shall mean a model like the one studied in Question
1 of this Chapter, and therefore based on the following assumptions:
• consumption function of disposable income, investment function of 𝑌𝑌 and 𝑖𝑖, nominal mon-
ey demand function of 𝑃𝑃, 𝑌𝑌 and 𝑖𝑖;
• 𝐺𝐺 and 𝑇𝑇 both exogenous;
• the central bank chooses a value 𝑖𝑖 = 𝚤𝚤̅ for the interest rate, and sets nominal money supply
to whatever level is consistent with the attainment of this target value for 𝑖𝑖;
• constant prices, and therefore current and future expected inflation rates equal to zero.
264
The IS-LM model
b. Consider now two different countries, Delta and Epsilon, whose IS curves
are drawn in the graphs below. Suppose that the different slopes of the two
curves only reflect differences in the value that the parameter 𝑑𝑑2 , the sensi-
tivity of investment to the interest rate, takes on in the two countries. All
the remaining parameters take on identical values in Delta and in Epsilon.
Explain what is meant by “monetary policy multiplier”,
𝛥𝛥𝑌𝑌� 𝑑𝑑2
=−
𝛥𝛥𝚤𝚤̅ (1 − 𝑐𝑐1 − 𝑑𝑑1 )
and, making explicit reference to this concept (discussed in the answer to
Question 1 of this Chapter), discuss if the central bank's decision of chang-
ing the interest rate by the same 𝛥𝛥𝚤𝚤̅ in the two countries will change equilib-
rium output more in Delta or in Epsilon.
𝑖𝑖 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑖𝑖 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
𝐼𝐼𝐼𝐼𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷
𝐼𝐼𝐼𝐼𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
𝑌𝑌 𝑌𝑌
...........................................................................................................................
...........................................................................................................................
The monetary policy multiplier is the constant by which one has to multiply any
given change in the level of interest rate chosen by the central bank in order to
...........................................................................................................................
get the corresponding change in equilibrium output. The IS curve is flatter the
...........................................................................................................................
larger is 𝑑𝑑2 , the sensitivity of investment to the interest rate. It follows from
the graphs above that 𝑑𝑑2 is larger in Delta. Since monetary policy interven-
...........................................................................................................................
tions − decisions of changing 𝚤𝚤̅ taken by the central bank − affect equilibrium
...........................................................................................................................
output by changing those components of aggregate demand that depend on the
interest rate (in the standard model analyzed in the present question, invest-
...........................................................................................................................
ment only), equilibrium output will rise more in Delta, where 𝑑𝑑2 is larger and
...........................................................................................................................
where investment and aggregate demand will therefore respond more to any
given change in the interest rate. More formally, the ratio on the right-hand
...........................................................................................................................
side of the expression of the fiscal policy multiplier written above is increasing
in 𝑑𝑑2 ; it follows that the same will be true about the change in equilibrium
output caused by any given 𝛥𝛥𝚤𝚤̅ decided by the central bank.
265
Macroeconomics. Problems and Questions
Question 4
𝑖𝑖
𝚤𝚤̅2 2
LM1
𝚤𝚤̅0 1
LM0
0
ISO IS1
𝑌𝑌�0 𝑌𝑌�1 𝑌𝑌
266
The IS-LM model
b. Suppose now that Macro’s central bank intends to bring back equilibrium
income to its initial level, 𝑌𝑌0 . To achieve its goal, should it raise or lower
the interest rate? Show in the graph the new equilibrium that will be
reached following the monetary policy intervention that you are propos-
ing, denoting it by ‘2’. Finally, compare the composition of aggregate de-
mand at ‘2’ with that prevailing in the initial equilibrium ‘0’.
The central bank will have to raise the interest rate. In the new equilibrium
‘2’, the interest rate is 𝚤𝚤̅2 (> 𝚤𝚤̅0 ), and income is back to its initial level. It fol-
lows that aggregate demand will have to take on, at ‘2’, the same value it was
taking on at ‘0’. Being both G and I exogenous, this requires consumption to
be, in the final equilibrium ‘2’, the same as in the initial equilibrium ‘0’ – the
favorable impact of the decrease in net taxes, which tends to raise 𝐶𝐶, must
have been exactly offset by the adverse impact that, in this economy, a higher
interest rate has on consumption.
267
Macroeconomics. Problems and Questions
Question 5
True or false?
Explain whether the following statements are true or false. Motivate your answer
in a brief but rigorous way, making explicit reference to the relevant theory.
Lack of proper explanations will result in zero points.
a. “In an IS-LM model that departs from the standard case only for the fact
that, rather than the interest rate, the central bank chooses the nominal
money supply, keeping it constant at the level 𝑀𝑀 = 𝑀𝑀 � , the higher the sensi-
tivity of investment to the interest rate, the larger the increase in equilibri-
um income caused by an expansionary fiscal policy”.
268
The IS-LM model
b. “In a standard IS-LM model, in which the central bank chooses the inter-
est rate and keeps it constant at the level deemed appropriate given the
state of the economy (for instance, at 𝑖𝑖 = 𝚤𝚤̅), the higher the sensitivity of in-
vestment to the interest rate, the larger the increase in equilibrium income
caused by an expansionary fiscal policy”.
False. As it is immediate to conclude also noticing that the parameter 𝑑𝑑2 does
not enter the expression for what has been defined ‘fiscal policy multiplier’ in
the answer to point c of Question 1 of this Chapter, in this case the extent by
which equilibrium income goes up following a fiscal stimulus is independent of
the interest rate sensitivity of investment.
In fact, and as discussed answering the previous point, the expansionary fiscal
policy still leads to a higher aggregate demand and a higher production. For a
given money supply, this would cause an increase in the interest rate. Howev-
er, since it now wants 𝑖𝑖 to remain at the chosen level, 𝑖𝑖 = 𝚤𝚤̅, the central bank
will in this case intervene, raising the money supply by the amount needed to
keep the interest rate unchanged. And, with an unchanged 𝑖𝑖, the sensitivity of
investment to changes in the interest rate will play no role in determining the
extent by which the fiscal expansion will impact on output.
269
Macroeconomics. Problems and Questions
Question 6
𝑖𝑖
1 2
𝚤𝚤̅ 𝐿𝐿𝐿𝐿
𝐼𝐼𝐼𝐼 𝐼𝐼𝐼𝐼′
𝑌𝑌� �
𝑌𝑌′ 𝑌𝑌
270
The IS-LM model
b. Consider now country Delta. The only difference between Gamma and
Delta lies in the policy rule followed by their central banks. While, as we
already know from the first part of this question, Gamma's central bank
chooses a level for the interest rate, Delta's central bank chooses a level for
the nominal supply of money 𝑀𝑀 and, given that level, lets the interest rate
take on any value turns out to be consistent with the macroeconomic equi-
librium. Suppose now that, when the two countries are in an initial equilib-
rium with identical values of 𝑌𝑌 and 𝑖𝑖, Delta experiences the same increase
in 𝑐𝑐0 discussed in the previous point of this question. Compared with what
happened in Gamma, will income change more or less in Delta? Represent
graphically, and explain.
𝑖𝑖
𝐼𝐼𝐼𝐼 𝐼𝐼𝐼𝐼′
𝐿𝐿𝐿𝐿𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷
2𝐷𝐷
1 2𝐺𝐺
𝚤𝚤̅ 𝐿𝐿𝐿𝐿𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺
271
Macroeconomics. Problems and Questions
Question 7
a.2 Assuming that all the other behavioral functions (investment, money de-
mand, etc.) are standard, explain if and why, following an expansionary
monetary policy, when ℎ2 > 0 equilibrium income increases more or less
than in the standard case (ℎ2 = 0) [Hint: no formal derivation of the IS
and LM curves is required – just provide the economic intuition underlying
your answer].
a.2 When ℎ2 > 0, a monetary expansion raises 𝑌𝑌 more than in the standard
case – the decrease in the interest rate decided by the central bank boosts
not just investment, but also consumption, thus causing a larger increase
in aggregate demand and equilibrium income.
272
The IS-LM model
𝑖𝑖
0 1
𝚤𝚤̅ 𝐿𝐿𝐿𝐿
𝐼𝐼𝐼𝐼′ℎ2>0
𝐼𝐼𝐼𝐼ℎ2>0
𝐼𝐼𝐼𝐼ℎ2=0 𝐼𝐼𝐼𝐼′ℎ2=0
𝑌𝑌�0 𝑌𝑌�1 𝑌𝑌
273
Macroeconomics. Problems and Questions
Question 8
True or false?
Explain whether the following statements are true or false. Motivate your answer
in a brief but rigorous way, making explicit reference to the relevant theory.
Lack of proper explanations will result in zero points.
True.
The expansionary fiscal policy will disturb the equilibrium in the goods mar-
ket, raising output by the income multiplier times the change in autonomous
demand caused by the fiscal stimulus. If, for instance, the government has de-
cided to raise 𝐺𝐺̅ , equilibrium output will go up by 𝛥𝛥𝑌𝑌� = [1⁄(1 − 𝑐𝑐1 − 𝑑𝑑1 )] ·
𝛥𝛥𝐺𝐺̅ . In turn, this increase in income will disturb the money market equilibri-
um. Money demand, that depends positively on 𝑌𝑌, will rise and, should the
central bank keep money supply constant, at the initial interest rate 𝑖𝑖 = 𝚤𝚤̅
there would be an excess demand for money on the supply of money. It fol-
lows that, to prevent this disequilibrium from pushing 𝑖𝑖 above 𝚤𝚤̅, the central
bank will have to intervene. More specifically, the central bank will have to
increase money supply exactly by the amount by which the rise in equilibrium
income has raised money demand − an amount that is larger the more sensi-
tive money demand is to changes in income (that is, the larger is the parame-
ter 𝑓𝑓1 we have defined when discussing the analytical version of the IS-LM
model in Question 1 of this Chapter).
274
The IS-LM model
b. “When the economy is in a liquidity trap, with the nominal interest rate at
its ‘zero lower bound’, an expansionary fiscal policy cannot influence the
equilibrium level of output”.
False.
When the economy is in a liquidity trap, to be powerless to affect output is
monetary policy (or, at least, so are the “conventional” monetary policy tools
discussed in this Chapter). In fact, a monetary expansion affects the demand
for goods, and therefore production, by lowering the interest rate, thus raising
the components of aggregate demand that depend on 𝑖𝑖. If, however, the inter-
est rate is already at its lower bound, it cannot fall any further, and the chan-
nel through which monetary policy affects the real economy is no longer oper-
ational. In a similar situation, the only policy able to raise equilibrium output
is fiscal policy.
275
Macroeconomics. Problems and Questions
Question 9
𝑖𝑖
𝐿𝐿𝐿𝐿1
𝐿𝐿𝐿𝐿3
𝐼𝐼𝐼𝐼1
𝐼𝐼𝐼𝐼2
2 1 D
𝑖𝑖1 = 𝑖𝑖2 = 0
𝑌𝑌2 𝑌𝑌1 E Y
−(1⁄𝑓𝑓2 )(𝑀𝑀⁄𝑃𝑃)
−(1⁄𝑓𝑓2 )(𝑀𝑀′⁄𝑃𝑃 )
276
The IS-LM model
If we allow for the possibility that the nominal interest rate reaches its lower
bound (that is, zero), the LM for an economy in which the central bank
chooses a value for the nominal money supply consists of two portions with
different slopes: one that, as discussed in the answer to Question 2 of this
Chapter, is positively sloped for values of the interest rate greater than zero;
and a second one that − since the nominal interest rate cannot take on nega-
tive values − coincides with the x-axis for 𝑖𝑖 = 0. Furthermore, increases in
money supply cause parallel, rightward shifts of the positively sloped portion
of the curve, prolonging at the same time the horizontal portion. In the figure,
we are assuming that, initially, the LM is given by the broken line 0D-𝐿𝐿𝐿𝐿1 .
Since we are told that the economy is in a liquidity trap (that is, in an equilib-
rium with 𝑖𝑖 = 0), the initial intersection between the IS and the LM curves
must take place somewhere along the horizontal portion of the LM, at a point
like ′1′ in the figure, where output is 𝑌𝑌1 and the interest rate is 𝑖𝑖1 = 0. If au-
tonomous consumption 𝑐𝑐0 and net taxes 𝑇𝑇� fall at the same time and by the
same amount, so that 𝛥𝛥𝑐𝑐0 = 𝛥𝛥𝑇𝑇� < 0, autonomous demand 𝐴𝐴 = 𝑐𝑐0 − 𝑐𝑐1 𝑇𝑇� +
𝐼𝐼 ̅ + 𝐺𝐺̅ changes by 𝛥𝛥𝛥𝛥 = 𝛥𝛥𝑐𝑐0 − 𝑐𝑐1 𝛥𝛥𝑇𝑇� = (1 − 𝑐𝑐1 )𝛥𝛥𝑐𝑐0 < 0. It follows that the IS
curve will shift to the left, and that the equilibrium will become ′2′ in the
graph. At point ′2′, the economy is still in a liquidity trap, with a zero interest
rate and a lower equilibrium output. Since, in the move from ′1′ to ′2′, invest-
ment falls (because of the decrease in 𝑌𝑌, and the constancy of 𝑖𝑖), national
saving, in equilibrium equal to investment, must be lower, too.
b. Suppose now that the central bank of the country attempts to return
income to the initial level, 𝑌𝑌1 , by implementing a conventional mone-
tary policy − for instance, an open market operation. Show in the
graph the equilibrium that will prevail after the central bank’s inter-
vention. Explain.
To achieve its end, the central bank could resort to an open market purchase
...........................................................................................................................
of government bonds. However, this ‘conventional’ monetary policy would re-
...........................................................................................................................
sult in a rightward shift of the positively sloped portion of the 𝐿𝐿𝐿𝐿 curve only,
and would make the horizontal one longer. The initial LM, 0D-𝐿𝐿𝐿𝐿1 , would be
...........................................................................................................................
replaced by a new one, such as 0E-𝐿𝐿𝐿𝐿3 , with the intersection between this lat-
...........................................................................................................................
ter curve and an unchanged 𝐼𝐼𝐼𝐼 curve still taking place at point ‘′2′, that will
therefore remain the equilibrium position for the economy. Since the interest
...........................................................................................................................
rate was already at its lower bound, there is not going to be any decrease in 𝑖𝑖,
...........................................................................................................................
and therefore no increase in 𝑌𝑌. In a liquidity trap, a conventional monetary
policy is ineffective.
277
Macroeconomics. Problems and Questions
Question 10
True or false?
Explain whether the following statements are true or false. Motivate your answer
in a brief but rigorous way, making explicit reference to the relevant theory.
Lack of proper explanations will result in zero points.
Define the concept of real interest rate (𝑟𝑟), and write the equation that shows
how 𝑟𝑟 and nominal interest rate (𝑖𝑖) are related to one another. Use this equa-
tion to explain if you agree, or do not agree, with the following statements:
a. “If individuals expect positive inflation, then the real interest rate will be
greater than the nominal one.”
False. While the nominal interest rate tells us how a sum that has been bor-
rowed/lent out grows over time in units of currency (Euros, for instance), the
real interest rate tells us how that sum grows in real terms – that is, how its
purchasing power changes over time [alternative definition:”the real interest
rate is the interest rate in terms of goods; it tells us how many goods one has
to repay in the future in exchange for borrowing the equivalent of one good
today”]. The real and the nominal interest rates are related to one another as
implied by the equation 𝑟𝑟 = 𝑖𝑖 − 𝜋𝜋 𝑒𝑒 , where 𝜋𝜋 𝑒𝑒 is expected inflation. From this
relation it follows that 𝑟𝑟 < 𝑖𝑖 whenever 𝜋𝜋 𝑒𝑒 > 0, so that we can conclude that
the above statement is incorrect.
278
The IS-LM model
b. “The zero lower bound for the nominal interest rate implies that the real interest
rate cannot be greater than minus the expected inflation rate, −𝜋𝜋 𝑒𝑒 ”.
279
Macroeconomics. Problems and Questions
Question 11
𝑟𝑟
1 0
𝑟𝑟̅ LM0
2
𝑟𝑟̅ ’ LM1
ISO
IS1
𝑌𝑌�1 𝑌𝑌�0 𝑌𝑌
280
The IS-LM model
If the autonomous component of investment 𝐼𝐼 ̅ and net taxes 𝑇𝑇� fall at the same
time and by the same amount, autonomous spending 𝐴𝐴 = 𝑐𝑐0 − 𝑐𝑐1 𝑇𝑇� + 𝐼𝐼 ̅ + 𝐺𝐺̅
changes by 𝛥𝛥𝛥𝛥 = 𝛥𝛥𝐼𝐼 ̅ − 𝑐𝑐1 𝛥𝛥𝑇𝑇� = (1 − 𝑐𝑐1 )𝛥𝛥𝐼𝐼 ̅ < 0. It follows that the IS will
shift to the left, and that the new equilibrium will be at point ′1′ in the figure,
with an unchanged interest rate and a lower equilibrium income. In the move
from equilibrium ′0′ to equilibrium ′1′, investment has gone down (due to the
decrease in its autonomous component and because of the fall in 𝑌𝑌), while the
sign of the change in consumption is uncertain (consumption tends to rise due
to the cut in taxes, and to fall because of the decrease in income). Even in the
case in which consumption ends up rising, the amount by which it increases
will however be less than that by which investment falls – in fact, at point ′1′
production has gone down, and therefore aggregate demand must necessarily
be lower than at point ′0′; being 𝐺𝐺 unchanged, it follows that the sum of the
private components of demand, 𝐶𝐶 and 𝐼𝐼, must have gone down in the move
from the first to the second equilibrium.
b. To return equilibrium output to the initial level (that is, the one pre-
vailing at point ′0′), what kind of monetary policy intervention should
the central bank implement? In the graph, denote by ′2′ the equilibri-
um that will be reached following the monetary policy you are suggest-
ing, and compare the composition of aggregate demand at point ′2′
with that prevailing in the initial equilibrium (point ′0′).
To return output to the initial level, 𝑌𝑌�0 , the central bank will have to lower the
real rate to 𝑟𝑟̅ ′. Compared to ′0′, in the equilibrium point ′2′ that the economy
will reach the supply of goods is unchanged; the same must therefore be true
about the aggregate demand for goods. Since, at ′2′, 𝐺𝐺̅ is unchanged and con-
sumption is higher (income is the same as at ′0′, but net taxes are lower), in
the move from ′0′ to ′2′ investment must necessarily have gone down (the im-
pact of the decrease in the real interest rate, that tends to raise 𝐼𝐼, must have
been more than offset by that stemming from the fall in its autonomous com-
ponent, 𝐼𝐼 )̅ .
281
Macroeconomics. Problems and Questions
Question 12
Consider a country described by an ‘extended’ IS-LM that differs from the one
described in the previous question only for the fact that consumption takes on
the following functional form:
������� .
𝐶𝐶 = 𝑐𝑐0 + 𝑐𝑐1 (𝑌𝑌 − 𝑇𝑇�) + 𝑎𝑎 𝑊𝑊𝑊𝑊𝑊𝑊
In the equation above, 𝑊𝑊𝑊𝑊𝑊𝑊 is the individuals’ financial and housing wealth,
assumed to be exogenous, and the parameter 𝑎𝑎 is greater than zero.
a. In this economy, will the slope of the IS curve differ from that
prevailing in the standard case, where consumption is a function of
disposable income only (𝑎𝑎 = 0)? If so, will the IS curve be steeper or
flatter than in the standard case? If not, why? Explain. [Hint: you are
not being asked to derive the analytical expression of the IS curve and of
its slope, but just to discuss whether this slope will be different from the
one prevailing in the standard case, and to provide the economic intuition
underlying your answer.] .
In the (𝑌𝑌, 𝑟𝑟) plane in which the IS-LM model is represented, the slope of the
IS depends on the extent by which a given change in the interest rate (the var-
iable measured along the vertical axis) changes the aggregate demand in the
economy, and therefore the level of production for which the goods market is
in equilibrium, given the values that the other variable on which aggregate
demand depends and not measured along the axes of the graph. If, for in-
stance (and for given 𝑐𝑐0 , 𝐼𝐼 ,̅ 𝐺𝐺̅ , 𝑇𝑇�, 𝑊𝑊𝑊𝑊𝑊𝑊
�������, etc.), a one percentage point decrease
in 𝑟𝑟 raises aggregate demand by a lot, the increase in production needed to re-
turn to goods market equilibrium will be large, and the IS curve therefore rel-
atively ‘flat’. It follows that the fact that demand also depends on the individ-
uals’ financial and housing wealth has nothing to do with the slope of the IS –
it just affects the position of this curve in the (𝑌𝑌, 𝑟𝑟) space. When, rather than
zero, the parameter 𝑎𝑎 is positive, an increase (a decrease) in 𝑊𝑊𝑊𝑊𝑊𝑊 raises
(lowers) the demand for goods for any given value of the real interest rate,
thus causing a rightward (leftward) parallel shift of the IS curve.
282
The IS-LM model
𝑟𝑟
𝑟𝑟̅ 2 1
LM1
IS2 IS1
𝑌𝑌�2 𝑌𝑌�1 𝑌𝑌
Both changes will shift the IS curve to the left. In the new equilibrium
(point’2’ in the figure), the interest rate will remain at the level chosen by the
central bank, while output will be lower. As for the composition of aggregate
demand, in the move from the old to the new equilibrium both investment
(due to the increase in the borrowing rate caused by the rise in 𝑥𝑥, and to the
decrease in 𝑌𝑌) and consumption (due to the increase in 𝑥𝑥 and to the decreases
in 𝑌𝑌 and in 𝑊𝑊𝑊𝑊𝑊𝑊) will fall. Finally, being exogenous, government purchases
of goods and service will of course remain unchanged.
283
Chapter 3 - The labor market, the IS-LM-PC
model, and inflation
285
Macroeconomics. Problems and Questions
Question 1
𝑊𝑊
𝑃𝑃
1 1 𝑃𝑃𝑃𝑃
1 + 𝑚𝑚 0
𝑊𝑊𝑊𝑊′
𝑊𝑊𝑊𝑊
𝑢𝑢𝑛𝑛 𝑢𝑢′𝑛𝑛 𝑢𝑢
286
The labor market, the IS-LM-PC model, and inflation
b. Realizing that the law just passed has an impact on employment, but still
determined to provide income support for those who lose their job, the
government implements measures aiming at increasing the degree of com-
petition in the goods market. Assuming that such measures succeed in re-
turning the unemployment rate to the natural level − that is, to the level
prevailing before the increase in unemployment benefits −, show the ef-
fects of this second policy intervention in the same graph used to answer
the previous point of this question.
𝑊𝑊
𝑃𝑃
1 2
𝑃𝑃𝑃𝑃′
1 + 𝑚𝑚′
1 1
𝑃𝑃𝑃𝑃
1 + 𝑚𝑚 0
𝑊𝑊𝑊𝑊′
𝑊𝑊𝑊𝑊
𝑢𝑢𝑛𝑛 𝑢𝑢′𝑛𝑛 𝑢𝑢
The economy is initially at point 1 in the graph, reached after the increase in
unemployment benefits. If the government succeeds in his attempt to increase
the degree of competition in the goods market, firms' market power is re-
duced, the mark-up 𝑚𝑚 falls, and the PS curve shifts upwards. Since we are
told that, with this intervention, the unemployment rate is returned to the ini-
tial level, the one prevailing before the rise in benefits, the new value of 𝑚𝑚,
𝑚𝑚′, will have to be such that the new PS (the curve PS' in the figure) crosses
the new WS (WS') for 𝑢𝑢 = 𝑢𝑢𝑛𝑛 − that is, at point 2 in the graph.
287
Macroeconomics. Problems and Questions
Question 2
...........................................................................................................................
a.1 𝜋𝜋𝑡𝑡 − 𝜋𝜋𝑡𝑡−1 = − 𝛼𝛼(𝑢𝑢𝑡𝑡 − 𝑢𝑢𝑛𝑛 ) or, equivalently, 𝜋𝜋𝑡𝑡 − 𝜋𝜋𝑡𝑡−1 = (𝑚𝑚 + 𝑧𝑧) − 𝛼𝛼𝑢𝑢𝑡𝑡
...........................................................................................................................
relationship between the unemployment rate and the change in the in-
...........................................................................................................................
flation rate: low unemployment is associated with rising inflation, and
high unemployment leads to decreasing inflation.
a.2 Rate of unemployment at which inflation neither decreases nor increases.
As clear from the equation for the Phillips curve written when answering
the previous point of this question, if 𝜋𝜋𝑡𝑡𝑒𝑒 = 𝜋𝜋𝑡𝑡−1 the NAIRU (“Non-
Accelerating Inflation Rate of Unemployment”) is equal to the natural
rate of unemployment 𝑢𝑢𝑛𝑛 (or, if you want, it gives another way of think-
ing about 𝑢𝑢𝑛𝑛 ).
a.3 Situation characterized by the coexistence of stagnation and inflation,
typically associated with a negative supply shock.
288
The labor market, the IS-LM-PC model, and inflation
b. Explain if and why you agree or disagree with the following statement:
“In order to increase the natural level of production 𝑌𝑌𝑛𝑛 , policy-makers can
follow two alternative strategies: (i) they can try to increase the demand for
goods permanently, for example by opting for a permanent increase in ei-
ther the money supply or in government purchases of goods and services,
or (ii) they can decide to implement ‘supply-side’ policies, such as those
leading to an increase in the degree of competition in the goods market.
The difference between the two strategies above is that the first one will
lead not just to an increase in 𝑌𝑌𝑛𝑛 , but also to a permanently higher level of
prices, while the second strategy will push the economy towards an equilib-
rium characterized by a higher 𝑌𝑌𝑛𝑛 and a lower general price level.”
The statement is incorrect. Monetary and fiscal policies have no effect what-
soever on the natural level of production (in the medium run, monetary policy
only affects the price level, while fiscal policy causes – in addition to a change
in the price level – a change in the composition of aggregate demand, but not
in its overall level). The only policies that can change the natural rate of un-
employment (and therefore the natural level of production) are supply-side
policies − for example, policies that affect the degree of competition in the
goods market, or the ‘flexibility’ of the labour market.
289
Macroeconomics. Problems and Questions
Question 3
True or False?
Explain whether the following statements are true or false. Motivate your answer
in a brief but rigorous way, by making explicit reference to the relevant theory.
Lack of proper explanations will result in zero points.
a. “The zero lower bound for the nominal interest rate implies that the real
interest rate cannot be smaller than minus the expected inflation rate,
−𝜋𝜋 𝑒𝑒 ”.
290
The labor market, the IS-LM-PC model, and inflation
291
Macroeconomics. Problems and Questions
Question 4
True or False?
Explain whether the following statements are true or false. Motivate your answer
in a brief but rigorous way, by making explicit reference to the relevant theory.
Lack of proper explanations will result in zero points.
...........................................................................................................................
True. With 𝜋𝜋𝑡𝑡𝑒𝑒 = 𝜋𝜋𝑡𝑡−1 , the equation for the expectations-augmented Phillips
...........................................................................................................................
curve is 𝜋𝜋𝑡𝑡 − 𝜋𝜋𝑡𝑡−1 = −𝛼𝛼(𝑢𝑢𝑡𝑡 − 𝑢𝑢𝑛𝑛 ). From this expression it follows that
...........................................................................................................................
𝑢𝑢𝑡𝑡 < 𝑢𝑢𝑛𝑛 if and only if 𝜋𝜋𝑡𝑡 > 𝜋𝜋𝑡𝑡−1 − inflation must increase over time. To
understand why this must be the case, recall that 𝜋𝜋𝑡𝑡𝑒𝑒 = 𝜋𝜋𝑡𝑡−1 . From 𝜋𝜋𝑡𝑡 > 𝜋𝜋𝑡𝑡−1
...........................................................................................................................
it then follows that, for given 𝑃𝑃𝑡𝑡−1 , 𝑃𝑃𝑡𝑡 > 𝑃𝑃𝑡𝑡𝑒𝑒 − workers are underestimating
...........................................................................................................................
the general price level, and therefore are overestimating the real wage they
are receiving. This overestimation is what is needed to bring unemployment
...........................................................................................................................
below the natural rate.
292
The labor market, the IS-LM-PC model, and inflation
b. The smaller the fraction of wages indexed to the inflation rate, the larger
the increase in inflation associated with any given decrease in the rate of
unemployment.
False. Assume that a fraction 𝜆𝜆 (with 0 < 𝜆𝜆 < 1) of wages is indexed, and
that 𝜋𝜋𝑡𝑡𝑒𝑒 = 𝜋𝜋𝑡𝑡−1 . The expectations-augmented Phillips curve in this case be-
comes:
𝛼𝛼
𝜋𝜋𝑡𝑡 − 𝜋𝜋𝑡𝑡−1 = − (𝑢𝑢 − 𝑢𝑢𝑛𝑛 ).
1 − 𝜆𝜆 𝑡𝑡
The sensitivity of inflation to unemployment is 𝛼𝛼/(1 − 𝜆𝜆), which is increasing
in 𝜆𝜆 .
To understand why this is the case, notice that, when wages are not indexed
(𝜆𝜆 = 0), if this year unemployment falls, wages will increase, leading to an
increase in prices and inflation. With 𝜋𝜋𝑡𝑡𝑒𝑒 = 𝜋𝜋𝑡𝑡−1 , even though current infla-
tion is now higher, there will be no further increase in current year's wages
and prices. If, however, at least some wages are indexed, the increase in prices
that takes place this year leads to a further increase in those wages which are
indexed, and this will in turn lead to a new increase in this year's prices. The
effect of a change in unemployment on the inflation rate is therefore larger in
the presence of indexation. The larger is 𝜆𝜆, the stronger this effect is going to
be.
293
Macroeconomics. Problems and Questions
Question 5
True or False?
Explain whether the following statements are true or false. Motivate your answer
in a brief but rigorous way, by making explicit reference to the relevant theory.
Lack of proper explanations will result in zero points.
True. One of the ways in which the Phillips curve can be written is:
𝜋𝜋𝑡𝑡 − 𝜋𝜋𝑡𝑡𝑒𝑒 = (𝑚𝑚 + 𝑧𝑧) − 𝛼𝛼𝑢𝑢𝑡𝑡 .
A decrease in firms' market power amounts to a reduction in the mark-up 𝑚𝑚
and therefore, other things the same, to a fall in current inflation, 𝜋𝜋𝑡𝑡 . The rea-
son is that today, time 𝑡𝑡, firms with less market power will set lower prices for
the goods they produce. For given prices at time 𝑡𝑡 − 1, lower prices at 𝑡𝑡 imply
a lower inflation rate.
[One could reach the same conclusion also using the following, alternative
version of the Phillips curve:
𝜋𝜋𝑡𝑡 = 𝜋𝜋𝑡𝑡𝑒𝑒 − 𝛼𝛼(𝑢𝑢𝑡𝑡 − 𝑢𝑢𝑛𝑛 ).
The WS-PS model implies that the natural rate of unemployment depends
positively on the mark-up 𝑚𝑚. A decrease in 𝑚𝑚 will therefore lower 𝑢𝑢𝑛𝑛 , and −
for any given 𝜋𝜋𝑡𝑡𝑒𝑒 and 𝑢𝑢𝑡𝑡 − from the previous equation it follows that 𝜋𝜋𝑡𝑡 will
fall].
294
The labor market, the IS-LM-PC model, and inflation
...........................................................................................................................
False. Current inflation can fall also if, for given 𝑢𝑢𝑡𝑡 and 𝑢𝑢𝑛𝑛 , individuals start
...........................................................................................................................
expecting a lower inflation rate − that is, if 𝜋𝜋𝑡𝑡𝑒𝑒 falls. The reason is that, since
they now expect lower inflation, workers will be willing to accept a lower
nominal wage. This decrease in labor costs will enable firms to set prices at a
lower level. For given prices in the previous period, a lower current rate of in-
flation will result.
295
Macroeconomics. Problems and Questions
Question 6
True or False?
Explain whether the following statements are true or false. Motivate your answer
in a brief but rigorous way, by making explicit reference to the relevant theory.
Lack of proper explanations will result in zero points.
a. “In country Alpha 𝜋𝜋𝑡𝑡𝑒𝑒 = 𝜋𝜋𝑡𝑡 , while in country Beta 𝜋𝜋𝑡𝑡𝑒𝑒 = 2%. It follows
that, to keep the rate of unemployment at the natural level (𝑢𝑢𝑡𝑡 = 𝑢𝑢𝑛𝑛 for
each time 𝑡𝑡), the rate of inflation must remain constant in Alpha, and in-
crease at a rate greater than 2% in Beta”.
296
The labor market, the IS-LM-PC model, and inflation
b. “In country Gamma 𝜋𝜋𝑡𝑡𝑒𝑒 = 3%, while in country Delta 𝜋𝜋𝑡𝑡𝑒𝑒 = 𝜋𝜋𝑡𝑡−1 . It fol-
lows that, to keep the rate of unemployment at the natural level (𝑢𝑢𝑡𝑡 = 𝑢𝑢𝑛𝑛
for each time 𝑡𝑡), in both countries the rate of inflation must remain con-
stant over time ”.
To conclude that the statement is true it suffices to notice that, given the rela-
tionship between the deviation of the inflation rate from its expected value and
the deviation of the unemployment rate from its natural level used to answer
the previous point, to have 𝑢𝑢𝑡𝑡 = 𝑢𝑢𝑛𝑛 for each time 𝑡𝑡 one needs an inflation rate
always equal to 3%, and therefore constant over time, in Gamma; further-
more, in Delta the rate of inflation will have to be always equal to the level
prevailing in the previous period, and therefore once again constant (even if
not necessarily at the 3% level as in country Gamma).
297
Macroeconomics. Problems and Questions
* Question 7
[The natural rate of interest - Monetary policy and fiscal policy in the medium-
run]
a. Define the concept of natural rate of interest, 𝑟𝑟𝑛𝑛 , and discuss its deter-
minants using a graph in which the real rate 𝑟𝑟 is measured along the
vertical axis, and goods' supply and demand along the horizontal one.
𝑟𝑟
𝑟𝑟𝑛𝑛 1
𝐶𝐶 + 𝐼𝐼 + 𝐺𝐺
0
𝑌𝑌𝑛𝑛 supply of goods,
demand for goods
298
The labor market, the IS-LM-PC model, and inflation
The natural rate of interest, 𝑟𝑟𝑛𝑛 , is the value of the real rate 𝑟𝑟 associated with
the natural level of output, 𝑌𝑌𝑛𝑛 − that is, with the level of output that the econ-
omy produces when unemployment is at its natural rate, 𝑢𝑢𝑛𝑛 . More specifical-
ly, 𝑟𝑟𝑛𝑛 is the value of the real interest rate for which the goods market is in a
medium-run equilibrium. Since, in this equilibrium, 𝑌𝑌 = 𝑌𝑌𝑛𝑛 , the natural rate is
implicitly defined by the following equation:
𝑌𝑌𝑛𝑛 = 𝐶𝐶(𝑌𝑌𝑛𝑛 − 𝑇𝑇�) + 𝐼𝐼(𝑟𝑟𝑛𝑛 + 𝑥𝑥, 𝑌𝑌𝑛𝑛 ) + 𝐺𝐺̅ .
In the figure, the left-hand side (the supply of goods) is the line vertical at the
natural level of output; in fact, in the medium-run the supply of goods does
not depend on 𝑟𝑟, but rather on the factors on which the WS-PS model focuses
(technology, institutional characteristics of the labour market, the degree of
competition in goods and factor markets, etc.) and that jointly determine the
natural rate of unemployment. The right-hand side (the demand for goods) is,
in the same graph, a curve with a negative slope, as investment is decreasing in
𝑟𝑟. The natural rate of interest is found at the intersection of the two curves.
Since, as you will remember, in goods market equilibrium national saving
equals investment, an alternative (and fully equivalent) way of defining the
natural rate of interest is to think of 𝑟𝑟𝑛𝑛 as that value of 𝑟𝑟 for which − in me-
dium-run equilibrium, and therefore when output is at its natural level − the
sum of private and public saving equals investment.
Money is neutral if, in the medium run, monetary policy can only affect the
general price level and the variables measured in nominal terms, leaving un-
changed 'real' variables such as output, unemployment, consumption, invest-
ment, the real interest rate, etc. It is important to realize that the fact that
money is neutral in the medium run does not mean that it never affects the
economy, but just that its effects are going to be transitory, bound to disap-
pear over time.
299
Macroeconomics. Problems and Questions
To verify that, in our model, money is indeed neutral, suppose that − starting
from a medium-run equilibrium like point 1 in the figure − the central bank im-
plements a monetary expansion. In particular, assume that it decides to lower
the policy rate and that, to this end, it raises the money supply (for instance,
through an open market purchase of bonds).
We know from the IS-LM-PC model that, in the short run, the cut in the policy
rate will increase aggregate demand. Output will rise above its natural level,
and inflation will become positive (that is, it will rise above its expected value,
that for simplicity we have taken to be equal to zero). Prices will therefore
start rising. Let us ask ourselves, however, not how the central bank interven-
tion will affect the short-run equilibrium, but rather how it will affect the econ-
omy in the medium run, the relevant time horizon for both the previous figure
and the 'neutrality of money' proposition. The monetary expansion will not
change 𝑌𝑌𝑛𝑛 (the natural level of output does not depend on 𝑀𝑀, but on those 'sup-
ply-side' factors mentioned before), or the level of aggregate demand prevailing
in medium-run equilibrium, 𝐶𝐶(𝑌𝑌𝑛𝑛 − 𝑇𝑇�) + 𝐼𝐼(𝑟𝑟𝑛𝑛 , 𝑌𝑌𝑛𝑛 ) + 𝐺𝐺̅ (as 𝑀𝑀 is not among the
variables on which 𝐶𝐶, 𝐼𝐼 or 𝐺𝐺 depend). Therefore, following a monetary expan-
sion, none of the two curves in the graph above will shift, and the natural rate of
interest will not change. In the new medium-run equilibrium, output and the real
interest rate will be the same as before, and the composition of aggregate de-
mand will be unchanged, too. Compared to the initial equilibrium, the only var-
iable that will take on a different value is the price level, which will be higher.
300
The labor market, the IS-LM-PC model, and inflation
𝑟𝑟
𝑟𝑟𝑛𝑛 1
𝐶𝐶 + 𝐼𝐼 + 𝐺𝐺̅
𝑟𝑟𝑛𝑛′ 2
𝐶𝐶 + 𝐼𝐼 + 𝐺𝐺̅ ′
0
𝑌𝑌𝑛𝑛 supply of goods,
demand for goods
Suppose that government spending on goods and services is cut from 𝐺𝐺̅ to the
new level 𝐺𝐺̅ ′ < 𝐺𝐺̅ . This change does not affect the supply of goods prevailing
in the medium run, since 𝑌𝑌𝑛𝑛 depends on supply-side factors that we have as-
sumed to be independent of 𝐺𝐺. It will however lead to a lower aggregate de-
mand for goods. In the figure, the curve representing the aggregate demand
prevailing in the medium run shifts down and to the left, and the medium-run
equilibrium becomes point 2, where output is unchanged and the natural inter-
est rate is lower. In the move from the old to the new medium-run equilibrium,
the overall level of aggregate demand is unchanged (as it must be, being the
supply of goods unchanged); its composition is however different − 𝐺𝐺 is lower,
consumption is unchanged (because disposable income is unchanged), and in-
vestment is higher (due to the fall in the real interest rate). Since the overall
level of aggregate demand has not been affected by the fiscal policy in consid-
eration, one can also conclude that investment must have gone up by the same
amount by which 𝐺𝐺 has been cut − the fall in the natural rate (from 𝑟𝑟𝑛𝑛 to 𝑟𝑟𝑛𝑛′ in
the figure) will take care of delivering the required rise in investment.
In conclusion, and even though it does not affect output in the medium run,
fiscal policy affects the natural interest rate and the composition of aggregate
demand over the same time horizon. It follows that, contrary to what we have
concluded about monetary policy, fiscal policy is not neutral, not even in the
medium run.
301
Macroeconomics. Problems and Questions
* Question 8
where, as usual, the positive constant 𝑐𝑐0 is autonomous consumption, 𝑐𝑐1 − the
marginal propensity to consume − is between zero and one, and the other
symbols have the usual meaning.
𝑟𝑟
𝐼𝐼𝐼𝐼2
𝐼𝐼𝐼𝐼1
2
𝑟𝑟𝑛𝑛′ 𝐿𝐿𝐿𝐿2
1'
𝑟𝑟𝑛𝑛 𝐿𝐿𝐿𝐿1
1
𝑌𝑌𝑛𝑛 𝑌𝑌
𝜋𝜋 − 𝜋𝜋−1 𝑃𝑃𝑃𝑃
1'
0
𝑌𝑌𝑛𝑛 𝑌𝑌
302
The labor market, the IS-LM-PC model, and inflation
The increase in 𝑐𝑐0 raises the demand for goods and shifts the IS curve to the
right. Since the central bank keeps the policy rate at the level 𝑟𝑟𝑛𝑛 , the economy
goes from the initial medium-run equilibrium to the new short-run equilibrium
1′. Output rises above 𝑌𝑌𝑛𝑛 , since firms meet the higher demand they face by
producing more, and unemployment falls below 𝑢𝑢𝑛𝑛 . This drop in the unem-
ployment rate leads to an increase in wages, which firms will pass onto higher
prices for the goods they produce. Inflation will rise, as shown in the lower
panel of the graph. Finally, the increase in 𝑌𝑌 will raise the equilibrium values
of both consumption and investment.
b. How should the central bank intervene if, in the short-run, it intends to
keep the policy rate at 𝑟𝑟𝑛𝑛 ? Do you think that 𝑟𝑟 can be kept at this level
indefinitely? If not, at what value should the policy rate be allowed to
converge? Motivate your answer by making explicit reference both to
the graph you have just drawn and to the one used to answer Question
7 of this Chapter.
Since 𝑟𝑟 = 𝑖𝑖 − 𝜋𝜋 𝑒𝑒 , and given expected inflation, to keep 𝑟𝑟 constant the central
bank will have to rely on the control it exerts on i (for instance, through open
market operations). More specifically, the central bank will have to prevent
any change in the difference between 𝑖𝑖 and 𝜋𝜋 𝑒𝑒 , and therefore in the real rate,
resulting from the following two forces: (i) the increase in 𝑌𝑌 caused by the
rise in 𝑐𝑐0 raises the price level and inflation, therefore leading, sooner or later,
to an increase in 𝜋𝜋 𝑒𝑒 ; (ii) both a higher 𝑃𝑃 and a higher 𝑌𝑌 cause an excess de-
mand for money in the money market, and therefore tend to raise 𝑖𝑖. If, as a
result of the two forces above, the difference between 𝑖𝑖 and 𝜋𝜋 𝑒𝑒 , and therefore
𝑟𝑟, tends to rise (fall) by 1%, the central bank will have to implement a mone-
tary expansion (contraction) that lowers (raises) the nominal interest rate by
the same 1%. However, this policy cannot be pursued indefinitely. In fact, the
increase in 𝑐𝑐0 raises the natural interest rate (in the graph introduced in
Question 7, the curve representing the demand for goods shifts to the right; in
the IS-LM-PC graph above, the value of 𝑟𝑟 for which the new IS curve and the
dashed, vertical line going through 𝑌𝑌 = 𝑌𝑌𝑛𝑛 − an intersection that, in that
graph, always takes place for the natural rate of interest − is now 𝑟𝑟𝑛𝑛′ > 𝑟𝑟𝑛𝑛 ). If
the central bank persisted in keeping r at its initial level, 𝜋𝜋 would keep rising,
and the economy would never return to a medium-run equilibrium. Once it has
become aware of the nature and the size of the shock, and with the lags with
which it typically acquires adequate knowledge on the actual state of the
economy, it is therefore plausible that − as we shall always assume in similar
situations − the central bank will bring 𝑟𝑟 to the new equilibrium level 𝑟𝑟𝑛𝑛′ .
303
Macroeconomics. Problems and Questions
Question 9
a. To reduce a budget deficit deemed too high, the government of Eta de-
cides to raise taxes. At the same time, the central bank decides to resort to
an open market operation, aimed at preventing the fiscal policy just men-
tioned from changing the inflation rate, π. In an IS-LM-PC diagram, de-
note the initial medium-run equilibrium by ‘1’ and represent the new me-
dium-run equilibrium to which Eta will converge after the implementation
of the policy-mix described above. In particular, describe the type of open
market operation (purchase; sale) that the central bank should implement
to reach its objective.
𝑟𝑟 𝐼𝐼𝐼𝐼1
𝐼𝐼𝐼𝐼2
𝑟𝑟𝑛𝑛2 𝐿𝐿𝐿𝐿2
2
𝑌𝑌𝑛𝑛 𝑌𝑌
𝜋𝜋 − 𝜋𝜋−1 𝑃𝑃𝑃𝑃
0
𝑌𝑌𝑛𝑛 𝑌𝑌
1'
304
The labor market, the IS-LM-PC model, and inflation
The tax hike lowers consumption and shifts the IS curve to the left. If the cen-
tral bank did not intervene, the fall in aggregate demand caused by the de-
crease in consumption would lower output, and the economy would go from
the initial medium-run equilibrium 1 to the new short-run equilibrium 1′. Out-
put would fall below its natural level, and the unemployment rate rise above
𝑢𝑢𝑛𝑛 . These changes would lower wages, and therefore prices. To prevent the
ensuing fall in inflation, the central bank will have to lower the policy rate to
𝑟𝑟𝑛𝑛2 , thus shifting the 𝐿𝐿𝐿𝐿 curve downwards to 𝐿𝐿𝐿𝐿2 . What is needed is therefore
a monetary expansion, that − since it has decided to resort to an open market
operation − the central bank will have to implement by purchasing bonds in
the secondary market for these assets. Notice that the new LM that will result
from this intervention will have to intersect the new IS curve for 𝑌𝑌 = 𝑌𝑌𝑛𝑛 − in
fact, from the Phillips curve it follows that an intersection for any level of
output different from the natural one would lead, rather than to an unchanged
π, to an inflation rate rising or falling over time, depending on whether, at the
intersection point, output is greater than 𝑌𝑌𝑛𝑛 , or less than 𝑌𝑌𝑛𝑛 .
305
Macroeconomics. Problems and Questions
Question 10
a. Having explained if, in the (𝑌𝑌, 𝑟𝑟) space, the slope of the IS curve is in this
case negative, zero or positive, assume that the economy is initially in a
medium-run equilibrium, with 𝑌𝑌 = 𝑌𝑌𝑛𝑛 , 𝑟𝑟 = 𝑟𝑟𝑛𝑛 and 𝜋𝜋 − 𝜋𝜋−1 = 0. Show in
the graph, and discuss, the short-run effects of a permanent increase in the
financial markets participants’ degree of risk aversion, assuming that the
central bank keeps the policy rate constant at the initial level, 𝑟𝑟𝑛𝑛 . In the
move from the initial to the new short-run equilibrium, how will
consumption and investment change? Explain.
𝑟𝑟 𝐼𝐼𝐼𝐼1
𝐼𝐼𝐼𝐼2
2 1
𝑟𝑟𝑛𝑛 𝐿𝐿𝐿𝐿1
0
𝑌𝑌2 𝑌𝑌𝑛𝑛 𝑌𝑌
𝜋𝜋 − 𝜋𝜋−1 𝑃𝑃𝑃𝑃
1
0
𝑌𝑌𝑛𝑛 𝑌𝑌
2
306
The labor market, the IS-LM-PC model, and inflation
In this economy, a decrease in 𝑟𝑟 raises not just investment, but also consump-
tion. As in the standard case, the demand for goods will depend negatively on
the real rate, and the IS curve will therefore be negatively sloped in the (𝑌𝑌, 𝑟𝑟)
plane. When, starting from the initial medium-run equilibrium denoted by 1 in
the figure, the degree of risk aversion rises, the IS shifts to the left, as the in-
crease in the risk premium 𝑥𝑥 leads to an increase in the borrowing rate that
lowers consumption and investment. Since, by assumption, the central bank
does not change the policy rate, the new short-run equilibrium becomes 2,
where both consumption and investment have gone down, due to the rise in 𝑥𝑥
and the ensuing fall in 𝑌𝑌.
b. Suppose that, once the economy has reached the short-run equilibrium
described in the answer to the previous point, the government decides to
return output to the natural level by changing 𝐺𝐺̅ . To achieve its goal,
should the government raise or lower 𝐺𝐺̅ ? Compare the levels of invest-
ment, consumption, private saving, public saving and national saving in
the new medium-run equilibrium that will be reached after the govern-
ment’s intervention to the levels of the same variables in the initial one
(that is, the medium-run equilibrium prevailing before the increases in the
degree of risk aversion and in 𝐺𝐺̅ ). Explain. [Hint: write down the (private)
saving function for this economy].
To return output to its natural level, the government will have to bring the IS
curve back to its initial position. This requires an increase in 𝐺𝐺̅ . After this fis-
cal policy intervention, the medium run equilibrium will be once again at point
1 in the figure, with lower consumption and investment (𝑟𝑟 and Y are un-
changed, but the risk premium is now higher, and with it the borrowing rate).
Government saving will be lower, too (𝐺𝐺̅ has gone up, and net taxes 𝑇𝑇� have
not changed), while private saving 𝑆𝑆 = (𝑌𝑌 − 𝑇𝑇�) − 𝐶𝐶 = −𝑐𝑐0 + (1 − 𝑐𝑐1 )(𝑌𝑌 −
𝑇𝑇�) + ℎ2 (𝑟𝑟 + 𝑥𝑥) will be higher, due to the increase in 𝑥𝑥. Since investment has
gone down, the same must be true about national saving (the amount by
which private saving has risen will be smaller than that by which public saving
has fallen).
307
Macroeconomics. Problems and Questions
Question 11
𝑟𝑟 𝐼𝐼𝐼𝐼1
𝐼𝐼𝐼𝐼2
2 1
𝑟𝑟𝑛𝑛 𝐿𝐿𝐿𝐿1
3
𝐿𝐿𝐿𝐿3
0
𝑌𝑌2 𝑌𝑌𝑛𝑛 𝑌𝑌
𝜋𝜋 − 𝜋𝜋−1
𝑃𝑃𝑃𝑃
1
0
𝑌𝑌𝑛𝑛 𝑌𝑌
308
The labor market, the IS-LM-PC model, and inflation
Although, in this economy, a fall in 𝑟𝑟 will not affect investment, it will raise
consumption. It follows that, as in the standard case, goods demand depends
negatively on the real interest rate, so that the IS curve will still be negatively
sloped in the (𝑌𝑌, 𝑟𝑟) plane. When, starting from the initial medium-run equilib-
rium 1 in the figure, autonomous consumption and net taxes change by 𝛥𝛥𝑐𝑐0 =
𝛥𝛥𝑇𝑇� < 0, autonomous demand will change by 𝛥𝛥𝑐𝑐0 − 𝑐𝑐1 𝛥𝛥𝑇𝑇� = (1 − 𝑐𝑐1 )𝛥𝛥𝑐𝑐0 < 0,
and the IS curve will therefore shift to the left. Since the central bank does not
change the policy rate, the new short-run equilibrium becomes 2, where in-
come is lower. Given that, being exogenous, both investment and 𝐺𝐺 have re-
mained constant, consumption will have to be lower in this new short-run equi-
librium.
b. Suppose that, once the economy has reached the short run equilibrium
you have described when answering the previous point, the central bank
decides to bring income back to the natural level by implementing an
open market operation. To achieve its aim, should it buy or sell bonds in
the open market? Show in the graph the new equilibrium that will be
reached following the central bank’s intervention you consider appropri-
ate. In this new equilibrium, how will the levels of investment, consump-
tion, private saving, public saving and national saving compare to the lev-
els of the same variables in the initial medium-run equilibrium (that is, the
equilibrium prevailing before the changes in autonomous consumption
and the fiscal and monetary policy interventions described above)?
To return income to the natural level, the central bank will have to lower the
policy rate. This calls for a purchase of bonds in the open market, something
that will cause a downward shift in the LM curve. In the figure, the new equi-
librium becomes point 3. In this new medium-run equilibrium, 𝑌𝑌 is the same as
at point 1. It follows that aggregate demand, too, will have to be the same in
the two equilibria. And since 𝐺𝐺 and 𝐼𝐼 are unchanged, in the move from 1 to 3
consumption, too, must have remained unchanged. Finally, since investment is
exogenous, and therefore constant, also national saving will have to be un-
changed. It follows that, since public savings has gone down (net taxes have
been cut), private saving must have gone up (thanks to the tax cut and the de-
crease in 𝑐𝑐0 , and the fall in the real interest rate notwithstanding) by the same
amount.
309
Macroeconomics. Problems and Questions
Question 12
In the figure, the IS curve shift leftwards to 𝐼𝐼𝐼𝐼2 , and output falls to 𝑌𝑌1′ < 𝑌𝑌𝑛𝑛 .
To return it to its natural level, the central bank should cut the policy rate to
𝑟𝑟𝑛𝑛2 , thus shifting the LM curve downwards till it becomes the dashed, horizon-
tal line drawn for this latter value of the real rate. Since 𝑟𝑟 = 𝑖𝑖 − 𝜋𝜋 𝑒𝑒 , a central
bank wishing to reduce 𝑟𝑟 will usually do so by lowering the nominal interest
rate, 𝑖𝑖. In this case, however, the central bank will not be able to bring the real
rate to the target level. In fact, being 𝜋𝜋 𝑒𝑒 = 𝜋𝜋� = 0, in this economy 𝑟𝑟 = 𝑖𝑖. The
Zero Lower Bound − that is, the fact that the nominal interest rate cannot
fall below zero − implies that the real rate cannot take on negative values, and
therefore that 𝑟𝑟𝑛𝑛2 cannot be reached. The most the central bank can do in a
similar situation is to set to zero both 𝑖𝑖 and 𝑟𝑟, shifting downwards the LM to
𝐿𝐿𝐿𝐿0 and moving the economy to point 2′, where output is greater than 𝑌𝑌1′ , but
still below its natural level.
310
The labor market, the IS-LM-PC model, and inflation
𝑟𝑟 𝐼𝐼𝐼𝐼1
𝐼𝐼𝐼𝐼2
1' 1
𝑟𝑟𝑛𝑛1 𝐿𝐿𝐿𝐿1
2′
0 𝐿𝐿𝐿𝐿0
𝑟𝑟𝑛𝑛2 2
𝑌𝑌1′ 𝑌𝑌𝑛𝑛 𝑌𝑌
𝜋𝜋 𝑃𝑃𝑃𝑃
0
𝑌𝑌𝑛𝑛 𝑌𝑌
1'
311
Macroeconomics. Problems and Questions
Question 13
𝑊𝑊/𝑃𝑃
𝐴𝐴/(1+𝑚𝑚) 𝑃𝑃𝑃𝑃
𝐴𝐴′/(1+𝑚𝑚) 𝑃𝑃𝑃𝑃′
𝑊𝑊𝑊𝑊
𝑢𝑢𝑛𝑛 𝑢𝑢′𝑛𝑛 𝑢𝑢
312
The labor market, the IS-LM-PC model, and inflation
𝑟𝑟
2
𝑟𝑟𝑛𝑛2 𝐿𝐿𝐿𝐿2
1
𝑟𝑟𝑛𝑛1 𝐿𝐿𝐿𝐿1
1'
𝐼𝐼𝐼𝐼1
𝑌𝑌𝑛𝑛′ 𝑌𝑌𝑛𝑛 𝑌𝑌
𝜋𝜋 − 𝜋𝜋−1 𝑃𝑃𝑃𝑃'
𝑃𝑃𝑃𝑃
1'
𝑌𝑌𝑛𝑛′
0
𝑌𝑌𝑛𝑛 𝑌𝑌
In the IS-LM-PC diagram, the PC curve shifts upwards. If the central bank
does not change the policy rate, the new short-run equilibrium is point 1′,
where output is unchanged and inflation higher. The rise in inflation is due to
the fact that, as discussed above, the fall in A leads firms to supply each unit
of output at a higher price. Given last period's prices, a higher current price
level implies more inflation. To prevent inflation from rising period after peri-
od, sooner or later the central bank will have to raise the policy rate. When
this latter will be set to 𝑟𝑟𝑛𝑛2 , the economy will once again be in a medium-run
equilibrium position, with constant inflation and output at its (new) natural
level. Compared to the initial equilibrium (1), in this new medium-run equilib-
rium (2) both consumption (due to the fall in 𝑌𝑌) and investment (due to the
fall in 𝑌𝑌 and the rise in 𝑟𝑟) will be lower.
313
Macroeconomics. Problems and Questions
Question 14
𝑟𝑟
2
𝑟𝑟𝑛𝑛2 𝐿𝐿𝐿𝐿2
1
𝑟𝑟𝑛𝑛1 𝐿𝐿𝐿𝐿1
1'
𝐼𝐼𝐼𝐼1
𝑌𝑌𝑛𝑛′ 𝑌𝑌𝑛𝑛 𝑌𝑌
𝜋𝜋 − 𝜋𝜋−1 𝑃𝑃𝑃𝑃'
𝑃𝑃𝑃𝑃
1'
𝑌𝑌𝑛𝑛′
0
𝑌𝑌𝑛𝑛 𝑌𝑌
An increase in the minimum wage leads to a higher wage set by wage setters
for any given unemployment rate. In the WS-PS model, it is represented by
an increase in 𝑧𝑧 which shifts the WS curve up and to the right, thus causing an
increase in the natural rate of unemployment and a decrease in the natural
level of output.
314
The labor market, the IS-LM-PC model, and inflation
In the figure, the new natural level of output is 𝑌𝑌𝑛𝑛′ (< 𝑌𝑌𝑛𝑛 ). In the IS-LM-PC
diagram, the PC curve shifts up and to the left. Since we are told that the po-
sition of the IS curve is not affected by the change in consideration, if the cen-
tral bank does not vary the policy rate the new short-run equilibrium becomes
point 1′, where output, consumption and investment are unchanged, but infla-
tion is higher. The inflation rate rises because, due to the increase in the min-
imum wage and to the ensuing rise in wages, now firms charge higher unit
prices for the goods they produce. For given prices prevailing in the previous
period, a higher general price level today implies a higher inflation rate.
b. Suppose that, once the economy has reached the short-run equilibrium
described in the answer to the previous point, the central bank decides to
bring back income to its natural level by implementing an open market
operation. Explain if, to achieve its goal, the central bank should purchase
or sell bonds, and show in the figure the new policy rate consistent with
the new medium run equilibrium, denoting it by 𝑟𝑟𝑛𝑛2 . Finally, discuss how
the central bank should act in order to return not just output to the natu-
ral level, but also the general price level to the value it was taking on in the
initial medium run equilibrium [Hint: you are not asked to show in the
graph the strategy that, in this latter case, the central bank should follow;
just illustrate verbally its main features].
...........................................................................................................................
To bring income to the new natural level, the central bank should raise the
policy rate till 𝑟𝑟𝑛𝑛2 , thus shifting the 𝐿𝐿𝐿𝐿 curve upwards to 𝐿𝐿𝐿𝐿2 . This of course
...........................................................................................................................
requires an open market sale of bonds. As long as the economy remains in the
...........................................................................................................................
short-run equilibrium 1′, with income above the new natural level, the infla-
...........................................................................................................................
tion rate is positive, and the price level will therefore keep rising. If the central
bank aims at bringing back not just output to the natural level, but also the
...........................................................................................................................
general price level to the value it was taking on in the initial medium run equi-
librium, it should temporarily bring the policy rate above 𝑟𝑟𝑛𝑛2 , and therefore
production below the natural level. Being 𝑌𝑌 < 𝑌𝑌𝑛𝑛′ , the inflation rate will be
negative, and the general price level falling. Once it is back to its initial value,
the central bank should lower the real rate to 𝑟𝑟𝑛𝑛2 , thus achieving its two goals.
315
Macroeconomics. Problems and Questions
Question 15
a. To understand the cause of the fall in the real interest rate, the govern-
ment of the country consults two economists, Harry and Ginny. Accord-
ing to Harry, the fact that the inflation rate has remained constant allows
one to conclude that the economy must have been hit by an adverse de-
mand shock, one to which the central bank has reacted by bringing 𝑟𝑟 to
the new, lower medium run equilibrium level. The reduction in the real
rate therefore reflects, without any doubt, a decrease in its natural level,
𝑟𝑟𝑛𝑛 . Ginny instead thinks that, to be able to conclude that the economy has
been experiencing a fall in 𝑟𝑟𝑛𝑛 , rather than a decision of the central bank to
bring the real rate below an unchanged natural level, further information
is needed. In particular, one needs to know whether, over the past two
years, the inflation rate has remained constant at 2%, or at a level greater
than 2%. Represent in the graph below the medium run equilibrium pre-
vailing in Macro two years ago (𝑟𝑟𝑛𝑛 = 3%), denoting it by ‘1’. In the same
graph, denote by ‘2’ the equilibrium, associated with a real rate of 1%,
that would prevail if the fall in 𝑟𝑟 is due to a decrease in the natural, medi-
um run, real rate, and by ‘3’ that which would instead prevail if the de-
crease of the real rate to 1% is the outcome of the decision of the central
bank to bring 𝑟𝑟 below an unchanged natural level. Which of the two eco-
nomists is right? Why? Explain.
𝑟𝑟
𝐼𝐼𝐼𝐼1
𝐼𝐼𝐼𝐼2 1
𝑟𝑟𝑛𝑛1 = 3% 𝐿𝐿𝐿𝐿1
3
1% 𝐿𝐿𝐿𝐿2,3
2
0
𝑌𝑌𝑛𝑛 𝑌𝑌3 𝑌𝑌
𝜋𝜋 − 2% 𝑃𝑃𝑃𝑃
3
2
1
0
𝑌𝑌𝑛𝑛 𝑌𝑌3 𝑌𝑌
316
The labor market, the IS-LM-PC model, and inflation
The medium run equilibrium prevailing two years ago is 1 in the two graphs.
Harry thinks that the current 1% real rate is the by-product of a leftward shift
of the IS curve, and of the central bank’s decision to allow the economy to
reach the new medium run equilibrium 2 by decreasing the policy rate till the
new, lower natural level of 1%. According to Ginny, however, one should also
consider the possibility that the economy is at point 3 – no demand shock has
hit the economy; rather, the central bank is insisting on keeping income
above, and the real rate below, their natural levels, both unchanged compared
to two years ago. To be able to conclude which of the two economists is right,
one must look at the lower panel of the figure. From the Phillips curve it fol-
lows that, if Harry if right, then over the past two years inflation should have
remained constant at 2%; if Ginny is right, inflation should have been con-
stant, but at a level greater than 2%. Since we are just told that inflation has
remained constant, but not at which level, Ginny is right – to be able to assess
the cause of the low real interest rate, more information is needed.
b. Say you are now told that, in Macro, rather than an inflation rate con-
stant at 2%, individuals always expect an inflation rate equal to that ob-
served in the previous period, so that 𝜋𝜋 𝑒𝑒 = 𝜋𝜋−1 . Which of the two econo-
mists is right, in this case? Why? Explain.
In this case, the upper panel of the figure remains unchanged; however, to be
measured along the vertical axis of the lower one is now the difference be-
tween π and 𝜋𝜋−1, rather than that between the current inflation rate and 2%.
It follows that inflation will remain constant over time if, and only if, the
economy is in a medium run equilibrium. The constancy of the inflation rate
over the past two years allows one to conclude that, in this case, the economy
must have experienced a fall in the natural real rate of interest, just like sug-
gested by Harry.
317
Macroeconomics. Problems and Questions
Question 16
A country in which expected inflation for the current year equals the inflation
rate prevailing in the previous year, 𝜋𝜋 𝑒𝑒 = 𝜋𝜋−1 , and in which 𝑖𝑖 ≥ 0, is initially in
a medium run equilibrium, with 𝑌𝑌 = 𝑌𝑌𝑛𝑛 , 𝑟𝑟𝑛𝑛 = 0 and 𝜋𝜋 𝑒𝑒 = 𝜋𝜋−1 = 0.
a. Assuming that the central bank chooses the interest rate, represent in the
two-panel IS-LM-PC diagram the initial medium run equilibrium, denot-
ing it by 1. Having explained which value the nominal interest rate, 𝑖𝑖, will
necessarily take on in this initial equilibrium, suppose that the government
launches an ambitious program of liberalizations, leading to an increase in
the degree of competition in the country’s goods markets. In the two
panels of the graph below, denote by 2 the new short run equilibrium
that the economy will reach. In the move from 1 to 2, how will have in-
come changed? And what about the rate of inflation? Why? Explain.
[Hint: when answering, assume that the position of the IS curve is not af-
fected by the change described above].
𝑟𝑟
3 𝐿𝐿𝐿𝐿3
𝑟𝑟3
1 4 𝐿𝐿𝐿𝐿1
𝑟𝑟𝑛𝑛1 = 0
2
𝑌𝑌𝑛𝑛 𝑌𝑌𝑛𝑛′ 𝑌𝑌
𝐼𝐼𝐼𝐼4
𝐼𝐼𝐼𝐼1
𝜋𝜋 − 𝜋𝜋−1 𝑃𝑃𝑃𝑃
𝑃𝑃𝑃𝑃'
𝑌𝑌𝑛𝑛 1 4
0
𝑌𝑌𝑛𝑛′ 𝑌𝑌
2
3
318
The labor market, the IS-LM-PC model, and inflation
In the IS-LM-PC diagram, the PC curve shifts to the right, crossing the x-
axis for the new, higher natural level of production. If the central bank does
not change its choice of the real policy rate, the new short run equilibrium be-
comes point 2 in the two panels, where production is unchanged and the infla-
tion rate is lower. In particular, from zero that it was in initial the equilibrium
1, the inflation rate becomes negative – in the current period, prices are lower
than in the previous one. In fact, given that their market power has fallen,
firms will now be willing to supply each unit of output at a price lower than
that prevailing before the launch of the liberalization program.
b. If policy-makers do not intervene, how will the real interest rate and in-
come change next period? Why? Show in the graph, denoting by 3 the
new short run equilibrium that, absent any policy intervention, the econ-
omy would attain. To make sure that, rather than from 1 to 2, from 2 to
3, etc., the economy goes immediately from the initial medium run equi-
librium 1 to the new medium run equilibrium that you will denote by 4 in
the graph, the implementation of the liberalization program should be
combined with a fiscal policy intervention, or with a monetary policy one?
And, once the kind of economic policy most appropriate to go directly
from the equilibrium 1 to the equilibrium 4 has been detected, the pro-
posed policy should be a restrictive or an expansionary one? Show in the
graph the effects of the policy intervention you suggest, and comment.
Since 𝜋𝜋 𝑒𝑒 = 𝜋𝜋−1, next period individuals will start expecting a negative inflation
rate, and this will lead to a higher 𝑟𝑟. The real interest rate, which was initially
zero, will become positive, rising for instance to the level denoted by 𝑟𝑟3 in the
graph. Notice that the central bank will be unable to keep the real rate at 𝑟𝑟𝑛𝑛1 ; in
fact, to do so it should lower the nominal interest rate by the amount needed to
offset the impact on 𝑟𝑟 of the decrease in expected inflation. However, we know
that the nominal interest rate is already at its lower bound (zero), and therefore
cannot be lowered any further. We may conclude that, absent policy interven-
tions − not just by the central bank, but also by the government −, the economy
will therefore reach the new short run equilibrium 3, with a level of output which
is lower, due to the rise in the real interest rate. Finally, to make sure that, from
the initial equilibrium 1, the economy directly goes to the new medium run equi-
librium 4, the implementation of the liberalization program should be combined
with an expansionary fiscal policy, one that shifts to the right the 𝐼𝐼𝐼𝐼 curve from
𝐼𝐼𝐼𝐼1 to 𝐼𝐼𝐼𝐼4 , thus immediately bringing output to the new natural level 𝑌𝑌𝑛𝑛′ . In the
new medium run equilibrium, the natural real rate will still be 𝑟𝑟𝑛𝑛1 , and the infla-
tion rate constant and equal to zero.
319
Macroeconomics. Problems and Questions
* Question 17
320
The labor market, the IS-LM-PC model, and inflation
• in the medium run, monetary policy does not affect the natural level of
output, the natural interest rate, or the composition of aggregate demand;
changes in the rate of growth of nominal money supply only cause propor-
tional changes in inflation − money is neutral;
• in the short run, the policy rate can deviate from the natural one, and
monetary policy does have real effects. For instance, to soften a recession
and accelerate the recovery of the economy, the central bank could cut the
policy rate, allowing 𝑀𝑀 to grow at a rate temporarily higher than the one
it has chosen to implement in the medium run. However, such deviations
cannot be permanent, if the economy has to return to a medium-run equi-
librium. It follows that the real effects of monetary policy are necessarily
transitory.
b. If, in the medium run, inflation depends on the rate of money growth cho-
sen by the central bank, and if inflation is a 'bad', why the world's major
central banks target an inflation rate that, rather than zero, is positive (al-
beit 'small')? Mention two factors that help explain this choice.
1. Let's suppose that, maybe because they suffer from money illusion, work-
ers tend to resist cuts in their nominal wage, and that the economy is hit
by an adverse supply shock. In this case, a positive inflation allows for
those downward adjustments in the real wage needed to return to a medi-
um-run equilibrium more easily than a zero rate of inflation.
2. A positive, and sufficiently high, inflation rate makes less likely that the
Zero Lower Bound will be hit, thus giving central banks more room to re-
sort to conventional monetary policy tools when the economy is in a reces-
sion.
321
Chapter 4 - Expectations, financial markets,
and economic policies
Macroeconomics. Problems and Questions
Question 1
We are at time 𝑡𝑡. In country Tau, only one-year and two-year bonds exist. The
time-𝑡𝑡 price of two year bonds issued in that time period is €𝑃𝑃2𝑡𝑡 = €94. In ad-
𝑒𝑒
dition, 𝑖𝑖1𝑡𝑡+1 − the yield that market participants expect on one-year bonds
that, issued at 𝑡𝑡 + 1, will mature at 𝑡𝑡 + 2 − is 4%.
Plugging €𝑃𝑃2𝑡𝑡 = €94 into €𝑃𝑃2𝑡𝑡 = €100/(1 + 𝑖𝑖2𝑡𝑡 )2 , and solving, one gets
1 𝑒𝑒 𝑒𝑒
𝑖𝑖2𝑡𝑡 = 3.14%. Since 𝑖𝑖2𝑡𝑡 = 2 (𝑖𝑖1𝑡𝑡 + 𝑖𝑖1𝑡𝑡+1 ) and 𝑖𝑖1𝑡𝑡+1 = 4%, it is straightfor-
...........................................................................................................................
ward to compute 𝑖𝑖1𝑡𝑡 = 2 · 3.14% − 4% = 2.28%.
324
Expectation, financial markets, and economic policies
b. Suppose now that you do not share the market’s expectations about
𝑒𝑒′
future short-term rates. In particular, you expect 𝑖𝑖1𝑡𝑡+1 = 5%, rather
𝑒𝑒
than 𝑖𝑖1𝑡𝑡+1 = 4%. If you are interested in how much you will have two
years from today, should you buy two-year bonds or a sequence of
one-year bonds? Or maybe you should be indifferent between the two
alternatives? Explain.
The purchase of two-year bonds at the price €𝑃𝑃2𝑡𝑡 = €94, one that reflects the
market participants’ average opinion about the future value of short-term
rates, delivers an average yearly return of 3.14% (remember that 𝑖𝑖2𝑡𝑡 =
3.14%). However, since your expectations about the future level of short-term
rates differ from those held by the market, by purchasing one-year bonds you
will get a 2.28% return on the first year, and one that you expect to be 5%
the next one, corresponding to an expected average yearly return of
3.64% (> 3.14%). You should purchase one-year bonds.
325
Macroeconomics. Problems and Questions
Question 2
a. Alpha and Beta − two countries where only one, two and three-year bonds
exist – differ just for the expectations held by market participants about
the monetary policy that, in each of the two nations, will be implemented
in the future. The graph below shows the yield curve prevailing in the two
countries in the current period, time 𝑡𝑡 [N.B.: the yield curve prevailing in
Alpha (the bold, continuous line in the graph) and that observed in Beta (the
dashed, bold line) overlap for maturities up to two years; afterwards, Beta’s
yield curve declines faster than Alpha’s]. Which differences in individuals’
expectations about the future monetary policy that will be implemented in
each of the two countries can explain the observed differences in the two
yield curves? Using the data provided in the graph, compute the current
and future expected one-year rates 𝑖𝑖1𝑡𝑡 , 𝑖𝑖1𝑒𝑒 𝑡𝑡+1 and 𝑖𝑖1𝑒𝑒 𝑡𝑡+2 prevailing today
(time 𝑡𝑡) in each of the two countries.
Yield
to
maturity
7%
Alpha
6%
Beta
5%
1 2 3 Maturity
...........................................................................................................................
A flat (negatively sloped) yield curve signals expectations of constant (de-
creasing) short-term rates. In both countries short-term rates are therefore
...........................................................................................................................
expected to remain next year at today’s level, and then to decrease two years
...........................................................................................................................
from now. This expected future decrease is larger in country Beta. Since, by
assumption, these different expectations on future interest rates only reflect
...........................................................................................................................
differences in the monetary policy that is expected to be implemented in the
...........................................................................................................................
future, we may conclude that market participants think that next year the
stance of monetary policy will be the same as today’s both in Beta and in Al-
...........................................................................................................................
pha; however, they also expect that, in two years, monetary policy will be-
come more expansionary in both countries, and more so in Beta.
326
Expectation, financial markets, and economic policies
From the graph it also follows that 𝑖𝑖1𝑡𝑡 = 7%, 𝑖𝑖2𝑡𝑡 = 7% and 𝑖𝑖3𝑡𝑡 = 6% in Al-
pha,, while 𝑖𝑖1𝑡𝑡 = 7%, 𝑖𝑖2𝑡𝑡 = 7% e 𝑖𝑖3𝑡𝑡 = 5% in Beta. Since 𝑖𝑖2𝑡𝑡 = 12(𝑖𝑖1𝑡𝑡 +
𝑒𝑒 𝑒𝑒
𝑖𝑖1𝑡𝑡+1 ), plugging the values of 𝑖𝑖1𝑡𝑡 and 𝑖𝑖2𝑡𝑡 , and solving, in Alpha 𝑖𝑖1𝑡𝑡+1 = 7%.
𝑒𝑒 𝑒𝑒
Furthermore, since 𝑖𝑖3𝑡𝑡 = 3(𝑖𝑖1𝑡𝑡 + 𝑖𝑖1𝑡𝑡+1 + 𝑖𝑖1𝑡𝑡+2 ), plugging the values of 𝑖𝑖3𝑡𝑡 , 𝑖𝑖1𝑡𝑡
1
𝑒𝑒 𝑒𝑒
and 𝑖𝑖1𝑡𝑡+1 , and solving, for Alpha one computes 𝑖𝑖1𝑡𝑡+2 = 4%.
Following the same steps, in the case of Beta it is straightforward to conclude
𝑒𝑒 𝑒𝑒
that, in that country, 𝑖𝑖1𝑡𝑡 = 7%, 𝑖𝑖1𝑡𝑡+1 = 7% and 𝑖𝑖1𝑡𝑡+2 = 1%.
b. Consider now Gamma, a country where stock prices have recently soared.
To deflate what it thinks is a stock market bubble, Gamma’s central bank
decides to intervene to return stock prices to a level closer to fundamentals.
To achieve this goal, should the central bank implement an expansionary
or a restrictive monetary policy? Why? Motivate your answer by making
reference to the formula for stock prices, showing the determinants of the
value of these financial assets [Hint: when answering, assume that, in each
time period, the economy is described by a static IS-LM model, with con-
sumption and investment that depend on contemporaneous variables only].
327
Macroeconomics. Problems and Questions
Question 3
a. In country Zeta, only one-year and two-year bonds exist. Investors, who
do care about risk, ask for a risk premium 𝑥𝑥 to hold the two-year bond
(which is risky, as they do not know the price at which they will be able to
sell it in a year). Use the arbitrage equation to derive the (approximate) re-
lation that will hold in this case among the yield to maturity of a two-year
𝑒𝑒
bond (𝑖𝑖2𝑡𝑡 ), the current (𝑖𝑖1𝑡𝑡 ) and future expected (𝑖𝑖1,𝑡𝑡+1 ) yields on one-year
bonds, and the risk premium (𝑥𝑥).
where the term on the right-hand side is the expected yield on a two-year
bond. Solving for €𝑃𝑃2𝑡𝑡 , and equating the expression thus obtained for €𝑃𝑃2𝑡𝑡 to
the one that follows from the definition of the yield to maturity on the same
bond, one gets
𝑒𝑒
(1 + 𝑖𝑖2𝑡𝑡 )2 = (1 + 𝑖𝑖1𝑡𝑡 + 𝑥𝑥)�1 + 𝑖𝑖1,𝑡𝑡+1 �.
𝑒𝑒
For 𝑖𝑖2𝑡𝑡 , 𝑖𝑖1𝑡𝑡 e 𝑖𝑖1,,𝑡𝑡+1 ‘small enough’ (close to zero), the previous equation im-
plies that one can write
1 𝑒𝑒
𝑖𝑖2𝑡𝑡 = 2�𝑖𝑖1𝑡𝑡 + 𝑖𝑖1,𝑡𝑡+1 + 𝑥𝑥�. (∗)
328
Expectation, financial markets, and economic policies
b. Suppose that, in the current period (time 𝑡𝑡), Zeta’s yield curve is the one in
the figure below. Write on the axes the name of the variables measured
along each of them, and use your answer to the previous point of this ques-
tion to compute the numerical value that the risk premium 𝑥𝑥 takes on in
this economy, knowing that investors expect the future yield on one-year
𝑒𝑒
bonds to be the same as the current one (𝑖𝑖1𝑡𝑡 = 𝑖𝑖1,𝑡𝑡+1 ).
Yield
to
maturity
4%
1%
1 2 Maturity
𝑒𝑒
In this economy, 𝑖𝑖2𝑡𝑡 = 4% and 𝑖𝑖1𝑡𝑡 = 𝑖𝑖1,𝑡𝑡+1 = 1%. Plugging these values into
(∗),
1
4% = 2(1% + 1% + 𝑥𝑥) .
Solving,
𝑥𝑥 = 6% .
329
Macroeconomics. Problems and Questions
Question 4
where the term on the right-hand side is the expected yield on a two-year
bond. Solving for €𝑃𝑃2𝑡𝑡 , and equating the expression thus obtained for €𝑃𝑃2𝑡𝑡 to
the one that follows from the definition of the yield to maturity on the same
bond, one gets
𝑒𝑒
(1 + 𝑖𝑖2𝑡𝑡 )2 = (1 + 𝑖𝑖1𝑡𝑡 + 𝑥𝑥)�1 + 𝑖𝑖1,𝑡𝑡+1 �.
𝑒𝑒
For 𝑖𝑖2𝑡𝑡 , 𝑖𝑖1𝑡𝑡 e 𝑖𝑖1,,𝑡𝑡+1 ‘small enough’ (close to zero), the previous equation im-
plies that one can write
1 𝑒𝑒
𝑖𝑖2𝑡𝑡 = 2�𝑖𝑖1𝑡𝑡 + 𝑖𝑖1,𝑡𝑡+1 + 𝑥𝑥�. (∗)
330
Expectation, financial markets, and economic policies
b. Suppose that, in the current period (time 𝑡𝑡), the yield curve in Zeta – a
country where the lower bound on the yield on one-year bonds is not zero,
but negative, equal to −1% - is the one in the figure below. Write on the
axes the name of the variables measured along each of them, and use your
answer to the previous point of this question to compute the numerical
value that the risk premium 𝑥𝑥 takes on in this economy, knowing that
𝑒𝑒
𝑖𝑖1𝑡𝑡+1 = −3𝑖𝑖1𝑡𝑡 .
Yield
to
maturity
0.2%
0%
1 2 Maturity
𝑒𝑒
In this economy, 𝑖𝑖2𝑡𝑡 = 0%, 𝑖𝑖1𝑡𝑡 = 0.2% 𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖 1,𝑡𝑡+1 = −3 ∙ 0.2% = −0.6%.
Plugging these values into (∗),
1
0% = 2(0.2% − 0.6% + 𝑥𝑥) .
Solving,
𝑥𝑥 = 0.4% .
331
Macroeconomics. Problems and Questions
Question 5
a. We are at time t. Write down the expression defining the price (in nominal
terms) of a stock that has already paid the current dividend, and define
carefully all the variables entering it. From which principle/condition is
this expression derived? [Hint: you are not expected to derive the expression
for the nominal stock price formally; just describe in detail the considerations
on which its derivation is based].
The price (in nominal terms) of a stock that has already paid the current div-
idend can be written as:
𝑒𝑒 𝑒𝑒
€𝐷𝐷𝑡𝑡+1 €𝐷𝐷𝑡𝑡+2
€𝑄𝑄𝑡𝑡 = + 𝑒𝑒 + … ,
1 + 𝑖𝑖1𝑡𝑡 + 𝑥𝑥 (1 + 𝑖𝑖1𝑡𝑡 + 𝑥𝑥)(1 + 𝑖𝑖1𝑡𝑡+1 + 𝑥𝑥)
where €𝐷𝐷 𝑒𝑒 denotes expected dividends at various future time periods, 𝑥𝑥 is the
equity premium, and the discount rates appearing at the denominator of the
terms on the right-hand side of the equation are the current and the future ex-
pected nominal yields on one-year bonds.
The expression for the price of a stock can be derived from the arbitrage con-
dition, which requires the expected return from holding stocks for one year to
be the same as the expected return from holding alternative assets, for in-
stance one-year bonds.
332
Expectation, financial markets, and economic policies
b. Explain if, and why, you agree, or do not agree, with the following state-
ments [Hint: when answering, assume that, in each time period, the economy
is described by a standard, static IS-LM model, with consumption and in-
vestment that depend on contemporaneous variables only]:
b.2 if, at time 𝑡𝑡, individuals learn that from 𝑡𝑡 + 1 onwards fiscal
policy will become permanently more expansionary, and
monetary policy permanently more restrictive, then time 𝑡𝑡 stock
prices, €𝑄𝑄𝑡𝑡 , will unambiguously fall.
b.1 The statement is correct. Since the question is silent about possible
changes in the monetary policy stance, we may assume that at 𝑡𝑡 + 2 the
central bank will keep the interest rate at the level prevailing before the
increase in 𝑐𝑐0 . The only effect of the change in autonomous consumption
will therefore be an increase in income at time 𝑡𝑡 + 2, and in the dividends
expected for that period. It follows that €𝑄𝑄𝑡𝑡 will rise.
b.2 False. Without additional information on the size of the two policy inter-
ventions and on the characteristics of the economy, is not possible to con-
clude anything definite about the direction in which €𝑄𝑄𝑡𝑡 will change. In
fact, the monetary contraction will lead to higher future interest rates,
something that tends to lower €𝑄𝑄𝑡𝑡 (in fact, higher future expected interest
rates decrease the present value of any given flow of dividends expected in
the future). However, one must also take into account how the announced
policy-mix will affect future income levels and dividends. The monetary
contraction will lower future incomes, while the fiscal expansion will raise
them. If to prevail is this latter effect, and if the increase in future incomes
(and therefore dividends) is large enough, stock prices today could even
increase; if, on the other hand, future incomes do not increase enough, or
if they fall because the adverse impact on economic activity of the mone-
tary contraction prevails on that of the fiscal expansion, €𝑄𝑄𝑡𝑡 would fall.
333
Macroeconomics. Problems and Questions
Question 6
True or False?
Explain whether the following statements are true or false. Motivate your answer
in a brief but rigorous way, by making explicit reference to the relevant theory.
Lack of proper explanations will result in zero points.
False. Remember that stock prices, €𝑄𝑄𝑡𝑡 , can be written as the present value of
the flow of future dividends, computed using the current and future expected
short-term interest rates as discount rates. Taking this into account, it follows
that the statement is incorrect. In fact, if 𝐼𝐼 ̅ falls, future incomes will be lower.
Individuals will therefore expect lower future dividens, and this will tend to
decrease €𝑄𝑄𝑡𝑡 . Since the queston does not mention anything about future
changes in the monetary policy stance, we may assume that the central bank
will keep future interest rates at the level at which they were set before the
change in 𝐼𝐼 .̅ Therefore, in the formula of the fundamental value of a stock, the
only terms that will change are the numerators of the ratios appearing on the
right-hand side, which will fall. It follows that, rather than rising, as stated in
the question, stock prices will fall, too.
334
Expectation, financial markets, and economic policies
False. Stock prices at time 𝑡𝑡, €𝑄𝑄𝑡𝑡 , are equal to the present value of expected
future dividends. If demand for investment does not depend on the interest
rate, the IS curve is vertical in every period, and an expansionary monetary
policy will not change either current income, nor expected future income lev-
els. Although, for this reason, expected future dividends will remain constant,
the policy we are considering will nevertheless lead to a reduction in interest
rates at time 𝑡𝑡 and in all future periods, and therefore to a decrease in the rate
at which those (constant) expected future dividends are discounted. It follows
that stock prices at time 𝑡𝑡 will rise.
335
Macroeconomics. Problems and Questions
* Question 7
[Intertemporal consumption choices – The microfoundations of the 'theory of the
very farsighted consumer']
There are only two time periods, 𝑡𝑡 (the 'present') and 𝑡𝑡 + 1 (the 'future'). Make
the following assumptions on the individuals populating the economy:
• their preferences are described by the utility function 𝑈𝑈(𝐶𝐶𝑡𝑡 , 𝐶𝐶𝑡𝑡+1 ), in-
creasing and concave in its two arguments – present consumption, 𝐶𝐶𝑡𝑡 ,
and future consumption, 𝐶𝐶𝑡𝑡+1 ;
• they have access to a credit market, where they can borrow and lend at
the real interest rate 𝑟𝑟;
• they earn a disposable (labor) income equal to (𝑌𝑌𝑡𝑡 − 𝑇𝑇𝑡𝑡 ) in the first pe-
𝑒𝑒 𝑒𝑒 )
riod, and expect to earn one equal to (𝑌𝑌𝑡𝑡+1 − 𝑇𝑇𝑡𝑡+1 in the second peri-
od.
a. Suppose that, at time 𝑡𝑡, the typical individual's financial wealth (stocks,
bonds, etc.) and housing wealth (apartments, commercial buildings, etc.)
are both zero. Write down the individual's budget constraints for each of
the two periods, combine them into a single 'intertemporal budget con-
straint' and represent in the (𝐶𝐶𝑡𝑡 , 𝐶𝐶𝑡𝑡+1 ) plane the problem the individual has
to solve in order to maximize his utility subject to such constraint. Where
is the optimal 'present consumption/future consumption' program located?
What determines whether, in the first period, the individual will be a bor-
rower, a lender, or rather consume exactly his disposable income?
336
Expectation, financial markets, and economic policies
1
𝑆𝑆, plus interest 𝑟𝑟𝑟𝑟 on that lending), or reduced by the same amount, if at 𝑡𝑡 he
was a borrower (𝑆𝑆 < 0), is going to be entirely consumed.1
Solving the first constraint for 𝑆𝑆, plugging the result into the second one, and
rearranging terms, it is possible to combine the two previous constraints into
the following "intertemporal budget constraint":
𝑒𝑒
(𝑌𝑌𝑡𝑡+1 𝑒𝑒 )
𝐶𝐶𝑡𝑡+1 − 𝑇𝑇𝑡𝑡+1
𝐶𝐶𝑡𝑡 + = (𝑌𝑌𝑡𝑡 − 𝑇𝑇𝑡𝑡 ) + .
1 + 𝑟𝑟 1 + 𝑟𝑟
The right-hand side − the present value of the individual's disposable labor in-
come − is sometimes referred to as "human wealth". Since we shall draw the
above constraint in the (𝐶𝐶𝑡𝑡 , 𝐶𝐶𝑡𝑡+1 ) plane, it is convenient to solve it for 𝐶𝐶𝑡𝑡+1:
𝑒𝑒 𝑒𝑒 )]
𝐶𝐶𝑡𝑡+1 = [(1 + 𝑟𝑟)(𝑌𝑌𝑡𝑡 − 𝑇𝑇𝑡𝑡 ) + (𝑌𝑌𝑡𝑡+1 − 𝑇𝑇𝑡𝑡+1 − (1 + 𝑟𝑟)𝐶𝐶𝑡𝑡 ,
which is the equation of the straight line in the figure, having a positive vertical
intercept (given by the term in squared brackets) and a negative slope −(1 + 𝑟𝑟).
Notice that the horizontal intercept of the constraint (the value it implies for
𝐶𝐶𝑡𝑡 when 𝐶𝐶𝑡𝑡+1 = 0) is given by what we have just termed 'human wealth'.
𝐶𝐶𝑡𝑡+1
𝑒𝑒
(𝑌𝑌𝑡𝑡+1 𝑒𝑒 ) 𝐴𝐴
− 𝑇𝑇𝑡𝑡+1
•
𝐸𝐸
∗
𝐶𝐶𝑡𝑡+1 •
• 𝐵𝐵
• 𝑒𝑒 𝑒𝑒 )
(𝑌𝑌𝑡𝑡+1 − 𝑇𝑇𝑡𝑡+1 𝐶𝐶𝑡𝑡
(𝑌𝑌𝑡𝑡 − 𝑇𝑇𝑡𝑡 ) 𝐶𝐶𝑡𝑡∗ (𝑌𝑌𝑡𝑡 − 𝑇𝑇𝑡𝑡 ) +
1 + 𝑟𝑟
1
Why, on the right-hand side of the budget constraint for time t + 1, there is no term analogous to the
term 𝑆𝑆 appearing in the constraint for time 𝑡𝑡? The reason is that t + 1 is the second, and last, period of
the model (or, if you want, of the individual's lifetime). At t + 1, the individual would like to borrow
as much as possible, since this loan will come due only at an inexistent time t + 2, and therefore nev-
er. But, exactly because of this, he will find no one willing to lend. In the last period, the individual
will therefore consume all the resources that, also as a result of the choices made in the first one, he
has available, nothing more and nothing less.
337
Macroeconomics. Problems and Questions
𝑒𝑒 𝑒𝑒 )]
The budget constraint goes always through the point [(𝑌𝑌𝑡𝑡 − 𝑇𝑇𝑡𝑡 ), (𝑌𝑌𝑡𝑡+1 − 𝑇𝑇𝑡𝑡+1
− a point that, in the figure, we initially assume to be 𝐴𝐴. In fact, to consume in
each period exactly his contemporaneous disposable income is a strategy al-
ways at the individual's reach (albeit certainly not the only, nor necessarily
the optimal, one). In the same graph, we have drawn some of the indifference
curves corresponding to the utility function 𝑈𝑈(𝐶𝐶𝑡𝑡 , 𝐶𝐶𝑡𝑡+1 ). As Microeconomics
allows us to conclude, the optimal choice is given by point 𝐸𝐸 in the figure,
where the budget constraint is tangent to an indifference curve, and by the as-
∗
sociated levels of present consumption 𝐶𝐶𝑡𝑡∗ and future consumption 𝐶𝐶𝑡𝑡+1 . No-
tice that, given the way we have drawn the figure, the individual will find it op-
timal to borrow today [𝐶𝐶𝑡𝑡∗ > (𝑌𝑌𝑡𝑡 − 𝑇𝑇𝑡𝑡 )], and then repay this loan tomorrow
∗ 𝑒𝑒 𝑒𝑒 )].
[𝐶𝐶𝑡𝑡+1 < (𝑌𝑌𝑡𝑡+1 − 𝑇𝑇𝑡𝑡+1 If, however, for given preferences and slope of the
budget constraint, the point representing the sequence of disposable incomes
had been 𝐵𝐵, rather than A, to maximize his utility the individual would have
chosen to be a lender at time 𝑡𝑡. Similarly, and this time for given disposable
incomes in the two periods, the fact that the individual will be a lender rather
than a borrower also depends on the value of 𝑟𝑟, as well as on the individual's
preferences (for instance, on how steep are his indifference curves). Having
said that, it is important to realize that the fact that the individual will choose
a positive, a negative, or a zero value for 𝑆𝑆 in the first period does not change
any of the conclusions that will be reached when answering the next point of
this question, or the properties of the consumption function we are about to
derive.
b. Assuming that both 𝐶𝐶𝑡𝑡 and 𝐶𝐶𝑡𝑡+1 are 'normal goods', explain how the optimal
choice of present consumption will be affected by the following changes:
• a transitory increase in current disposable income [𝛥𝛥(𝑌𝑌𝑡𝑡 − 𝑇𝑇𝑡𝑡 ) > 0 and
𝑒𝑒 𝑒𝑒 )
𝛥𝛥(𝑌𝑌𝑡𝑡+1 − 𝑇𝑇𝑡𝑡+1 = 0]
• an increase in future expected disposable income [𝛥𝛥(𝑌𝑌𝑡𝑡 − 𝑇𝑇𝑡𝑡 ) = 0 and
𝑒𝑒 𝑒𝑒 )
𝛥𝛥(𝑌𝑌𝑡𝑡+1 − 𝑇𝑇𝑡𝑡+1 > 0] ;
𝑒𝑒 𝑒𝑒 )
• a permanent increase in disposable income [𝛥𝛥(𝑌𝑌𝑡𝑡 − 𝑇𝑇𝑡𝑡 ) = 𝛥𝛥(𝑌𝑌𝑡𝑡+1 − 𝑇𝑇𝑡𝑡+1 >
0].
What can you conclude about the consumption function implied by the
analysis of the individual's intertemporal consumption choices?
All the changes we are asked to investigate raise the individual's human
wealth (the present value of his disposable labor incomes), causing a
rightward shift in his intertemporal budget constraint. Being 𝐶𝐶𝑡𝑡 and 𝐶𝐶𝑡𝑡+1
normal goods, this will induce the consumer to raise both present and future
consumption levels.
338
Expectation, financial markets, and economic policies
In this case, the term 𝑊𝑊𝑊𝑊𝑊𝑊𝑡𝑡 must be added to the left-hand side (resources)
of the individual's budget constraint for time 𝑡𝑡, and – as it is straightforward
to conclude – to human wealth in the expression of the horizontal intercept of
the intertemporal budget constraint. This latter intercept now equals the sum
of human and nonhuman wealth, a sum also called 'total wealth'. If total
wealth rises, because of an increase in human and/or in financial and housing
wealth, the budget constraint will shift to the right, and today's consumption
will go up. It follows that the consumption function now becomes:
𝐶𝐶𝑡𝑡 = 𝐶𝐶(𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤ℎ𝑡𝑡 ).
(+)
339
Macroeconomics. Problems and Questions
Question 8
There are only two periods, period 𝑡𝑡 (“the present”) and period 𝑡𝑡 + 1 (“the fu-
ture”). In the attempt to boost current economic activity, the government of
country Delta cuts by 100 the taxes each individual will have to pay in the cur-
rent period (time 𝑡𝑡). At the same time, the government however announces
that future taxes will be increased by the same amount. In other words, denot-
ing per-capita net taxes by 𝑇𝑇, the fiscal policy intervention just described can
𝑒𝑒
be summarized as follows: ∆𝑇𝑇𝑡𝑡 = −100, ∆𝑇𝑇𝑡𝑡+1 = ∆𝑇𝑇𝑡𝑡+1 = +100.
a. Suppose that all individuals are identical and that, at the beginning of
time 𝑡𝑡, their non-human wealth is zero. Moreover, assume that 𝑟𝑟 =
0, where 𝑟𝑟 is the real interest rate. Using the analysis of the intertemporal
consumption choices, evaluate ∆𝑐𝑐𝑡𝑡 and ∆𝑐𝑐𝑡𝑡+1 − that is, the changes in
current and future consumption levels of the typical inhabitant of country
Delta caused by the intertemporal reallocation of taxes implemented by
the government. Will the government be successful in its attempt to in-
crease consumption, and hence aggregate demand and equilibrium pro-
duction, at time 𝑡𝑡? If yes, indicate the fraction of the tax cut by which time
𝑡𝑡 consumption of the typical individual will rise. If no, why? In motivating
your answer, make explicit reference to the way in which savings by the
typical individual will change at time 𝑡𝑡.
Since individuals have zero non-human wealth at the beginning of period 𝑡𝑡,
their total wealth equals their human wealth, which − being 𝑟𝑟 = 0 − is just
the sum of their current and future expected disposable income levels, (𝑌𝑌𝑡𝑡 −
𝑒𝑒 𝑒𝑒 ).
𝑇𝑇𝑡𝑡 ) + (𝑌𝑌𝑡𝑡+1 − 𝑇𝑇𝑡𝑡+1
𝑒𝑒
It follows that, since ∆𝑇𝑇𝑡𝑡 = −∆𝑇𝑇𝑡𝑡+1 , the fiscal policy under consideration will
not change the present value of disposable income. The individuals' budget
constraints will remain in their initial position, and their intertemporal con-
sumption choices will not change. But, if consumption at time 𝑡𝑡 does not
change, aggregate demand will not change either, and the policy under con-
sideration will not affect economic activity.
340
Expectation, financial markets, and economic policies
Notice that, at time 𝑡𝑡, the tax cut raises disposable income. Since individuals
do not change their consumption choices, this means that they will save the
whole increase in disposable income brought about by the tax cut at time 𝑡𝑡.
Next period, individuals will use these extra savings to pay the higher taxes
due at time 𝑡𝑡 + 1, and this will allow them to keep time 𝑡𝑡 + 1 consumption un-
changed.
The tax cut implemented by the government raises individuals’ disposable in-
...........................................................................................................................
come at time 𝑡𝑡, thus allowing those who are facing liquidity constraints to in-
crease their consumption at 𝑡𝑡, bringing it closer to their preferred level of con-
...........................................................................................................................
sumption for that period. In this case, and even if the present value of their
...........................................................................................................................
disposable income does not change, time 𝑡𝑡 consumption by liquidity-
constrained individuals will rise. It follows that aggregate demand and the
...........................................................................................................................
equilibrium level of income will increase, too.
341
Macroeconomics. Problems and Questions
Question 9
True or False?
Explain whether the following statements are true or false. Motivate your answer
in a brief but rigorous way, by making explicit reference to the relevant theory.
Lack of proper explanations will result in zero points.
a. Suppose that today (time 𝑡𝑡) there is a fall in house prices. The consumption
function based on the analysis of the intertemporal consumption decisions
implies that time 𝑡𝑡 consumption will rise – since houses are now less expen-
sive than before, individuals will need to save less to purchase one, and this
will allow them to consume more.
342
Expectation, financial markets, and economic policies
b. Today (time 𝑡𝑡), stock prices fall. The consumption function based on the
analysis of the intertemporal consumption decisions implies that, at time 𝑡𝑡,
households will cut their consumption expenditures.
True. A fall in stock prices reduces individuals’ financial wealth and therefore,
as it is clear from the answer to the previous point, households’ current con-
sumption expenditures. Other things the same, it follows that a drop in stock
prices leads to lower aggregate demand and equilibrium income.
343
Macroeconomics. Problems and Questions
Question 10
In country Macro, current and future expected inflation are equal to zero, so
that nominal and real interest rates are the same. At time 𝑡𝑡 + 1 (‘the future’),
consumption depends on 𝑡𝑡 + 1 disposable income only, while investment is en-
̅ . As for the current period, (𝑡𝑡, ‘the present’), con-
tirely exogenous, 𝐼𝐼𝑡𝑡+1 = 𝐼𝐼𝑡𝑡+1
sumption is increasing both in the current and in the future expected levels of
disposable income, 𝐶𝐶𝑡𝑡 = 𝐶𝐶(𝑌𝑌𝑡𝑡 − 𝑇𝑇�𝑡𝑡 , 𝑌𝑌𝑡𝑡+1
𝑒𝑒
− 𝑇𝑇�𝑡𝑡+1
𝑒𝑒
), investment is exogenous, 𝐼𝐼𝑡𝑡 =
𝐼𝐼𝑡𝑡̅ , 𝐺𝐺 and 𝑇𝑇 are as usual exogenous in both periods, and the central bank
chooses a level for the interest rate in both periods.
𝑖𝑖 ISO
0
𝚤𝚤̅0 LM0
𝚤𝚤̅1
1 LM1
𝑌𝑌�0 𝑌𝑌
344
Expectation, financial markets, and economic policies
b. Suppose that only one-year bonds and two-year bonds exist and that,
before the announcement described above, at time 𝑡𝑡 the yield curve of
Macro was flat. Draw the new yield curve that, at time 𝑡𝑡, will prevail
in each of the following three cases: (i) the central bank has announced
that it will cut the future short-rate rate less than the current one; (ii) it
has announced that it will proceed to an equal cut in current and fu-
ture rates; (iii) it has announced that it will cut the future short-rate
rate more than the current one. Explain.
Yield
to
maturity
“before”
(i)
(ii) “after”
(iii)
1 2 Maturity
Given that both the current one-year rate and the current two-year one (𝑖𝑖2𝑡𝑡 )
go down, the new yield curve will lie below the initial one. Since 𝛥𝛥𝛥𝛥2𝑡𝑡 =
1 𝑒𝑒
2
�𝛥𝛥𝑖𝑖1𝑡𝑡 + 𝛥𝛥𝑖𝑖1,𝑡𝑡+1 � − or, if you prefer, recalling that a positively (negatively)
sloped yield curve signals expectations of short-term rates rising (falling)
over time, and a flat one expectations of short rates constant over time −, it is
straightforward to conclude that, in each of the three cases considered in the
question, the position in the plane and the slope of the yield curve will be those
in the figure.
345
Macroeconomics. Problems and Questions
Question 11
a. In country Macrolandia, there are only one-year and two-year bonds. The
current and the expected future inflation rates are both zero, so that the
real and the nominal interest rates are equal. In period 𝑡𝑡 + 1 (“the future”),
a standard IS-LM model describes the functioning of the economy. In par-
ticular, in the year 𝑡𝑡 + 1 consumption depends only on disposable income
at 𝑡𝑡 + 1, and investment on the interest rate and output at 𝑡𝑡 + 1 only.
Turning now to the current period (𝑡𝑡, “the present”), consumption is in-
creasing in both current and expected future disposable income, 𝐶𝐶𝑡𝑡 =
𝐶𝐶(𝑌𝑌𝑡𝑡 − 𝑇𝑇�𝑡𝑡 , 𝑌𝑌𝑡𝑡+1
𝑒𝑒
− 𝑇𝑇�𝑡𝑡+1
𝑒𝑒
), investment depend positively on current and ex-
pected future income levels, and negatively on the current and expected fu-
ture levels of short-term interest rates, the demand for money has the usual
functional form, and 𝐺𝐺 and 𝑇𝑇 are exogenous as usual. Starting from an ini-
tial equilibrium, at time 𝑡𝑡 the government of Macrolandia announces an
increase of its purchases of goods and services at time 𝑡𝑡 + 1, ∆𝐺𝐺̅𝑡𝑡+1 > 0. At
the same time, the central bank announces that it will adjust the policy rate
so as to prevent any change in equilibrium income that, at time 𝑡𝑡 and/or at
time 𝑡𝑡 + 1, could be caused by the fiscal policy just described. Explain how
these announcements, which are unexpected and credible, affect the time 𝑡𝑡
yield to maturity on the two-year bonds circulating in Macrolandia, 𝑖𝑖2𝑡𝑡 .
...........................................................................................................................
The increase in government purchases of goods and services that will be im-
plemented at 𝑡𝑡 + 1 will shift to the right the IS curve for that period. To keep
...........................................................................................................................
𝑌𝑌𝑡𝑡+1 constant, the central bank will have to raise the short-term interest rate,
...........................................................................................................................
𝑖𝑖1𝑡𝑡+1 . At time 𝑡𝑡, this will lead individuals to expect a higher short-term future
interest rate. These expectations will lower time 𝑡𝑡 investment, and will there-
...........................................................................................................................
fore cause a leftward shift of the IS curve for the current period. It follows
that, to prevent 𝑌𝑌𝑡𝑡 from falling, the central bank will have to cut the current
short-term rate, 𝑖𝑖1𝑡𝑡 .
Since 𝑖𝑖2𝑡𝑡 is (approximately) equal to the average of the current and the fu-
ture expected short term interest rates, and since these rates move in opposite
directions, one cannot conclude anything definite about the way in which yield
to maturity on the two-year bonds at time t will change − it could rise, fall, or
remain constant.
346
Expectation, financial markets, and economic policies
b. Assume for simplicity that, in Macrolandia, at time 𝑡𝑡 the yield curve is ini-
tially horizontal. Explain how the position and the slope of this curve
change after the announcement studied above. Represent both curves, the
one “before” and the one “after” the announcement, in the graph below.
Clarify whether it is possible to determine the position and the slope of the
new yield curve unambiguously.
Yield
to
maturity
“before” “after”
1 2 Maturity
Since 𝑖𝑖1𝑡𝑡 falls, while the sign of the change in 𝑖𝑖2𝑡𝑡 is uncertain, the dashed seg-
ments in the figure show three new, equally plausible yield curves for the
economy in consideration. In particular, and no matter the direction in which
...........................................................................................................................
𝑖𝑖2𝑡𝑡 will change, the new curve will have a positive slope. Since we know that
...........................................................................................................................
𝑖𝑖1𝑡𝑡 will be lower, it is easy to understand why the new yield curve will be posi-
tively sloped if 𝑖𝑖2𝑡𝑡 will rise, or remain constant. But what if 𝑖𝑖2𝑡𝑡 ends up fall-
...........................................................................................................................
1 𝑒𝑒 𝑒𝑒
ing? From 𝛥𝛥𝛥𝛥2𝑡𝑡 = �𝛥𝛥𝑖𝑖1𝑡𝑡 + 𝛥𝛥𝑖𝑖1,𝑡𝑡+1 �, 𝛥𝛥𝑖𝑖1𝑡𝑡 < 0 and 𝛥𝛥𝑖𝑖1,𝑡𝑡+1 > 0 it follows that
...........................................................................................................................
2
𝛥𝛥𝛥𝛥2𝑡𝑡 − 𝛥𝛥𝑖𝑖1𝑡𝑡 > 0. The slope of the yield curve, whose sign is equal to that of
the difference (𝑖𝑖2𝑡𝑡 − 𝑖𝑖1𝑡𝑡 ), will therefore rise − going from zero to a positive
value − also in this case. [To put it differently, even if it should end up falling,
being the average of the current short-term yield, which falls, and the future
expected one, which rises, 𝑖𝑖2𝑡𝑡 will necessarily fall less than 𝑖𝑖1𝑡𝑡 ]. As usual, the
positive slope of the new yield curve signals expectations of short term rates
increasing over time (in this case, due to the fall in the current short rate, and
the expectation of a rise in the future one).
347
Macroeconomics. Problems and Questions
Question 12
a. In country Macrolandia, there are only one-year and two-year bonds. The
current and the expected future inflation rates are both zero, so that the
real and the nominal interest rates are equal. In period 𝑡𝑡 + 1 (“the future”),
an IS-LM model describes the functioning of the economy. In particular,
in the year 𝑡𝑡 + 1 consumption depends only on disposable income at 𝑡𝑡 + 1,
and investment on the borrowing rate (the sum of the interest rate and the
risk premium 𝑥𝑥𝑡𝑡+1 ) and an output at 𝑡𝑡 + 1 only. Turning now to the cur-
rent period (𝑡𝑡, “the present”), consumption is increasing in both current
and expected future disposable income, 𝐶𝐶𝑡𝑡 = 𝐶𝐶(𝑌𝑌𝑡𝑡 − 𝑇𝑇�𝑡𝑡 , 𝑌𝑌𝑡𝑡+1
𝑒𝑒
− 𝑇𝑇�𝑡𝑡+1
𝑒𝑒
), in-
vestment depend positively on current and expected future income levels,
and negatively on the current and expected future borrowing rates, the
central bank chooses in each period the interest rate, and 𝐺𝐺 and 𝑇𝑇 are ex-
ogenous as usual. Starting from an initial equilibrium position in both pe-
riods, at time 𝑡𝑡 individuals start expecting a decrease in the risk premium
for time 𝑡𝑡 + 1, 𝛥𝛥𝑥𝑥𝑡𝑡+1 < 0. At the same time, the central bank announces
that it will adjust the policy rate so as to prevent any change in equilibrium
income that, at time 𝑡𝑡 (and at time 𝑡𝑡 only), could be caused by the change
in 𝑥𝑥𝑡𝑡+1 just described. Explain how these changes and announcements,
which are unexpected and credible, affect the time 𝑡𝑡 yield to maturity on
the two-year bonds circulating in Macrolandia, 𝑖𝑖2𝑡𝑡 .
At time 𝑡𝑡 + 1, the decrease in the risk premium lowers the borrowing rate,
raises investment and shifts to the right the IS curve for that period. It follows
that income rises at 𝑡𝑡 + 1. At time 𝑡𝑡, the IS curve shifts to the right both for
the increase in the future expected equilibrium income and for the decrease in
the borrowing rate for time 𝑡𝑡 + 1. To prevent this from increasing time 𝑡𝑡
equilibrium income, the central bank will have to raise the current policy rate.
Since the future expected short rate remains constant, while the current one
goes up, the current long rate 𝑖𝑖2𝑡𝑡 increases.
348
Expectation, financial markets, and economic policies
b. Assume for simplicity that, in Macrolandia, at time 𝑡𝑡 the yield curve is ini-
tially horizontal. Explain how the position and the slope of this curve
change after the change and the announcement studied above. Represent
both curves, the one “before” and the one “after”, in the graph below.
Clarify whether it is possible to determine the position and the slope of the
new yield curve unambiguously.
Yield
to
maturity “after”
“before”
1 2 Maturity
Given that both the current short rate (𝑖𝑖1𝑡𝑡 ) and the current long one (𝑖𝑖2𝑡𝑡 ) go
up, the new yield curve will lie above the initial one. Since 𝛥𝛥𝛥𝛥2𝑡𝑡 =
1 𝑒𝑒 𝑒𝑒
2
�𝛥𝛥𝑖𝑖1𝑡𝑡 + 𝛥𝛥𝑖𝑖1,𝑡𝑡+1 �, and being 𝛥𝛥𝑖𝑖1,𝑡𝑡+1 = 0, the increase in the current long rate
will be half that in short one, so that the new curve will be negatively sloped.
349
Macroeconomics. Problems and Questions
Question 13
In country Gamma, current and future expected inflation rates coincide and
are equal to zero, so that the real and the nominal interest rates are equal. In
period 𝑡𝑡 + 1 (“the future”), consumption depends only on disposable income
at 𝑡𝑡 + 1, and investment is 𝐼𝐼𝑡𝑡+1 = 𝐼𝐼𝑡𝑡+1 ̅ + 𝑑𝑑1 𝑌𝑌𝑡𝑡+1 − 𝑑𝑑2 𝑖𝑖𝑡𝑡+1 , where symbols have
the usual meaning. Turning now to the current period (𝑡𝑡, “the present”), con-
sumption is increasing in both current and expected future disposable income,
𝐶𝐶𝑡𝑡 = 𝐶𝐶(𝑌𝑌𝑡𝑡 − 𝑇𝑇�𝑡𝑡 , 𝑌𝑌𝑡𝑡+1
𝑒𝑒
− 𝑇𝑇�𝑡𝑡+1
𝑒𝑒
), while investment is increasing in current and ex-
pected future income levels, and decreasing in the current and expected future
levels of short-term interest rates. Finally, 𝐺𝐺 and 𝑇𝑇 are exogenous in both peri-
ods.
a. At time 𝑡𝑡, individuals revise downwards their expectation about the value
that the autonomous component of investment will take on in the future.
More specifically, they start expecting that 𝐼𝐼𝑡𝑡+1 ̅ will drop to 𝐼𝐼 ′̅ 𝑡𝑡+1, with
𝐼𝐼 ′̅ 𝑡𝑡+1 < 𝐼𝐼𝑡𝑡+1
̅ . At the same time, the central bank announces that, in the fu-
ture, it will implement a monetary policy aimed at preventing any change
in time 𝑡𝑡 + 1 equilibrium output that could be caused by the expected
drop in autonomous investment in that period. To achieve its goal, what
kind of monetary policy (expansionary? restrictive?) should the central
bank implement? Describe, and represent in the graph below, the effects
of the two announcements on Gamma’s current (that is to say, time 𝑡𝑡) in-
come and interest rate equilibrium levels.
𝑖𝑖𝑡𝑡
0 1
𝐿𝐿𝐿𝐿𝑡𝑡
𝐼𝐼𝐼𝐼𝑡𝑡1
𝐼𝐼𝐼𝐼𝑡𝑡0
𝑌𝑌𝑡𝑡
350
Expectation, financial markets, and economic policies
b. Suppose that only one-year bonds and two-year bonds exist and that, be-
fore the announcements described above, at time 𝑡𝑡 the yield curve was
flat. What will be the effects of the two announcements on the position
and the slope of the yield curve of Gamma?
The current one-year yield does not change, while the future expected one
1 𝑒𝑒
falls. Since 𝑖𝑖2𝑡𝑡 = 2 �𝑖𝑖1𝑡𝑡 + 𝑖𝑖1,𝑡𝑡+1 �, the time 𝑡𝑡 yield to maturity on two-year
𝑒𝑒 1
bonds will drop, too (more specifically, it will fall by 𝛥𝛥𝑖𝑖1,𝑡𝑡+1 ). The changes
2
analyzed in the previous point of this question will therefore lead to a nega-
tively sloped yield curve.
351
Macroeconomics. Problems and Questions
Question 14
a. In country Alpha, there are only one-year and two-year bonds. The cur-
rent and the expected future inflation rates are both zero, so that the real
and the nominal interest rates are equal. In period 𝑡𝑡 + 1 (“the future”), a
standard IS-LM model describes the functioning of the economy. In par-
ticular, in year 𝑡𝑡 + 1 consumption depends only on disposable income at
𝑡𝑡 + 1, and investment on the interest rate and output at 𝑡𝑡 + 1 only. Turn-
ing now to the current period (𝑡𝑡, “the present”), consumption is increasing
in both current and expected future disposable income levels, 𝐶𝐶𝑡𝑡 = 𝐶𝐶(𝑌𝑌𝑡𝑡 −
𝑇𝑇�𝑡𝑡 , 𝑌𝑌𝑡𝑡+1
𝑒𝑒
− 𝑇𝑇�𝑡𝑡+1
𝑒𝑒
), investment is exogenous, 𝐼𝐼𝑡𝑡 = 𝐼𝐼,̅ and the same is true
about 𝐺𝐺 and 𝑇𝑇. Rather than the interest rate, Alpha's central bank chooses
a value for the nominal money supply 𝑀𝑀 and, given this level at which 𝑀𝑀 is
set, lets the interest rate free to take on any value is consistent with the
macroeconomic equilibrium. It follows that, in the (𝑌𝑌, 𝑖𝑖) plane, the LM
curve of Alpha is the curve discussed in Question 2 − and, for the case of
an economy in a liquidity trap, in Question 10 − of Chapter 2. Finally, in
the initial equilibrium, time 𝑡𝑡 + 1 income and interest rates levels are both
positive, while at time 𝑡𝑡 the economy is in a liquidity trap. Suppose now
that, at time 𝑡𝑡, the central bank announces that it will decrease nominal
money supply at 𝑡𝑡 + 1. Explain how this announcement, which is unex-
pected and credible, affects the time 𝑡𝑡 yield to maturity on the two-year
bonds circulating in Alpha, 𝑖𝑖2𝑡𝑡 .
.........................................................................................................................
The decrease in money supply announced for 𝑡𝑡 + 1 will shift the LM for that
year to the left. This will lead to a new equilibrium in which income 𝑌𝑌𝑡𝑡+1 is
...........................................................................................................................
lower, and the short-term interest rate 𝑖𝑖1𝑡𝑡+1 higher. At time 𝑡𝑡, the fall in ex-
...........................................................................................................................
pected future income will decrease consumption, the IS will shift to the left,
...........................................................................................................................
and the economy will converge to an equilibrium in which 𝑌𝑌𝑡𝑡 is lower and 𝑖𝑖1𝑡𝑡
unchanged (since at time 𝑡𝑡 the economy is in a liquidity trap, the intersection
...........................................................................................................................
between the IS and the LM curves will still take place in the horizontal por-
...........................................................................................................................
tion of the latter curve, even after the leftward shift in the IS). Since 𝑖𝑖2𝑡𝑡 is
(approximately) equal to the average of the current and the future expected
...........................................................................................................................
𝑒𝑒
short term interest rates, and since 𝑖𝑖1𝑡𝑡+1 rises and 𝑖𝑖1𝑡𝑡 does not change, the
yield to maturity of the two-year bonds at time t will definitely rise.
352
Expectation, financial markets, and economic policies
b. Draw the yield curve prevailing at time 𝑡𝑡 before the central bank’s an-
nouncement, and explain how this latter will affect the yield curve of Al-
pha. In particular, draw the new yield curve in the same graph, and explain
if it is possible to determine without ambiguity how its slope and position
will compare to those of the original curve.
Yield
to
maturity
“after”
“before”
1 2 Maturity
𝑒𝑒
Since we know that, before the announcement, 𝑖𝑖1𝑡𝑡 = 0 and 𝑖𝑖1𝑡𝑡+1 > 0, initial-
ly the slope of the yield curve is positive.
After the announcement, 𝑖𝑖1𝑡𝑡 remains equal to zero, while 𝑖𝑖2𝑡𝑡 rises. It follows
that the new curve will still be positively sloped, but steeper than the initial
one.
353
Macroeconomics. Problems and Questions
Question 15
In country ABC, there are only one-year and two-year bonds. The current and
the expected future inflation rates are both zero, so that the real and the nomi-
nal interest rates are equal. In period 𝑡𝑡 + 1 (“the future”), investment is entire-
ly exogenous, while consumption depends only on disposable income at 𝑡𝑡 + 1.
Turning now to the current period (𝑡𝑡, “the present”), consumption is increas-
ing in both current and expected future disposable income, 𝐶𝐶𝑡𝑡 = 𝐶𝐶(𝑌𝑌𝑡𝑡 −
𝑇𝑇�𝑡𝑡 , 𝑌𝑌𝑡𝑡+1
𝑒𝑒
− 𝑇𝑇�𝑡𝑡+1
𝑒𝑒
), and investment is once again exogenous. In both periods, the
demand for money has the usual functional form, and 𝐺𝐺 and 𝑇𝑇 are exogenous
as usual. Starting from an initial equilibrium, at time 𝑡𝑡 the government of
Macrolandia announces an increase in net taxes for time 𝑡𝑡 + 1, ∆𝑇𝑇�𝑡𝑡+1 > 0.
a. Assuming that, in both periods, ABC’s central bank chooses the interest
rate, describe and represent in the two graphs below the effects of this fis-
cal policy announcement on income and the interest rate levels prevailing
at time 𝑡𝑡 and at time 𝑡𝑡 + 1. How will the time 𝑡𝑡 yield to maturity on the
two-year bonds circulating in Macrolandia, 𝑖𝑖2𝑡𝑡 , change? Why?
2 1
𝑖𝑖1𝑡𝑡 𝐼𝐼𝐼𝐼𝑡𝑡2 𝐼𝐼𝐼𝐼𝑡𝑡1 𝑖𝑖1𝑡𝑡+1 𝐼𝐼𝐼𝐼𝑡𝑡+1 𝐼𝐼𝐼𝐼𝑡𝑡+1
2 1 2 1
𝚤𝚤1𝑡𝑡
��� 𝐿𝐿𝐿𝐿𝑡𝑡 𝚤𝚤1𝑡𝑡+1
������ 𝐿𝐿𝐿𝐿𝑡𝑡+1
At time 𝑡𝑡 + 1, the rise in 𝑇𝑇� will shift the 𝐼𝐼𝐼𝐼 – a curve that is vertical in both
periods, as no component of aggregate demand depends on the interest rate −
to the left, thus leading to a lower equilibrium income. At time 𝑡𝑡, the ensuing
decrease in expected future income and the expectation of higher future taxes
will lower consumption, causing a leftward shift in the IS curve. It follows that
production will fall in both periods, and that – given the assumption about the
way the central bank behaves – both the current and the future expected
short-term rates will remain unchanged. Being (approximately) equal to the
𝑒𝑒
average of 𝑖𝑖1𝑡𝑡 and 𝑖𝑖1𝑡𝑡+1 , and that these rates remain constant, 𝑖𝑖2𝑡𝑡 will remain
unchanged, too.
354
Expectation, financial markets, and economic policies
b. Repeat the same analysis carried out when answering the previous point
assuming that, rather than the interest rate, the central bank of the coun-
try chooses the money supply. Represent in the graphs below the effects of
the same fiscal policy announcement considered before and explain how
will 𝑖𝑖2𝑡𝑡 change in this case, and why.
𝐼𝐼𝐼𝐼𝑡𝑡2 𝐼𝐼𝐼𝐼𝑡𝑡1 2
𝐼𝐼𝐼𝐼𝑡𝑡+1 1
𝐼𝐼𝐼𝐼𝑡𝑡+1
𝑌𝑌𝑡𝑡 t+1 𝑌𝑌𝑡𝑡+1
The 𝐿𝐿𝐿𝐿 curve is now positively sloped in both periods. The increase in 𝑇𝑇� an-
nounced for time 𝑡𝑡 + 1 will lead to a leftward shift of the 𝐼𝐼𝐼𝐼 for that period
that will now cause a fall not just in income, but also in the future interest rate
(the decrease in income will lower money demand; since now the central bank
keeps 𝑀𝑀 constant at the chosen level, the interest rate for which the money
market is in equilibrium goes down). At time 𝑡𝑡, the expectation of a lower fu-
ture income and higher future taxes decreases consumption, shifting the IS to
the left. With lower current and future expected short rates, 𝑖𝑖2𝑡𝑡 (which is just
𝑒𝑒
the average of 𝑖𝑖1𝑡𝑡 and 𝑖𝑖1𝑡𝑡+1 ) will fall.
355
Chapter 5 - The open economy
Macroeconomics. Problems and Questions
Question 1
a. Country Iota’s Statistical Office announces that, between year 𝑡𝑡 and year
𝑡𝑡 + 1, gross investment has increased by €100bn, while public saving has
fallen by €50bn.
a.1 Knowing that Iota is a closed economy, by how much has private
saving changed between the same two years?
a.2 How would your answer change, were Iota an economy open to trade
in goods, services and financial assets with the rest of the world?
358
The open economy
b. Explain, briefly but rigorously, what is meant by ‘J-curve’ [in your answer,
make explicit reference to the so-called ‘Marshall-Lerner condition’].
359
Macroeconomics. Problems and Questions
Question 2
Consider an economy open to foreign trade, where only the goods market ex-
ists and prices are constant. Assume that foreign trade is initially balanced.
a. Suppose the government decides to cut net taxes, 𝑇𝑇�. In the two-panel dia-
gram that allows one to analyze simultaneously the determination of the
goods market equilibrium and the trade balance associated with that equi-
librium position, represent the effects of this fiscal policy decision on equi-
librium income and net exports. In the graph, denote by 𝑌𝑌� the initial level
of equilibrium income, and by 𝑌𝑌�′ its new level. Why do equilibrium in-
come and net exports change? Explain.
45° 𝐷𝐷𝐷𝐷′
Z
𝐷𝐷𝐷𝐷
𝑍𝑍𝑍𝑍′
𝑍𝑍𝑍𝑍
NX
Trade
𝑌𝑌
deficit
360
The open economy
b. In the same graph used above, find the equilibrium level of income that
would have been reached had the same tax cut been implemented in a
closed economy. Denote this new, closed-economy equilibrium income by
𝑌𝑌�′′. Will 𝑌𝑌�′′ be less than, equal to, or greater than 𝑌𝑌�′? Why?
Were the economy closed, the new equilibrium income would be the one corre-
sponding to the intersection between the DD curve and the 45-degree line, ra-
...........................................................................................................................
ther than between this latter line and the ZZ curve. In the graph, the new
equilibrium income would therefore be 𝑌𝑌�′′, greater than 𝑌𝑌�′. It follows that the
...........................................................................................................................
effect of a tax cut on income will be greater in a closed economy than in an
...........................................................................................................................
open economy. The reason is that, while in a closed economy the increase in
...........................................................................................................................
demand due to the decrease in taxes falls entirely on domestic goods, in an
open economy part of the additional demand falls on foreign goods, thus rais-
...........................................................................................................................
ing foreign income, rather than domestic income. For this reason, the multi-
...........................................................................................................................
plier is smaller in an open economy than in a closed economy.
361
Macroeconomics. Problems and Questions
Question 3
a. Consider a country that is open to trade in goods and services with the rest
of the world, where prices are fixed and in which only the goods market ex-
ists. Initially, the country is in goods market equilibrium with a trade sur-
plus. Draw in the two-panel diagram below the initial equilibrium posi-
tion, and show how it changes following a reduction in the domestic price
level, 𝑃𝑃 [Hint: assume that, after this reduction, 𝑃𝑃 remains forever constant
at its new, lower level, so that the economy is still described by a model with
fixed prices]. In particular, explain if and why income and net exports will
change in the new equilibrium.
Z 45°
DD
ZZ’
1 ZZ
0
⦁ ⦁⦁ ⦁
𝑌𝑌�0 𝑌𝑌�1 𝑌𝑌𝑇𝑇𝑇𝑇 ′
𝑌𝑌𝑇𝑇𝑇𝑇 𝑌𝑌
NX
A A’
𝑌𝑌
B B’
NX’
NX
362
The open economy
b. How would your answer to the previous point of this question change, if
the quantities of goods and services exported and imported by the country
did not depend on the real exchange rate, but only on foreign and domestic
income levels, respectively? Explain.
...........................................................................................................................
In this case, net exports are given by the following expression:
...........................................................................................................................
1
𝑁𝑁𝑁𝑁 = 𝑋𝑋(𝑌𝑌 ∗ ) − 𝐼𝐼𝐼𝐼(𝑌𝑌),
...........................................................................................................................
𝜀𝜀
increasing in the real exchange rate 𝜀𝜀.
In this economy, the real depreciation brought about by the fall in 𝑃𝑃 lowers
net exports, since it does not change 𝑋𝑋 or 𝐼𝐼𝐼𝐼, but only causes an increase in
the price of each unit of goods imported from abroad in terms of domestic
goods. It follows that the Marshall-Lerner condition does not hold, and a fall
in 𝜀𝜀 shifts the ZZ curve downwards, rather than upwards. In the new equilib-
rium, income is lower, and the trade balance worsens.
363
Macroeconomics. Problems and Questions
Question 4
Consider a country that is open to trade in goods and services with the rest of
the world, where the exchange rate and prices are fixed and in which only the
goods market exists. In the initial equilibrium, the country has a trade surplus.
45°
𝐷𝐷𝐷𝐷′
Z
𝑍𝑍𝑍𝑍′
1 𝐷𝐷𝐷𝐷
𝑍𝑍𝑍𝑍
0
𝑁𝑁𝑁𝑁0
𝑁𝑁𝑁𝑁1
𝑌𝑌
364
The open economy
Starting from an initial equilibrium at point 0, with income 𝑌𝑌�0 and a trade
surplus 𝑁𝑁𝑁𝑁0 , an exogenous increase in investment leads to an increase in ag-
gregate demand and equilibrium output. Both the ZZ and the DD curves shift
upwards by an amount equal to the exogenous increase in investment
(𝛥𝛥𝐼𝐼 ̅ > 0). Equilibrium income becomes 𝑌𝑌�1 in the graph. In turn, this increase
in income leads to higher imports, thus worsening the trade balance, that now
becomes 𝑁𝑁𝑁𝑁1 (< 𝑁𝑁𝑁𝑁0 ). [Notice that, had investment increased by more than
assumed in the graph, net exports could have become negative.]
b. Does the increase in investment change the level of output for which trade
is balanced? Why, or why not?
...........................................................................................................................
𝑌𝑌𝑇𝑇𝑇𝑇 does not change, because the ZZ and the DD curves shift upwards in a
...........................................................................................................................
parallel fashion by the same amount (𝛥𝛥𝐼𝐼 ̅ ). It follows that they will keep inter-
secting for the same 𝑌𝑌𝑇𝑇𝑇𝑇 (the level of income for which foreign trade is bal-
...........................................................................................................................
anced). One can reach the same conclusion by noticing that the NX does not
...........................................................................................................................
shift, since − for any given 𝑌𝑌 − the change in 𝐼𝐼 ̅ does not affect net exports.
...........................................................................................................................
365
Macroeconomics. Problems and Questions
Question 5
45° 𝐷𝐷𝐷𝐷′
𝑍𝑍𝑍𝑍2
Z
2
𝐷𝐷𝐷𝐷
𝑍𝑍𝑍𝑍1′
1′
𝑍𝑍𝑍𝑍1
1
NX
1 2
0
𝑌𝑌
𝑁𝑁𝑁𝑁2
𝑁𝑁𝑁𝑁1
366
The open economy
An expansionary fiscal policy raises income, but worsens the country’s net
exports; a real depreciation increases income, but also improves net exports.
To raise 𝑌𝑌 and keep net exports equal to zero, policy-makers will have to re-
sort to an appropriate mix of fiscal expansion and real depreciation. In par-
ticular, an expansionary fiscal policy will shift up, and by the same amount,
the 𝑍𝑍𝑍𝑍 and the 𝐷𝐷𝐷𝐷 curves. They will therefore keep crossing for the same level
of production, and the new equilibrium income will become 𝑌𝑌1′ in the figure.
However, for this level of output 𝑁𝑁𝑁𝑁 < 0. To prevent net exports from becom-
ing negative, policy-makers will have to engineer a real depreciation of appro-
priate size – one that will shift the ZZ curve up, so that it will cross the new
DD curve exactly on the 45° line, and that, in the lower panel, will lead to an
upward shift in NX, so that it will cross the horizontal axis for the new equi-
librium output, 𝑌𝑌2 . As planned, at point 2 𝑁𝑁𝑁𝑁 = 0 and equilibrium income is
higher.
367
Macroeconomics. Problems and Questions
Question 6
a. Eta is initially in goods market equilibrium, with 𝐺𝐺̅ = 50, 𝑇𝑇� = 50, 𝑆𝑆 =
70, 𝐼𝐼 = 20, where 𝐺𝐺 is government spending on goods and services, 𝑇𝑇 net
taxes, 𝑆𝑆 private saving, and 𝐼𝐼 gross investment. Using this information,
represent the initial equilibrium of Eta in the two-panel diagram below
[Hint: you do not need to compute the equilibrium level of income; just
show clearly where the initial equilibrium position is located in each of the
two panels below, and explain why].
Z 45°
DD
ZZ’
1
ZZ
0
′
𝑌𝑌�0 𝑌𝑌𝑇𝑇𝑇𝑇 𝑌𝑌�1 𝑌𝑌𝑇𝑇𝑇𝑇 𝑌𝑌
NX
𝐴𝐴′
𝐴𝐴
𝐵𝐵′
𝐵𝐵 𝑌𝑌
NX’
NX
368
The open economy
In an open economy, the goods market equilibrium condition can also be writ-
ten as 𝑆𝑆 + (𝑇𝑇 − 𝐺𝐺) − 𝐼𝐼 = 𝑁𝑁𝑁𝑁. Since, in this case, 𝑆𝑆 + (𝑇𝑇 − 𝐺𝐺) − 𝐼𝐼 = 70 +
(50 − 50) − 20 = 50, in the initial equilibrium Eta runs a trade surplus,
𝑁𝑁𝑁𝑁 > 0. In the first graph, the ZZ and the DD curves will therefore intersect
each other below the 45-degree line, and equilibrium income, 𝑌𝑌�0 , will be lower
than the income level for which foreign trade is balanced, 𝑌𝑌𝑇𝑇𝑇𝑇 . The magnitude
of the initial trade surplus is equal, in the lower panel, to the length of the
segment AB.
b. Suppose now that real exchange rate ε falls – a real depreciation. Assum-
ing that the Marshall-Lerner condition holds true, represent the effects of
this change in the graph above. In particular, explain if it will affect the
level of income at which Eta’s foreign trade is balanced, 𝑌𝑌𝑇𝑇𝑇𝑇 , and – if your
answer is positive – in what direction 𝑌𝑌𝑇𝑇𝑇𝑇 will change. Finally, explain if
and why the trade balance will vary.
Since the Marshall-Lerner condition holds true, a fall in ε leads, other things
the same, to an improvement in Eta’s net exports. In the upper panel of the
figure, the ZZ curve shifts upwards, while the DD does not move. It follows
that the two curves will intersect for a higher level of income, and that
𝑌𝑌𝑇𝑇𝑇𝑇 (the income level for which foreign trade is balanced) will rise. One could
reach the same conclusion by noticing that, in the lower panel, the NX curve
shifts upwards. In the new equilibrium, income is higher, and the trade bal-
ance has improved (although by less than it would have done had domestic in-
come, and therefore imports, remained constant).
369
Macroeconomics. Problems and Questions
Question 7
Consider a country that is open to trade in goods and services with the rest of
the world, where prices are fixed and in which only the goods market exists.
Initially, the country is in goods market equilibrium, and trade is balanced.
a. Draw in the two-panel diagram below the initial equilibrium position and
show how it changes following a reduction in foreign output, 𝑌𝑌 ∗ . In par-
ticular, explain how and why net exports will have changed in the new
equilibrium.
Z 45°
DD
ZZ
0 ZZ’
′
𝑌𝑌𝑇𝑇𝑇𝑇 𝑌𝑌�1 𝑌𝑌�0 (= 𝑌𝑌𝑇𝑇𝑇𝑇 ) 𝑌𝑌
NX
𝑌𝑌
NX
NX’
370
The open economy
.................................................................................................................
A decrease in foreign output leads to a fall in the demand for domestically
.........
produced goods. The ZZ curve shifts down, and the same does the NX curve,
since net exports are now lower for any given 𝑌𝑌. This fall in net exports low-
...........................................................................................................................
ers aggregate demand and equilibrium output. The lower panel show that, alt-
...........................................................................................................................
hough in the new equilibrium 𝑌𝑌 is lower than before, net exports will neverthe-
less be smaller than in the initial equilibrium – they were initially zero, and
...........................................................................................................................
are now negative.
...........................................................................................................................
371
Macroeconomics. Problems and Questions
Question 8
a. Consider a country that is open to trade in goods and services with the rest
of the world, where prices are fixed and in which only the goods market ex-
ists. Initially, the country is in goods market equilibrium, and trade is bal-
anced.
Draw in the two graphs below the initial equilibrium position, and show
how this equilibrium changes following an increase in 𝐸𝐸, the nominal ex-
change rate [Hint: assume that E will remain forever at the new, higher lev-
el, and that domestic and foreign prices do not change]. Finally, explain if
and why, in the new equilibrium, income and net exports will have
changed.
Z 45°
DD
ZZ
0 ZZ’
′
𝑌𝑌𝑇𝑇𝑇𝑇 𝑌𝑌�1 𝑌𝑌�0 (= 𝑌𝑌𝑇𝑇𝑇𝑇 ) 𝑌𝑌
NX
𝑌𝑌
NX
NX’
372
The open economy
..........................................................................................................................
An increase in the nominal exchange rate causes an appreciation of the real
...........................................................................................................................
exchange rate 𝜀𝜀 ≡ 𝐸𝐸𝐸𝐸/𝑃𝑃∗ , and therefore reduces the price-competitiveness of
domestically produced goods. The ZZ curve shifts downwards, and the same
...........................................................................................................................
happens to the NX, since net exports are now lower for any given 𝑌𝑌. This fall
in net exports lowers aggregate demand and equilibrium output. As it is clear
from the lower panel of the graph above, although 𝑌𝑌 is now smaller, in the new
equilibrium net exports will be lower – the country will now be running a trade
deficit (the adverse impact of the real appreciation, which tends to decrease
net exports, prevails on the one coming from the decrease in domestic income,
which tends to lower imports, and therefore to improve the trade balance).
b. Consider now a different economy, where also financial markets exist and
under a flexible exchange rate regime. Show in the graph below, and dis-
cuss, how an increase in domestic money supply 𝑀𝑀 will affect the domestic
interest rate 𝑖𝑖, the country’s level of income and the exchange rate of its
currency, assuming that investment is exogenous, 𝐼𝐼 = 𝐼𝐼 ,̅ and therefore not
a function of 𝑖𝑖.
𝑖𝑖 𝑖𝑖
0 𝐿𝐿𝐿𝐿0 0
𝚤𝚤̅0
1 1
𝚤𝚤̅1
𝐿𝐿𝐿𝐿1
𝐼𝐼𝐼𝐼0
373
Macroeconomics. Problems and Questions
Question 9
374
The open economy
b. Write down the approximated version of the interest parity condition, and
check how good an approximation it is by repeating the computations you
carried out when answering the previous point of this question. Finally,
suggest two possible extensions that would likely increase the degree of re-
alism of the interest parity condition in its simplest form (be it approxi-
mated or not) considered in this question.
375
Macroeconomics. Problems and Questions
Question 10
The one-year interest rate in Japan is 1%, and the nominal exchange rate be-
tween the yen and the euro (number of yen needed to purchase one euro) is
140. Finally, assume that financial markets participants expect the euro to ap-
preciate by 5% against the yen in the following year.
a. For a European investor, what is the expected return from holding one-
year Japanese assets?
...........................................................................................................................
𝐸𝐸𝑡𝑡 = 140 (𝑦𝑦𝑦𝑦𝑦𝑦 𝑝𝑝𝑝𝑝𝑝𝑝 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒) = current exchange rate.
...........................................................................................................................
Market participants expect the euro to appreciate by 5% against the yen, or:
...........................................................................................................................
𝑒𝑒 𝑒𝑒
𝐸𝐸𝑡𝑡+1 − 𝐸𝐸𝑡𝑡 𝐸𝐸𝑡𝑡+1 − 140
...........................................................................................................................
= = 0.05.
𝐸𝐸𝑡𝑡 140
...........................................................................................................................
𝑒𝑒
Solving for 𝐸𝐸𝑡𝑡+1 ,
...........................................................................................................................
𝑒𝑒
𝐸𝐸𝑡𝑡+1 = 140(1 + 0.05) = 147.
...........................................................................................................................
To compute the expected return from holding Japanese bonds, notice that, at
the current exchange rate, with one euro a European investor can purchase
140 yen. Using these 140 yen to buy Japanese bonds, paying an interest of
1%, next year the European investor will receive 140(1 + 0.01) = 141.40
𝑒𝑒
yen, which are expected to be worth 141.40/𝐸𝐸𝑡𝑡+1 = 141.40/147 = 0.96
euro one year from now.
The expected return from investing in Japanese one-year bonds is therefore
negative, equal to −4% [(0.96 − 1)/1 = −0.04].
376
The open economy
b. Suppose that financial investors care only about the expected rate of re-
turn, and therefore want to hold only the assets with the highest expected
yield. Assuming that, in Europe, the one-year interest rate is 2%, would a
European investor purchase European assets or Japanese assets? In this
example, does the (uncovered) interest parity condition hold?
A European investor who invests today one euro in European one-year bonds
will receive, next year, 1(1 + .02) = 1.02 euros, for a rate of return of 2%.
Using the same euro to purchase one-year Japanese bonds, we already know
that the investor would receive, next year, 0.96 euros, so that the rate of re-
turn from investing in foreign bonds is negative (−4%).
The investor is clearly better off by purchasing euro-denominated bonds. In
this example, the interest parity condition does not hold, and there are there-
fore arbitrage opportunities between the two types of investments.
377
Macroeconomics. Problems and Questions
Question 11
Consider an economy freely trading goods, services and financial assets with
the rest of the world, in a flexible exchange rate regime. Domestic and foreign
prices are constant, and equal to one (𝑃𝑃 = 𝑃𝑃 ∗ = 1).
a. Using the pair of graphs ‘open economy IS-LM – interest parity condi-
tion’, show the initial equilibrium of the country, denoting it by ‘1’ (hint:
assume that the economy is described by a standard open economy IS-LM
model, with a central bank the central bank that chooses the interest rate).
Suppose now that the government raises its purchases of goods and ser-
vices and that, to keep equilibrium income constant, the central bank var-
ies the interest rate by implementing an open market operation. To
achieve its aim, should the central bank buy or sell bonds? In the figure,
denote by 2 the new equilibrium that will prevail after the increase in 𝐺𝐺
and the central bank intervention. In the move from 1 to 2, how will the
interest rate, the exchange rate, investment and net exports change? Ex-
plain.
𝑖𝑖 𝑖𝑖
2 𝐿𝐿𝐿𝐿2 2
𝚤𝚤̅2
1′ 1
𝚤𝚤̅1
1 𝐿𝐿𝐿𝐿1
𝐼𝐼𝐼𝐼2
𝐼𝐼𝐼𝐼1
378
The open economy
If the central bank did not intervene, the increase in 𝐺𝐺 would raise equilibrium
income. To prevent 𝑌𝑌 from changing, the central bank will have to increase
the policy rate, something that requires a sale of bonds in the open market. In
the new equilibrium (point 2 in the figure) the interest rate is higher, and this
leads to an exchange rate appreciation. Furthermore, investment is lower (be-
cause of the increase in 𝑖𝑖), consumption is unchanged (income and net taxes
have remained constant), and net exports are smaller (due to the appreciation
of the exchange rate).
From the answer to the previous point we know that, to prevent income from
changing, the central bank should raise the interest rate, thus causing an ap-
preciation of the exchange rate. It is therefore straightforward to conclude
that a central bank wishing to keep the exchange rate fixed at the chosen level
will have to accept the rise in income caused by the fiscal expansion imple-
mented by the government. The interest rate will have to be kept unchanged,
and in the figure the new equilibrium becomes in this case point 1′, where in-
come has gone up, consumption and investment are higher (𝑌𝑌 is higher, and
net taxes and the interest rate unchanged), and net exports lower (due to the
rise in 𝑌𝑌, and taking into account the fact that the exchange rate has remained
constant).
379
Macroeconomics. Problems and Questions
Question 12
Consider Alpha, an open economy with a flexible exchange rate and in which
investment is a function of 𝑌𝑌 and of the borrowing rate 𝑝𝑝 + 𝑥𝑥. Aside from this,
the country is described by a standard ‘open economy IS-LM – interest parity’
model with constant domestic and foreign prices, so that 𝑖𝑖 = 𝑝𝑝.
a. Assuming that the central bank chooses the interest rate, represent the
initial equilibrium of the economy in an ‘open economy IS-LM – interest
parity’ diagram, denoting it by ‘1’, and by 𝑖𝑖1 , 𝑌𝑌1 and 𝐸𝐸1 the associated
values of the interest rate, output and exchange rate. Suppose now that
the risk premium on which the borrowing rate depends, 𝑥𝑥, increases. In
the graph, denote by ‘2’ the new equilibrium that will be reached. In the
move from the initial equilibrium ‘1’ to the new one ‘2’, how will
production, consumption, investment, the exchange rate, net exports and
the country’s money supply and money demand change? Explain.
𝑖𝑖 𝑖𝑖
𝐼𝐼𝐼𝐼1
𝐼𝐼𝐼𝐼2
2 1 𝐿𝐿𝐿𝐿1 1
𝚤𝚤̅1
𝚤𝚤̅3 𝐿𝐿𝐿𝐿3 3
3
For a given interest rate 𝑖𝑖 chosen by the central bank, an increase in the risk
premium raises the borrowing rate and lowers investment. The IS curve shifts
to the left, and the new equilibrium becomes point 2 in the figure, where pro-
duction is lower. Consumption has gone down (due to the fall in income), and
the same is true about investment (income is lower, and the borrowing rate
higher).
380
The open economy
Since the central bank keeps the interest rate at the initial level, the exchange
rate remains constant and net exports improve (due to the decrease in in-
come). Finally, since in the new equilibrium money demand has gone down
(the interest rate is unchanged, but income is lower), money supply must be
lower, too. In fact, if the central bank did not change 𝑀𝑀, the interest rate
would fall (recall that the decrease in 𝑌𝑌 lowers money demand). To keep 𝑖𝑖 at
the chosen level, the central bank will have to decrease money supply by the
same amont by which money demand has fallen.
b. How would your answer to the previous point change, should Alpha’s
central bank decide to intervene in order to prevent the rise in 𝑥𝑥 from
affecting production, and therefore in order to keep 𝑌𝑌 at the same level
prevailing in the initial equilibrium (‘1’)? In the graph, denote by ‘3’ the
equilibrium that would be reached in this case and explain if and why, in
the move from ‘1’ to ‘3’, consumption, investment, the exchange rate, net
exports and the country’s money supply and money demand will change.
To keep production at the initial level, the central bank must lower the policy
rate till 𝚤𝚤̅3 , thus shifting downwards the 𝐿𝐿𝐿𝐿 curve to 𝐿𝐿𝐿𝐿3 . In the new equilib-
rium that will be reached in this case, compared to 1 both money supply (the
central bank has lowered the policy rate) and money demand (𝑖𝑖 is lower, 𝑌𝑌
unchanged) will be higher, the exchange rate has depreciated (due to the de-
crease in the domestic interest rate), net exports have improved (thanks to
the decrease in 𝐸𝐸) and consumption will be unchanged. Finally, and although
the rise in 𝑥𝑥 and the fall in 𝑖𝑖 tend to push it in opposite directions, investment
will necessarily be lower. In fact, in the two equilibria 1 and 3 the supply of
goods is the same; this means that aggregate demand will have to be the same,
too, and that, therefore, investment will have gone down by the same amount
by which net exports have gone up.
381
Macroeconomics. Problems and Questions
Question 13
Consider Zeta, an open economy with a fixed exchange rate and in which in-
vestment is a function of 𝑌𝑌 and of the borrowing rate 𝑝𝑝 + 𝑥𝑥. Aside from this,
the country is described by a standard ‘open economy IS-LM – interest parity’
model with constant domestic and foreign prices, so that 𝑖𝑖 = 𝑝𝑝, in wh ich th e
foreign interest rate is, as usual, denoted by 𝑖𝑖 ∗ , and where the value at which
the central bank keep the exchange rate constant is 𝐸𝐸� = 𝐸𝐸1 , with 𝐸𝐸� 𝑒𝑒 = 𝐸𝐸� = 𝐸𝐸1 .
a. Assuming that the central bank chooses the interest rate, represent the ini-
tial equilibrium of the economy in an ‘open economy IS-LM – interest
parity’ diagram, denoting it by ‘1’, and by 𝑖𝑖1 , 𝑌𝑌1 and 𝐸𝐸1 the associated val-
ues of the interest rate, output and exchange rate. Suppose now that the
risk premium on which the borrowing rate depends, 𝑥𝑥, decreases. In the
graph, denote by ‘2’ the new equilibrium that will be reached. In the move
from the initial equilibrium ‘1’ to the new one ‘2’, how will production,
consumption, investment, net exports and the country’s money supply
and money demand change? Explain.
𝑖𝑖 𝑖𝑖
𝐼𝐼𝐼𝐼2
𝐼𝐼𝐼𝐼1
Given the interest rate chosen by the central bank, 𝑖𝑖 = 𝑖𝑖 ∗ , a decrease in the
risk premium lowers the borrowing rate and raises investment. The IS curve
shifts to the right and the equilibrium becomes point 2 in the figure, where
production is higher. Consumption has gone up (because of the higher equilib-
rium income), and the same is true about investment (income is higher, and
the borrowing rate lower).
382
The open economy
Since the central bank keeps the interest rate constant at the initial level, the
exchange rate, too, remains constant, while net exports are lower (due to the
increase in domestic income). Finally, since in the new equilibrium money
demand has gone up (the interest rate is unchanged, but income is higher),
money supply, too, must be higher. In fact, if the central bank did not change
𝑀𝑀, the domestic interest rate would rise above 𝑖𝑖 ∗ (remember that the increase
in 𝑌𝑌 raises money demand), and the exchange rate above 𝐸𝐸1 . To prevent this
from happening, the central bank will have to raise money supply by the same
amount by which money demand has gone up.
b. Suppose now that, to bring back income to the level prevailing before the
fall in 𝑥𝑥 (that is, to 𝑌𝑌1 ), Zeta’s central bank decides to change from 𝐸𝐸1 to
𝐸𝐸3 the value at which the exchange rate is kept fixed, and that individuals
revise accordingly the value of the exchange rate they expect to prevail in
the future, so that the new future expected exchange rate now becomes
� = 𝐸𝐸3 . Having explained if, to achieve the central bank’s aim, 𝐸𝐸3
𝐸𝐸� 𝑒𝑒′ = 𝐸𝐸′
will have to be greater or smaller than 𝐸𝐸1 , in the pair of graphs used before
denote by ‘3’ the new equilibrium the economy will reach. Comparing the
initial equilibrium (‘1’) to the final one (‘3’), how will consumption,
investment, net exports and the country’s money supply and money
demand will change? Why? Explain.
To bring back income to the initial level, the central bank will have to resort
to an exchange rate revaluation of appropriate size. In particular, the new
value at which the exchange rate is kept fixed, 𝐸𝐸3 , will have to be consistent
with an IS curve that returns to 𝐼𝐼𝐼𝐼1, and this due to the adverse impact of the
revaluation on the country’s net exports. The new equilibrium is at point 3 in
the two panels [notice that, in the right panel, the line representing the inter-
est parity condition will now go through – as always it must do – the point in
which the interest rate is 𝑖𝑖 = 𝑖𝑖 ∗ and the exchange rate 𝐸𝐸 = 𝐸𝐸� 𝑒𝑒′ = 𝐸𝐸3 ]. As the
economy goes from the initial equilibrium ‘1’ to the final one ‘3’, consumption
is unchanged, investment is higher (income is unchanged, but the borrowing
rate is lower), and net exports have gone down (domestic and foreign income
levels are unchanged, but the real exchange rate is higher). Finally, since in-
come and the interest rate are unchanged, also money demand will be un-
changed; needless to say, the same must be true about money supply.
383
Macroeconomics. Problems and Questions
Question 14
Consider an economy freely trading goods, services and financial assets with
the rest of the world. Furthermore, assume that domestic and foreign prices
are constant, and equal to one (𝑃𝑃 = 𝑃𝑃∗ = 1).
𝑖𝑖 𝑖𝑖
2 1 1 2
𝚤𝚤̅1 = 𝑖𝑖 ∗
𝐼𝐼𝐼𝐼2 𝐼𝐼𝐼𝐼1
𝑌𝑌�2 ��11
𝑌𝑌𝑌𝑌 𝑌𝑌 𝐸𝐸 𝑒𝑒 = 𝐸𝐸1 𝐸𝐸 𝑒𝑒 ′ 𝐸𝐸
384
The open economy
For given 𝚤𝚤̅1 and 𝑖𝑖 ∗ , the increase in 𝐸𝐸 𝑒𝑒 lowers the expected return on foreign
assets, thus raising (appreciating) the exchange rate 𝐸𝐸 consistent with the in-
terest parity condition. The exchange rate appreciation lowers, for any given
𝑌𝑌, net exports and shifts the IS curve to the left. The new equilibrium becomes
point 2, where income is lower, 𝑖𝑖 unchanged, 𝐸𝐸 greater (equal to 𝐸𝐸 𝑒𝑒′ in the
figure) and the supply of money lower. In fact, the fall in 𝑌𝑌 lowers money de-
mand. To keep the domestic interest rate at the chosen level, 𝚤𝚤̅1 , the central
bank will have to lower the supply of money by the same amount by which
money demand has gone down.
To return output to the initial level, the government will have to shift the 𝐼𝐼𝐼𝐼
curve to the right, till 𝐼𝐼𝐼𝐼1. This requires a cut in net taxes. Once the economy
is back to the equilibrium corresponding to point 1, consumption will be high-
er than before the increase in 𝐸𝐸 𝑒𝑒 and the cut in 𝑇𝑇� (income has returned to the
initial level, but net taxes are lower), investment will be unchanged (both 𝑌𝑌
and 𝑖𝑖 are unchanged), 𝐺𝐺 unchanged (it is exogenous) and net exports lower
(due to the exchange rate appreciation).
385
Macroeconomics. Problems and Questions
Question 15
a. The world economy consists of just two countries, Alpha and Beta. Inter-
national capital mobility is perfect, and the exchange rate between the cur-
rencies of the two countries is kept fixed at the level 𝐸𝐸� . Alpha has just en-
tered a recession. To revive its economy, would you recommend Alpha the
use of monetary policy or of fiscal policy? Explain your answer and illus-
trate graphically, using the pair of graphs 'open economy IS-LM'-'interest
parity condition'.
𝑖𝑖 𝑖𝑖
0 1 𝐿𝐿𝐿𝐿0 𝑖𝑖 ∗ 0
𝚤𝚤̅0 = 𝑖𝑖∗ 1
′ ′
0 0
𝚤𝚤̅0 ′
𝐿𝐿𝐿𝐿1
𝐼𝐼𝐼𝐼0 𝐼𝐼𝐼𝐼1
𝑌𝑌 𝐸𝐸0′ 𝐸𝐸� 𝐸𝐸
Under a fixed exchange rate regime, monetary policy cannot be used to affect
...........................................................................................................................
the equilibrium level of income. In fact, if individual expect the exchange rate
to remain in the future at the current level 𝐸𝐸� , the value at which the central
...........................................................................................................................
bank is pegging it, the interest parity condition implies that the domestic in-
...........................................................................................................................
terest rate has to be equal to the foreign one. In the initial equilibrium, point 0
in the graph, this equality holds, with a domestic interest rate 𝚤𝚤̅0 (= 𝑖𝑖 ∗ ) and
...........................................................................................................................
an exchange rate equal to 𝐸𝐸� . If, starting from this initial equilibrium, to boost
...........................................................................................................................
economic activity the central bank decided to lower the interest rate to 𝚤𝚤̅0 ′
(for instance, by purchasing bonds in the open market), the exchange rate
...........................................................................................................................
would immediately tend to depreciate, falling to the level 𝐸𝐸0′ (< 𝐸𝐸� ).
...........................................................................................................................
386
The open economy
...........................................................................................................................
To avoid this depreciation, the central bank must immediately intervene in the
...........................................................................................................................
foreign exchange market, buying the domestic currency and selling the foreign
...........................................................................................................................
one. This intervention, that reduces 𝑀𝑀, must continue until 𝑀𝑀 returns to its
original level, and the LM curve to its initial position. But if, to make sure
that the exchange rate remains constant, the money supply and the domestic
interest rate must be returned to their initial levels, aggregate demand and
output will be unaffected.
Under fixed exchange rates, to increase equilibrium output one can only re-
sort to an expansionary fiscal policy that, by shifting the IS to the right (𝐼𝐼𝐼𝐼1 ),
leads to a new equilibrium such as point 1 in the figure.
b. Discuss the effects of the policy intervention you have just suggested on
the trade balance of Alpha and on that of Beta, always assuming a fixed
exchange rate.
387
Macroeconomics. Problems and Questions
Question 16
Consider an economy that trades goods, services and financial assets with the
rest of the world, under a fixed exchange rate regime. Domestic and foreign
prices are constant and, for simplicity, both equal to 1 (𝑃𝑃 = 𝑃𝑃 ∗ = 1). In the
pair of graphs ‘open economy IS-LM’-‘interest parity condition’, show the ini-
tial equilibrium, denoting by 𝑖𝑖0 , 𝑌𝑌0 and 𝐸𝐸0 the values of the interest rate, out-
put and exchange rate in that equilibrium. Market participants expect that the
exchange rate will be kept fixed at the current level 𝐸𝐸0 also in the future, so
that 𝐸𝐸 𝑒𝑒 = 𝐸𝐸0 .
a. Suppose that there is a fall in the foreign interest rate, 𝑖𝑖 ∗ , while foreign
output 𝑌𝑌 ∗ and all the other exogenous variables remain constant. Assum-
ing that the country’s central bank keeps fixing the exchange rate at 𝐸𝐸0 ,
show in the graph, and explain carefully, the effects of this exogenous de-
crease in 𝑖𝑖 ∗ on equilibrium output, interest rate, money supply and net ex-
ports of the country, denoting by ‘1’ the new equilibrium that will be
reached.
𝐼𝐼𝐼𝐼0 𝐼𝐼𝐼𝐼2
𝑖𝑖 𝑖𝑖
0 𝐿𝐿𝐿𝐿0 0
𝑖𝑖 ∗
1 2
𝑖𝑖 ∗ ’ 𝐿𝐿𝐿𝐿1 1, 2
388
The open economy
In the right panel, the fall in the foreign interest rate leads to a downward
shift in the line representing the interest parity condition; the new line will
now go through – as it has to do by construction – the point (𝐸𝐸 = 𝐸𝐸 𝑒𝑒 , 𝑖𝑖 = 𝑖𝑖 ∗ ′),
where 𝑖𝑖 ∗ ′ is the new level of the foreign interest rate. Absent any intervention
by the domestic central bank, the exchange rate would appreciate (it would
rise above 𝐸𝐸0 ). To keep it at 𝐸𝐸0 , the central bank will have to intervene. This
intervention will have to lower the domestic interest rate by the same amount
by which the foreign one has gone down, thus shifting the LM curve down-
wards till 𝐿𝐿𝐿𝐿1 . In the new equilibrium (point 1), the decrease in the domestic
interest rate has raised aggregate demand and equilibrium output. As for net
exports, they will now be lower, since domestic income is higher and the ex-
change rate unchanged.
b. How would your answer have changed if, when 𝑖𝑖 ∗ falls, foreign output 𝑌𝑌 ∗
had also gone up, rather than remaining constant? In the same graph used
before, denote by ‘2’ the equilibrium that the economy would have
reached in this case (lower 𝑖𝑖 ∗ and higher 𝑌𝑌 ∗ ) and compare it to the
equilibrium (‘1’) where the economy settles when to vary is just the foreign
interest rate. Finally, explain in which of the two cases the intervention of
the central bank (consisting in a change in the money supply aimed at
keeping the exchange rate constant) will have to be quantitatively larger.
In this case, the interest parity condition line will still shift downwards, while
...........................................................................................................................
the increase in 𝑌𝑌 ∗, that – other things the same – leads to higher net exports,
...........................................................................................................................
shifts the IS curve to the right in the first panel (𝐼𝐼𝐼𝐼2 ). The increase in domes-
tic output is now larger, since in this case the demand for domestically pro-
...........................................................................................................................
duced goods goes up not only because of the fall in the interest rate, but also
...........................................................................................................................
because of the rise in the demand by foreigners. The central bank’s interven-
tion, aimed at keeping 𝐸𝐸 constant, must therefore be larger than before. More
...........................................................................................................................
specifically, the domestic money supply will have to be raised by more than
when the only change taking place was the one in 𝑖𝑖 ∗ − now it will have to go
...........................................................................................................................
up not only to make sure that the domestic interest rate falls by the same
...........................................................................................................................
amount as the foreign one, but also to prevent the increase in income, and
...........................................................................................................................
therefore money demand, caused by the rise in 𝑌𝑌 ∗ from pushing the domestic
interest rate above the new level 𝑖𝑖 ∗′ consistent with the fixed exhange rate.
389
Macroeconomics. Problems and Questions
Question 17
Consider an open economy under a fixed exchange rate regime. Domestic and
foreign prices are constant and, for simplicity, both equal to 1 (𝑃𝑃 = 𝑃𝑃∗ = 1).
In the pair of graphs ‘open economy IS-LM’-‘interest parity condition’, show
the initial equilibrium, denoting it by ‘0’, and by 𝑖𝑖0 , 𝑌𝑌0 and 𝐸𝐸0 the associated
values of the interest rate, output and the exchange rate. Market participants
expect that the exchange rate will be kept fixed at the current level 𝐸𝐸0 also in
the future, so that 𝐸𝐸 𝑒𝑒 = 𝐸𝐸0 .
𝐼𝐼𝐼𝐼0 𝐼𝐼𝐼𝐼1
𝑖𝑖 𝑖𝑖
0 1 𝐿𝐿𝐿𝐿0 1 0
𝑖𝑖0 = 𝑖𝑖 ∗
390
The open economy
In the right-hand panel, the curve representing the interest parity condition
′
shifts upwards, now going through the new point (𝐸𝐸 = 𝐸𝐸 𝑒𝑒 = 𝐸𝐸1 ; 𝑖𝑖 = 𝑖𝑖 ∗). In
the first panel, there is a rightward shift of the IS curve, due to the fact that, for
given domestic and foreign prices, the devaluation depreciates the real exchange
rate, thus raising net exports and therefore the demand for domestically pro-
duced goods. In both panels, the new equilibrium is at point 1, where output is
higher and the domestic interest rate still equal to the foreign one (as it must
necessarily be the case if, as in the present setting, individuals expect the ex-
change rate to take on in the future the same value it is taking on today). In the
move from the old to the new equilibrium, the central bank must have increased
the money supply. In fact, the increase in income caused by the devaluation
raises money demand. If 𝑀𝑀 were kept constant, the domestic interest rate would
raise above the foreign one, and the exchange rate above the value 𝐸𝐸1 at which
the central bank now wants it to remain constant. Money supply will have to be
raised by the amount needed to make sure that, even though income is higher,
the domestic interest rate remains at its initial level, 𝑖𝑖0 = 𝑖𝑖 ∗ .
b. Suppose that, before the devaluation, both the domestic country and the
rest of the world were in a medium-run equilibrium, with income at its
natural level and zero inflation. In addition, assume that the inflation rate
is determined according to the following Phillips curve:
𝜋𝜋 = (𝛼𝛼/𝐿𝐿)(𝑌𝑌 − 𝑌𝑌𝑛𝑛 )
Once price adjustment − as implied by the previous equation − is taken
into account, do you think that a devaluation can permanently affect the
level of income of a country? Why, or why not? Discuss [Hint: no formal
analysis is required; just describe the likely dynamic adjustment of the
economy following a devaluation].
As we have just concluded, the devaluation will rise output above its natural
...........................................................................................................................
level. Domestic prices will start rising and, given that foreign prices are con-
stant, the real exchange rate will start appreciating, thus hurting the price-
...........................................................................................................................
competitiveness of domestically produced goods and worsening the trade bal-
...........................................................................................................................
ance. It follows that, in the figure above, sooner or later the curve labeled 𝐼𝐼𝐼𝐼1
will start shifting to the left. As long as output is above its natural level, this
...........................................................................................................................
process will continue. Eventually, the economy will converge to the same me-
...........................................................................................................................
dium-run equilibrium prevailing before the devaluation (‘0’), with a real ex-
change rate − on impact lower because of the fall in 𝐸𝐸 − back to its initial lev-
el, due to the rise in domestic prices.
391
Macroeconomics. Problems and Questions
Question 18
Consider an open economy under a fixed exchange rate regime. Domestic and
foreign prices are constant and, for simplicity, both equal to 1 (𝑃𝑃 = 𝑃𝑃∗ = 1).
In the pair of graphs ‘open economy IS-LM’-‘interest parity condition’, show
the initial equilibrium, denoting it by ‘0’, and by 𝑖𝑖0 , 𝑌𝑌0 and 𝐸𝐸0 the associated
values of the interest rate, output and the exchange rate. Initially, market par-
ticipants expect that the exchange rate will be kept fixed at the current level 𝐸𝐸0
also in the future, so that 𝐸𝐸 𝑒𝑒 = 𝐸𝐸0 .
a. Suppose that, in the initial equilibrium, income is below its natural level.
Given that, as discussed in the answer to the previous question, a decision
to devalue leads a higher equilibrium output in a country under a fixed
exchange rate regime, individuals start expecting an impeding devalua-
tion. It follows that the future expected exchange rate decreases from
𝐸𝐸 𝑒𝑒 = 𝐸𝐸0 to 𝐸𝐸 𝑒𝑒′ = 𝐸𝐸1 , with 𝐸𝐸1 < 𝐸𝐸0 . Analyze in the graph the effects of
this downward revision in the expectations on the exchange rate that will
prevail in the future on the levels of domestic income and interest rate, as-
suming that the central bank intends to keep the exchange rate fixed at 𝐸𝐸0 .
𝑖𝑖 𝐼𝐼𝐼𝐼0 𝑖𝑖
1 𝐿𝐿𝐿𝐿1 1
𝑖𝑖1
0 𝐿𝐿𝐿𝐿0 0′
𝑖𝑖0 = 𝑖𝑖 ∗ 0
392
The open economy
In the right-hand panel, the curve representing the interest parity condition
′
shifts upwards, now going through the new point (𝐸𝐸 = 𝐸𝐸 𝑒𝑒 = 𝐸𝐸1 ; 𝑖𝑖 = 𝑖𝑖 ∗ ). In
the first panel, the IS curve does not shift, as net exports do not depend on the
value that the exchange rate is expected to take on in the future, but rather on
the value the exchange rate is taking on today (a value that the central bank
is keeping constant at 𝐸𝐸0 ). To make sure that 𝐸𝐸 remains at 𝐸𝐸0 even after ex-
pectations of a devaluation have emerged, the central bank will have to raise
the domestic interest rate to 𝑖𝑖1 . In fact, if 𝑖𝑖 remained at the initial level, 𝑖𝑖0 , in
the right-hand side panel we would go from point 0 to 0’, with an exchange
rate that depreciates immediately. As implied by the interest parity condition,
to prevent this drop in the exchange rate, the central bank will have to set the
domestic interest rate to a level that exceeds the foreign one by an amount
equal to the expected devaluation of the domestic currency,
(𝐸𝐸1 − 𝐸𝐸0 )
𝑖𝑖1 − 𝑖𝑖0 = − .
𝐸𝐸0
As we already know, under a fixed exchange rate regime fiscal policy is the
only macroeconomic policy that can affect equilibrium income. In this case,
since equilibrium output tends to fall, the fiscal policy intervention that is
called for is an expansionary one. As for the role of monetary policy, and as
discussed before, it will have to make sure that the domestic interest rate
takes on a value consistent with the fixed exchange rate, given 𝑖𝑖 ∗ and the new
value of 𝐸𝐸 𝑒𝑒 .
393
Macroeconomics. Problems and Questions
Question 19
True or False?
Explain whether the following statements are true or false. Motivate your answer
in a brief but rigorous way, by making explicit reference to the relevant theory.
Lack of proper explanations will result in zero points.
True. Under flexible exchange rates, the decrease in the interest rate caused
by an expansionary monetary policy stimulates not only investment, but – by
inducing a depreciation of the exchange rate − also net exports, thus leading
to an increase in aggregate demand and equilibrium income.
On the contrary, under fixed exchange rates authorities must oppose to the
potential depreciation and intervene in the exchange rate market. This inter-
vention, which must necessarily consist in the purchase of the domestic cur-
rency and in the selling of the foreign currency, must go on until money supply
and the domestic interest rate are back to the initial levels. It follows that
equilibrium income will not vary either. With fixed exchange rates, monetary
policy cannot be used to stimulate the economy.
394
The open economy
b. If financial investors only care about the expected rate of return, and
therefore want to hold only the assets with the highest expected rate of re-
turn, then from the interest parity condition it follows that, under fixed ex-
change rates, the domestic interest rate can only be equal to the foreign in-
terest rate, 𝑖𝑖 = 𝑖𝑖 ∗ .
False. Under fixed exchange rates, 𝑖𝑖 = 𝑖𝑖 ∗ if 𝐸𝐸� = 𝐸𝐸 𝑒𝑒 , that is, if individuals ex-
pect that the exchange rate will be kept fixed at the current level 𝐸𝐸� also in the
future. If, however, there are expectations of a future revaluation or devalua-
tion, 𝐸𝐸� ≠ 𝐸𝐸 𝑒𝑒 , and the domestic interest rate 𝑖𝑖 will necessarily differ from 𝑖𝑖 ∗ .
If, for instance, there are expectations of an imminent devaluation of
the exchange rate, 𝐸𝐸� > 𝐸𝐸 𝑒𝑒 , and the domestic interest rate will have to be
greater than the foreign interest rate in order to compensate investors for
the expected depreciation of the domestic currency.
395
Macroeconomics. Problems and Questions
Question 20
𝑖𝑖 𝑖𝑖
𝐼𝐼𝐼𝐼0
𝐼𝐼𝐼𝐼2 0 𝐿𝐿𝐿𝐿0 0
𝚤𝚤̅0
1 𝐿𝐿𝐿𝐿1 1
𝚤𝚤̅1
2
396
The open economy
........................................................................................................................
In the new equilibrium, the interest rate is lower, the exchange rate has depre-
ciated, and income is higher. The direction in which net exports will change is
however uncertain – the exchange rate depreciation tends to rise them, but the
rise in income tends to worsen them.
b. Suppose now that the government of Psi implements a fiscal policy aimed
at bringing equilibrium output back to the level it was taking on before the
decrease in θ. What happens to the trade balance in this case? Explain.
In order to bring back income to its initial level, the government must imple-
ment a restrictive fiscal policy, thus shifting the IS curve to the left, up to 𝐼𝐼𝐼𝐼2 .
In the final equilibrium, point 2 in the first graph and point 1 in the second
one, income will be at the same level as than at point 0, but the interest rate
will be lower, and the exchange rate weaker. Due to the exchange rate depre-
ciation, in the new equilibrium (point 1) net exports will be higher than in the
initial equilibrium (point 0).
397
Macroeconomics. Problems and Questions
Question 21
Consider an economy freely trading goods, services and financial assets with
the rest of the world, in a flexible exchange rate regime. Domestic and foreign
prices are constant, and equal to one (𝑃𝑃 = 𝑃𝑃 ∗ = 1).
𝐼𝐼𝐼𝐼1
𝑖𝑖 𝑖𝑖
2 𝐿𝐿𝐿𝐿1 2
𝚤𝚤̅2
𝚤𝚤̅1 1
1 𝐿𝐿𝐿𝐿2
If investment is exogenous and net exports do not depend on the real ex-
change rate, then no component of aggregate demand for domestically pro-
duced goods depends on the domestic interest rate, and the IS is a vertical line
in the (𝑌𝑌, 𝑖𝑖) space. The central bank’s decision to sell bonds in the open mar-
ket lowers money supply and raises the domestic interest rate. The LM curve
shifts up and, for given levels of the foreign interest rate and of the expected
future exchange rate, the interest parity condition implies a nominal (and re-
al) appreciation of the currency. In the two panels, the equilibrium point
moves from 1 to 2. Income does not change, because − as already mentioned –
no component of aggregate demand depends on 𝑖𝑖.
398
The open economy
b. Suppose now that, rather than being independent of the real exchange
rate, net exports depend positively on ε – in other words, a real deprecia-
tion (appreciation) worsens (improves) the country’s trade balance. As-
suming that the remaining assumptions (exogeneity of investment, a flexi-
ble exchange rate, a central bank that chooses the interest rate, etc.) still
hold true, discuss the effects of the same monetary policy studied above
on the equilibrium levels of income, interest rate and exchange rate. Show
in the figure the new equilibrium that will be reached in this case, and ex-
plain.
𝑖𝑖 𝐼𝐼𝐼𝐼1 𝑖𝑖
2 𝐿𝐿𝐿𝐿2 2
𝚤𝚤̅2
1 1
𝚤𝚤̅1
𝐿𝐿𝐿𝐿1
399
Macroeconomics. Problems and Questions
Question 22
Gamma is an economy that trades goods, services and financial assets with the
rest of the world, under a flexible exchange rate regime. In Gamma, changes in
the autonomous components of the demand for domestic goods are the main
cause of the observed fluctuations in real GDP. Starting from an initial equi-
librium like point ‘0’ in the graph, sometimes the level of autonomous demand
is high, leading to an 𝐼𝐼𝐼𝐼 curve such as 𝐼𝐼𝐼𝐼1 in the figure; sometimes it is however
low, so that the 𝐼𝐼𝐼𝐼 curve shifts to the left in the graph (𝐼𝐼𝐼𝐼2 ). Economists Jack
and Jill are asked which monetary policy rule − the one assumed in the 'stand-
ard' version of the IS-LM model, in which the central bank chooses a value for
the interest rate, or the alternative one, in which the central bank chooses the
nominal money supply − would, in their opinion, help minimize the variability
of output around its initial level, 𝑌𝑌0 , caused by such demand fluctuations. Jack
thinks that the best option is for the central bank to choose the interest rate,
and keep it at the chosen value; on the contrary, Jill suggests that the central
bank should choose a level for the money supply, and then let the interest rate
to take on any value that, given this choice of 𝑀𝑀, is consistent with the macroe-
conomic equilibrium.
a. In the pair of graphs ‘open economy IS-LM - interest parity condition’ be-
low, show the equilibrium levels of output that, under flexible exchange
rates, will prevail when the central bank chooses the interest rate and, fol-
lowing the fluctuations in demand just discussed, the IS curve shifts to the
right (𝐼𝐼𝐼𝐼1 ) or to the left (𝐼𝐼𝐼𝐼2 ). In the figure, make sure to denote the cor-
responding equilibrium levels of output by 𝑌𝑌1 and 𝑌𝑌2 , respectively.
𝐼𝐼𝐼𝐼1
𝑖𝑖 𝐼𝐼𝐼𝐼0 𝑖𝑖
𝐿𝐿𝐿𝐿0𝑀𝑀
𝐼𝐼𝐼𝐼2
𝑖𝑖1
0 𝐿𝐿𝐿𝐿0𝑖𝑖 0’
𝚤𝚤̅0
𝑖𝑖2
400
The open economy
In this case, the LM curve (𝐿𝐿𝐿𝐿0𝑖𝑖 in the graph) is, as usual, horizontal at the
level of the interest rate chosen by the central bank (denoted by 𝚤𝚤̅0). The equi-
librium levels of output 𝑌𝑌1 and 𝑌𝑌2 prevailing as autonomous demand fluctuates
are shown in the figure. In the case of a positive (adverse) demand shock –
that is, IS curve that shifts to the right (left) – the central bank makes sure
that the interest rate remains at 𝚤𝚤̅0 by raising (lowering) the nominal money
supply. And, since the domestic interest rate does not change, the exchange
rate will remain constant, too.
b. In the same graph, denote by 𝑌𝑌1′ and 𝑌𝑌2′ the equilibrium levels of produc-
tion that, following the same changes in the autonomous components of
aggregate demand and the same shifts in the 𝐼𝐼𝐼𝐼 curve discussed before,
would prevail should the central bank choose the nominal money supply.
On the basis of your answers to this and to the previous point, do you
agree with Jack or with Jill? Provide the intuition for the lower output var-
iability in the central banks behaves in the way suggested by the economist
whose view you share.
The equilibrium levels of output 𝑌𝑌1′ and 𝑌𝑌2′ prevailing when the central bank
chooses the money supply are shown in the figure. In the case of a positive
(adverse) demand shock, the rise (fall) in the demand for goods and in equi-
librium income will increase (decrease) the demand for money. Being money
supply constant at the level chosen by the central bank, the change in money
demand will lead to a higher (lower) interest rate. In turn, this change in the
interest rate will mitigate the impact on equilibrium output of the changes in
autonomous demand both directly, through its effect on investment, and indi-
rectly, by affecting the exchange rate. For instance, following a positive de-
mand shock, both 𝑖𝑖 and 𝐸𝐸 will go up; this leads to an increase in output small-
er than the one that would prevail in the case studied in the previous point of
this question, where the central bank was keeping constant the interest rate,
•
rather than the money supply. Jill is right.
401
Macroeconomics. Problems and Questions
Question 23
a. We are at time 𝑡𝑡. Use the non-approximated form of the interest parity
condition to write the current period exchange rate, 𝐸𝐸𝑡𝑡 , as a function of the
current and future expected interest rates for each year over the next 𝑛𝑛
𝑒𝑒
years, as well as of the expected exchange rate for time 𝑡𝑡 + 𝑛𝑛 + 1, 𝐸𝐸𝑡𝑡+𝑛𝑛+1 .
402
The open economy
b.1 Abroad, the interest rate will be lower from time 𝑡𝑡 + 2 onwards. From
equation (∗∗∗∗) it follows that 𝐸𝐸𝑡𝑡 will rise – the domestic currency will
appreciate.
𝑖𝑖 𝑖𝑖
b.2 The policy-mix will lead
𝐿𝐿𝐿𝐿0 to an increase in the domestic interest rate from
time 𝑡𝑡 + 1 onwards, 𝐿𝐿𝐿𝐿2
0 thus appreciating the current exchange 0
rate.
b.3 Persistent and 1 widening current account deficits are not 1 sustainable indef-
initely, as they imply 2
2 that the country keeps borrowing from abroad, thus
increasing its foreign debt. It is therefore reasonable to assume that indi-
𝐼𝐼𝐼𝐼0
viduals will start expecting that, sooner or later, the exchange rate will
𝐼𝐼𝐼𝐼2
fall − that is, that eventually
𝐼𝐼𝐼𝐼 a depreciation will be needed to restore the
price -competitiveness of1 domestic goods and bring the dynamics of the
current account 𝑌𝑌�0 control.
𝑌𝑌�1 under 𝐸𝐸1 of𝐸𝐸the
𝑌𝑌 This decrease in the level 0 𝐸𝐸
exchange
𝑒𝑒
rate that financial investors expect to prevail in the long-run, 𝐸𝐸𝑡𝑡+𝑛𝑛+1 ,
leads to an immediate depreciation of the currency, as clear from equation
(∗∗∗∗) above.
403
Chapter 6 - Government debt and economic growth
Macroeconomics. Problems and Questions
* Question 1
[A graphical analysis of the evolution of the debt-to-GDP ratio]
Write down the government budget constraint as an equation that, for given
values of the real interest rate (𝑟𝑟), of the growth rate of the economy (𝑔𝑔) and
of the primary deficit-to-GDP ratio (𝑑𝑑), relates the debt-to-GDP ratio (𝐵𝐵⁄𝑌𝑌)
at time 𝑡𝑡 to the value of the same ratio at time 𝑡𝑡 − 1. Use that equation to
graphically analyze the evolution of the ratio 𝐵𝐵⁄𝑌𝑌 in the following four cases,
providing the intuition underlying your conclusions:
𝐵𝐵𝑡𝑡
45° debt/GDP line
𝑌𝑌𝑡𝑡
𝑏𝑏�
𝑏𝑏2
𝑏𝑏1
𝑑𝑑
The debt-to-GDP ratio evolves over time as implied by the following equation:
...........................................................................................................................
𝐵𝐵𝑡𝑡 𝐵𝐵𝑡𝑡−1 𝐵𝐵𝑡𝑡−1 𝐺𝐺𝑡𝑡 − 𝑇𝑇𝑡𝑡
− = (𝑟𝑟 − 𝑔𝑔) + , (∗)
...........................................................................................................................
𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡−1 𝑌𝑌𝑡𝑡−1 𝑌𝑌𝑡𝑡
...........................................................................................................................
or, defining 𝑏𝑏 ≡ 𝐵𝐵⁄𝑌𝑌, solving for 𝑏𝑏𝑡𝑡 and assuming that the primary deficit-to-
GDP ratio remains constant over time, so that (𝐺𝐺𝑡𝑡 − 𝑇𝑇𝑡𝑡 )⁄𝑌𝑌𝑡𝑡 ≡ 𝑑𝑑 ∀𝑡𝑡,
...........................................................................................................................
𝑏𝑏𝑡𝑡 = (1 + 𝑟𝑟 − 𝑔𝑔)𝑏𝑏𝑡𝑡−1 + 𝑑𝑑. (∗∗)
...........................................................................................................................
In the (𝑏𝑏𝑡𝑡−1 , 𝑏𝑏𝑡𝑡 ) plane, (∗∗) is the equation of a straight line with vertical in-
...........................................................................................................................
tercept equal to 𝑑𝑑 and slope (1 + 𝑟𝑟 − 𝑔𝑔). Being 𝑑𝑑 > 0, this line – the
...........................................................................................................................
"debt/GDP line" in the figure – crosses the vertical axis for the positive value
...........................................................................................................................
that, by assumption, the primary deficit-to-GDP ratio takes on in the econo-
my under consideration.
406
Government debt and economic growth
...........................................................................................................................
Furthermore, its slope is positive, but smaller than one (for realistic values of
𝑟𝑟 and 𝑔𝑔, the term 1 + 𝑟𝑟 − 𝑔𝑔 is, as we shall always assume, greater than zero
...........................................................................................................................
even when 𝑟𝑟 < 𝑔𝑔), and will therefore cross the straight, 45° line going through
...........................................................................................................................
the origin drawn in the figure for a positive value, let's call it 𝑏𝑏�, of the debt-to-
GDP ratio.
...........................................................................................................................
To understand how the figure we have just drawn helps determine the dynam-
...........................................................................................................................
ics of the debt-to-GDP ratio starting from any value of the same ratio inherit-
...........................................................................................................................
ed from the past, let us suppose that we are at time 𝑡𝑡 = 1 and that, at time ze-
ro, the debt-to GDP ratio was 𝑏𝑏0 . One uses the debt/GDP line to read, on the
vertical axis, the implied value for the debt ratio that will prevail today, 𝑏𝑏1 . At
𝑡𝑡 = 2, the value of 𝑏𝑏1 so determined becomes the debt ratio inherited from the
previous period, and can be used to determine 𝑏𝑏2 in the very same way we used
𝑏𝑏0 to determine 𝑏𝑏1 . In particular, using the 45° line we can transfer 𝑏𝑏1 from
the vertical to the horizontal axis, and then use the debt/GDP line to read, on
the vertical axis, the implied value for 𝑏𝑏2 . Proceeding in a similar fashion time
after time, one can determine the whole sequence of the values that 𝑏𝑏 will take
on from today onwards.
As clear from the figure, in the case under consideration the debt-to-GDP ra-
tio increases over time, but at a decreasing rate, and ends up converging to the
constant value 𝑏𝑏�. When 𝑏𝑏 takes on this latter value, corresponding to the in-
tersection between the debt/GDP line and the 45° line, today's 𝑏𝑏 is the same as
yesterday's, and the debt ratio will remain constant at this common vaue over
time. Because of this, 𝑏𝑏� is referred to as the steady state value of the debt-to-
GDP ratio. Analytically, its expression can be derived by setting 𝑏𝑏𝑡𝑡 = 𝑏𝑏𝑡𝑡−1 =
𝑏𝑏� in equation (∗) or equation (∗∗), and solving, to get:
𝑑𝑑
𝑏𝑏� = .
𝑔𝑔 − 𝑟𝑟
To understand why, in this economy, 𝑏𝑏 converges to a constant value, remem-
ber that the budget constraint of the government implies that, were the prima-
ry budget balanced, the stock of debt would grow at the rate 𝑟𝑟. Since income
𝑌𝑌 grows at the rate 𝑔𝑔, and given that in this economy 𝑟𝑟 < 𝑔𝑔 by assumption, if
the primary budget were balanced the debt ratio 𝐵𝐵/𝑌𝑌 would converge to zero.
However, by assumption 𝑑𝑑 is not equal to zero, but positive; it follows that 𝑏𝑏
will not converge to zero, but to that positive value such that the increase in
the debt ratio due to the fact that 𝑑𝑑, the second term on the right-hand side of
equation (∗), is positive is exactly offset by the decrease in the debt ratio due
to the first term (remember that 𝑟𝑟 < 𝑔𝑔).
407
Macroeconomics. Problems and Questions
𝑏𝑏2
𝑏𝑏1
𝑑𝑑
𝑏𝑏�
𝑏𝑏0 𝑏𝑏1 𝑏𝑏2 𝐵𝐵𝑡𝑡−1
𝑌𝑌𝑡𝑡−1
...........................................................................................................................
In this economy, the fact that 𝑟𝑟 exceeds 𝑔𝑔 tends to raise the debt ratio over
...........................................................................................................................
time, while the primary surplus (𝑑𝑑 < 0) tends to lower it. As clear from equa-
tion (∗), which of the two, opposing forces will prevail depends on the value of
the ratio 𝐵𝐵𝑡𝑡−1 ⁄𝑌𝑌𝑡𝑡−1 inherited from the past. As shown in the next figure, if
this ratio is high, greater than the steady state value of the debt ratio, 𝑏𝑏 will
keep rising over time, while it will keep shrinking over time if its initial level,
𝑏𝑏0 , is ‘small’, less than the steady state value 𝑏𝑏�.
408
Government debt and economic growth
debt/GDP line
𝐵𝐵𝑡𝑡 45°
𝑌𝑌𝑡𝑡
𝐵𝐵𝑡𝑡−1
𝑏𝑏0′ 𝑏𝑏� 𝑏𝑏0
𝑌𝑌𝑡𝑡−1
𝑑𝑑
In this final case, 𝑏𝑏 converges to a negative steady state value [to check your
understanding of the analysis carried out in this question, use equation (∗) to
explain why] – in the steady state, the government will be a creditor. This, of
course, provided that it will keep running primary surpluses, and will not
transform – maybe well before 𝑏𝑏 has turned negative – those surpluses into
deficits, eventually putting an end to the tendency of the debt ratio to fall over
time.
𝐵𝐵𝑡𝑡 45°
𝑌𝑌𝑡𝑡
debt/GDP line
𝑏𝑏�
𝑏𝑏0 𝐵𝐵𝑡𝑡−1
𝑑𝑑
𝑌𝑌𝑡𝑡−1
409
Macroeconomics. Problems and Questions
Question 2
The equation that allows us to analyze the change of the debt ratio over time
is:
𝐵𝐵𝑡𝑡 𝐵𝐵𝑡𝑡−1 𝐵𝐵𝑡𝑡−1 𝐺𝐺𝑡𝑡 − 𝑇𝑇𝑡𝑡
− = (𝑟𝑟 − 𝑔𝑔) + ,
𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡−1 𝑌𝑌𝑡𝑡−1 𝑌𝑌𝑡𝑡
which, defining 𝑏𝑏 ≡ 𝐵𝐵⁄𝑌𝑌, can be equivalently written as:
𝑏𝑏𝑡𝑡 = (1 + 𝑟𝑟 − 𝑔𝑔)𝑏𝑏𝑡𝑡−1 + 𝑑𝑑,
where (𝐺𝐺𝑡𝑡 − 𝑇𝑇𝑡𝑡 )⁄𝑌𝑌𝑡𝑡 (≡ 𝑑𝑑) is the ratio of the primary deficit to GDP. Using in
the latter equation the quantitative information we have been provided with, it
is straightforward to compute 𝑏𝑏1 = 1.02, 𝑏𝑏2 = 1.0396 e 𝑏𝑏� = 2.
The debt ratio clearly converges over time to its steady state value. Indeed,
since in this economy 𝑟𝑟 < 𝑔𝑔, the debt ratio would decrease over time towards
zero, were 𝑑𝑑 = 0. Given that, however, 𝑑𝑑 is positive (the government is run-
ning a primary deficit), 𝑏𝑏 increases, but at a decreasing rate, tending over
time to its steady state level (𝑏𝑏� = 2).
410
Government debt and economic growth
b. Suppose now that the government intends to stabilize 𝑏𝑏 at the value ob-
served at 𝑡𝑡 = 0. In other words, the government wants 𝑏𝑏 to continue to
take on the value 1 both in period 𝑡𝑡 = 1 and in all subsequent periods. To
achieve this goal, the Government is considering the possibility of generat-
ing a permanent change in the ratio of the primary deficit to GDP. Com-
pute the value that this ratio should take on to stabilize 𝑏𝑏 at the value 1
forever, and explain whether it implies that the Government should im-
plement a restrictive or an expansionary fiscal policy.
411
Macroeconomics. Problems and Questions
Question 3
At time 𝑡𝑡, a country inherits from the previous period a stock of government
0
debt greater than zero, corresponding to the debt-to-GDP ratio 𝑏𝑏𝑡𝑡−1 in the
graph below. Assuming that the real interest rate is smaller than the rate of
growth of the economy, and that the government runs a primary surplus,
a. show in the graph the steady state debt-to-GDP ratio in this economy and
explain if, absent any intervention, the debt-to-GDP ratio of the country
will converge or not to this stationary level;
𝐵𝐵𝑡𝑡
𝑌𝑌𝑡𝑡
debt/GDP line
𝑑𝑑′
𝑏𝑏� 0
𝐵𝐵𝑡𝑡−1
𝑑𝑑 𝑏𝑏𝑡𝑡−1
𝑌𝑌𝑡𝑡−1
The steady state debt-to-GDP ratio, 𝑏𝑏� < 0 in the graph, is that value of 𝐵𝐵⁄𝑌𝑌
for which the debt/GDP line (the continuous, bold line in the figure) crosses
the 45° line going through the origin. The debt-to-GDP ratio will converge to
that steady state following the arrowed path in the graph.
412
Government debt and economic growth
b. show in the graph the change in the ratio between the primary balance
0
and GDP needed to stabilize the debt-to-GDP ratio at the value 𝑏𝑏𝑡𝑡−1
from time 𝑡𝑡 onwards. Explain.
0
To stabilize the debt-to-GDP ratio at the level 𝑏𝑏𝑡𝑡−1 , at time 𝑡𝑡 the government
will have to run a primary deficit. As a ratio to GDP, the primary balance
will have to go from the value 𝑑𝑑 < 0 (primary surplus) in the graph to a level
𝑑𝑑′ > 0 (primary deficit) such that the new debt/GDP line (the bold, dashed
line in the figure) crosses the 45° line exactly for a debt-to-GDP ratio equal
0
to 𝑏𝑏𝑡𝑡−1 .
413
Macroeconomics. Problems and Questions
Question 4
414
Government debt and economic growth
0
b. Assuming that the debt-to-GDP ratio at time 𝑡𝑡 − 1 was 𝑏𝑏𝑡𝑡−1 , show in the
graph the values that this ratio will take on at times 𝑡𝑡 and 𝑡𝑡 + 1. Will the
debt-to-GDP ratio converge to a steady state value 𝑏𝑏�? If not, why? If yes,
show in the figure this steady state value and explain whether it is stable
(that is, if 𝑏𝑏 will converge to it independently of the value of the debt-to-
0
GDP ratio inherited from the past, 𝑏𝑏𝑡𝑡−1 ) or unstable (in which case, 𝑏𝑏 will
0
take on the steady state value if and only if 𝑏𝑏𝑡𝑡−1 = 𝑏𝑏�).
...........................................................................................................................
Since in this economy 𝑟𝑟 = 𝑔𝑔, the dynamics of debt/GDP ratio is given by the
...........................................................................................................................
equation:
...........................................................................................................................
𝐵𝐵𝑡𝑡 ⁄𝑌𝑌𝑡𝑡 − 𝐵𝐵𝑡𝑡−1⁄𝑌𝑌𝑡𝑡−1 = 𝑑𝑑.
...........................................................................................................................
Being 𝑑𝑑 > 0, absent any policy intervention the debt/GDP ratio will keep ris-
...........................................................................................................................
ing over time, and therefore will not converge to a stationary value (in the
economy under consideration, a steady state value of the debt/GDP ratio does
...........................................................................................................................
not exist).
..............................................................................................................
415
Macroeconomics. Problems and Questions
Question 5
𝐵𝐵𝑡𝑡
𝑌𝑌𝑡𝑡 45°
0.03
...........................................................................................................................
The dynamics of the debt ratio in this economy is the one implied by the equa-
...........................................................................................................................
tion 𝑏𝑏𝑡𝑡 = (1 + 𝑟𝑟 − 𝑔𝑔)𝑏𝑏𝑡𝑡−1 + 𝑑𝑑, where 𝑏𝑏 ≡ 𝐵𝐵⁄𝑌𝑌, and 𝑑𝑑 is the ratio of the pri-
mary deficit to GDP. Given the numerical values that 𝑟𝑟, 𝑔𝑔, 𝑑𝑑 and 𝑏𝑏0 take on
...........................................................................................................................
in this case, it is easy to compute 𝑏𝑏1 = 0.666, 𝑏𝑏2 = 0.736. The debt ratio
...........................................................................................................................
does not converge to a steady state. Since 𝑟𝑟 > 𝑔𝑔 and 𝑑𝑑 > 0, in the graph the
. debt/GDP line does not intersects the 45-degree line in the first quadrant [its
slope is 1.06 (> 1) ]. Being 𝑏𝑏0 positive, 𝑏𝑏 tends to +∞.
416
Government debt and economic growth
b. Suppose now that, rather than a deficit, the same country runs a primary
surplus of 6% of GDP. How would your answer to the previous point of
this question change? Compute the debt ratio at times 𝑡𝑡 = 1 and 𝑡𝑡 = 2,
and its steady state value, 𝑏𝑏�. Will the debt ratio converge to 𝑏𝑏�? Explain, us-
ing the graph below to motivate your conclusions.
𝐵𝐵𝑡𝑡
45°
𝑌𝑌𝑡𝑡
...........................................................................................................................
If 𝑑𝑑 = −0.06, following the same steps described above one can compute 𝑏𝑏1 =
...........................................................................................................................
0.576, 𝑏𝑏2 = 0.551.
The steady state debt ratio is in this case:
...........................................................................................................................
−𝑑𝑑 0.06
𝑏𝑏� =
...........................................................................................................................
= = 1.
(𝑟𝑟 − 𝑔𝑔) 0.06
...........................................................................................................................
This steady state value will never be reached: 𝑏𝑏 tends to decrease over time,
...........................................................................................................................
since 𝑏𝑏0 < 1 and the slope of the debt/GDP line is still 1.06 (> 1). Notice
that, in this economy, the fact that 𝑟𝑟 > 𝑔𝑔 tends, other things the same, to raise
...........................................................................................................................
𝑏𝑏 over time; on the other hand, the primary surplus tends to lower it. Given
...........................................................................................................................
the magnitude of the primary surplus, in this example the second of the two
forces just mentioned prevails, and 𝑏𝑏 ends up decreasing over time.
...........................................................................................................................
417
Macroeconomics. Problems and Questions
Question 6
We are at time 𝑡𝑡. The economy inherits from the previous period a debt-to-
0
GDP ratio 𝑏𝑏𝑡𝑡−1 . Consider the following graph:
45°
𝐵𝐵𝑡𝑡
New debt/GDP
𝑌𝑌𝑡𝑡
line
Debt/GDP
line
𝑏𝑏� 0
𝑏𝑏𝑡𝑡−1 𝐵𝐵𝑡𝑡−1
𝑌𝑌𝑡𝑡−1
a. In this economy, is the GDP growth rate higher or lower than the real in-
terest rate? Is the government running a primary surplus or a primary def-
icit? Finally, is the debt ratio 𝑏𝑏� a stable or an unstable steady state? Ex-
plain.
The vertical intercept of the debt/GDP line is equal to the primary deficit-to-
GDP ratio. Since, in this economy, that intercept is greater than zero, the
government is running a primary deficit. Furthermore, being the debt/GDP
line flatter than the 45° one going through the origin, 𝑟𝑟 < 𝑔𝑔 (recall that the
slope of the debt/GDP line is 1 + 𝑟𝑟 − 𝑔𝑔, and that this slope is less than one in
this case). It is straightforward to verify that the steady state 𝑏𝑏� is stable – the
debt-to-GDP ratio will always converge to 𝑏𝑏�, independently of the value of the
same ratio inherited from the past.
...........................................................................................................................
418
Government debt and economic growth
Finally, the steady state �𝑏𝑏 is unstable. As one can see from the graph, given
any initial value of the debt ratio different from �𝑏𝑏 , the economy will feature a
𝐵𝐵/𝑌𝑌 tending to +∞ if the initial value of the ratio is greater than the steady
state one, or to −∞ in the opposite case.
b. Suppose now that, at time 𝑡𝑡, the Government intends to stabilize the debt-
0
to-GDP ratio at the level 𝑏𝑏𝑡𝑡−1 by changing the economy’s growth rate.
To achieve its aim, should it attempt to increase or to decrease that
growth rate? Show how your answer is going to affect the graph used to
answer the previous question, and discuss.
0
Absent policy interventions, and starting from 𝑏𝑏𝑡𝑡−1 , the debt-to-GDP ratio
for this economy would converge to the steady state 𝑏𝑏�. To keep it at 𝑏𝑏𝑡𝑡−1
0
by
changing the economy’s growth rate, the government should lower 𝑔𝑔, so as to
0
lead to a new, steeper debt/GDP line crossing the 45° one for 𝑏𝑏𝑡𝑡−1 , thus mak-
ing this latter the new steady state value of the debt-to-GDP ratio. Notice
that the debt/GDP line will rotate around an unchanged vertical intercept,
since the primary deficit-to-GDP ratio has remained constant.
419
Macroeconomics. Problems and Questions
* Question 7
a. Consider a country with a zero primary deficit-to-GDP ratio (𝑑𝑑 = 0), and
in which the real interest rate and the rate of growth of the economy are
constant and equal to 𝑟𝑟 = 𝑟𝑟̅ and 𝑔𝑔 = 𝑔𝑔̅ , respectively, with 𝑟𝑟̅ < 𝑔𝑔̅ and 1 +
𝑟𝑟̅ − 𝑔𝑔̅ > 0. Write down the equation that gives the dynamics of the debt-to-
GDP ratio for this economy (the government budget constraint) and de-
rive the steady state value of that ratio. Assuming that at time 𝑡𝑡 the econ-
0
omy inherits from the past a debt-to-GDP ratio equal to 𝑏𝑏𝑡𝑡−1 > 0, explain
if, and why, the economy will ever converge to that steady state. Use the
graph below to motivate your answer.
𝐵𝐵𝑡𝑡 45°
𝑌𝑌𝑡𝑡 debt/GDP line
0
0 𝐵𝐵𝑡𝑡−1
𝑏𝑏𝑡𝑡−1
𝑌𝑌𝑡𝑡−1
.
Being 𝑑𝑑 = 0, the dynamics of the debt-to-GDP ratio is given by the equation
the bold line in the figure above. As clear from the graph, in this economy
there is just one steady state debt-to-GDP ratio, 𝑏𝑏� = 0. Since, by assump-
tion, 𝑟𝑟̅ < 𝑔𝑔̅ , the economy will converge to this value of 𝑏𝑏 starting from any
state debt-to-GDP ratio inherited from the past.
420
Government debt and economic growth
b. Suppose now that the interest rate at which the government can borrow is
no longer equal to 𝑟𝑟̅ , but rather to 𝑟𝑟̅ + 𝑣𝑣𝑏𝑏𝑡𝑡−1 , where 𝑣𝑣 is a positive parame-
ter. In other words, the real interest rate is no longer constant, but increas-
ing in the debt-to-GDP ratio (𝑏𝑏) prevailing in the last period. The growth
rate of the economy is however stiIl constant and, as before, 𝑟𝑟̅ < 𝑔𝑔̅ and 1 +
𝑟𝑟̅ − 𝑔𝑔̅ > 0. Repeat the analysis carried out in order to answer the previous
point of this question. In particular, derive the expression of the steady
state debt-to-GDP ratio, explain if and why 𝑏𝑏 will converge to a steady
state, and represent graphically.
debt/GDP
line
45°
𝐵𝐵𝑡𝑡
𝑌𝑌𝑡𝑡
0
0
𝑏𝑏𝑡𝑡−1 𝑏𝑏� 𝑏𝑏𝑡𝑡−1
00 𝐵𝐵𝑡𝑡−1
𝑌𝑌𝑡𝑡−1
Since now 𝑟𝑟 = 𝑟𝑟̅ + 𝑣𝑣𝑏𝑏𝑡𝑡−1 , the evolution of the debt-to-GDP ratio over time is
given by the equation
𝑏𝑏𝑡𝑡 = (1 + 𝑟𝑟̅ + 𝑣𝑣𝑏𝑏𝑡𝑡−1 − 𝑔𝑔̅ )𝑏𝑏𝑡𝑡−1
2
= (1 + 𝑟𝑟̅ − 𝑔𝑔̅ )𝑏𝑏𝑡𝑡−1 + 𝑣𝑣𝑏𝑏𝑡𝑡−1 ,
the bold curve in the figure. As usual, to find the steady state values of the
debt-to-GDP ratio one has to set 𝑏𝑏𝑡𝑡 = 𝑏𝑏𝑡𝑡−1 in the equation above, and then
solve. There are now two steady state values of 𝑏𝑏 (two intersections between
the parabola and the 45° line): zero, as before, and the new steady state 𝑏𝑏� =
(𝑔𝑔̅ − 𝑟𝑟̅ )⁄𝑣𝑣 (a positive quantity, given the hypotheses on the values the pa-
rameters take on in this economy). If the initial debt-to-GDP ratio happens to
be less than 𝑏𝑏�, as before there will be convergence to the steady state 𝑏𝑏� = 0.
But if the initial debt-to-GDP ratio is greater than 𝑏𝑏�, then 𝑏𝑏 will tend to +∞.
In fact, 𝑟𝑟 = 𝑟𝑟̅ + 𝑣𝑣𝑏𝑏𝑡𝑡−1 and 𝑏𝑏𝑡𝑡−1 > 𝑏𝑏� = (𝑔𝑔̅ − 𝑟𝑟̅ )⁄𝑣𝑣 imply 𝑟𝑟 > 𝑔𝑔 and therefore,
with a zero primary deficit, an unsustainable dynamics of the debt-to-GDP
ratio.
421
Macroeconomics. Problems and Questions
Question 8
𝛿𝛿 · (𝐾𝐾𝑡𝑡 ⁄𝑁𝑁)
(𝑌𝑌⁄𝑁𝑁)∗′ 𝑓𝑓(𝐾𝐾𝑡𝑡 ⁄𝑁𝑁)
(𝑌𝑌⁄𝑁𝑁)∗ ′
𝑠𝑠 · 𝑓𝑓(𝐾𝐾𝑡𝑡 ⁄𝑁𝑁)
𝐸𝐸 ′ 𝑠𝑠 · 𝑓𝑓(𝐾𝐾𝑡𝑡 ⁄𝑁𝑁)
𝐸𝐸
When the steady state level of capital per worker is 100, steady state output
per worker is:
3�
𝑌𝑌 ∗ 𝐾𝐾 ∗ 4
3�
� � = �� � � = 100 4.
𝑁𝑁 𝑁𝑁
In steady state, a situation in which capital and output per worker are con-
stant, saving and investment per worker (recall that, in a closed economy
goods market equilibrium, saving equals investment) are just enough to cover
depreciation, and capital and output per worker are constant.
422
Government debt and economic growth
...........................................................................................................................
It follows that, in steady state:
...........................................................................................................................
𝑌𝑌 𝐾𝐾
...........................................................................................................................
𝑠𝑠 = 𝛿𝛿 ,
𝑁𝑁 𝑁𝑁
...........................................................................................................................
a condition that, in the economy we are studying, can be written as:
...........................................................................................................................
3
𝑠𝑠 · 100 �4 = 0.1 · 100.
Solving, 𝑠𝑠 ≌ 0.32.
b. Assuming that the economy is initially in the steady state just described,
explain and represent graphically what happens to capital per worker,
output per worker and the growth rate of the economy following a reduc-
tion in the marginal propensity to consume.
423
Macroeconomics. Problems and Questions
Question 9
𝛿𝛿 · (𝐾𝐾𝑡𝑡 ⁄𝑁𝑁)
(𝑌𝑌⁄𝑁𝑁 )∗ 𝑓𝑓(𝐾𝐾𝑡𝑡 ⁄𝑁𝑁)
𝑠𝑠 · 𝑓𝑓(𝐾𝐾𝑡𝑡 ⁄𝑁𝑁)
𝐸𝐸
(𝐾𝐾/𝑁𝑁)∗ 𝐾𝐾 ⁄𝑁𝑁
= 200
...........................................................................................................................
...........................................................................................................................
In steady state, output and capital per worker are constant, and investment
per worker is equal to the depreciation per worker − that is, the following
...........................................................................................................................
condition holds:
...........................................................................................................................
𝐾𝐾 𝐾𝐾
𝑠𝑠 · 𝑓𝑓 � � = 𝛿𝛿 ,
...........................................................................................................................
𝑁𝑁 𝑁𝑁
1
...........................................................................................................................
where 𝑓𝑓(𝐾𝐾 ⁄𝑁𝑁) = 𝑌𝑌⁄𝑁𝑁 = (𝐾𝐾 ⁄𝑁𝑁) �2 .
By substituting the values the parameters take on in this economy, and impos-
...........................................................................................................................
1
ing 𝐾𝐾 ⁄𝑁𝑁 = 200, one gets 𝑠𝑠 · 200 �2 = 0.05 · 200. Solving for 𝑠𝑠, the value of
...........................................................................................................................
the saving rate we are looking for is 𝑠𝑠 ∗ ≌ 0.71.
.
424
Government debt and economic growth
b. Assuming that the economy is initially in the steady state just described,
explain, and show in the graph, what happens to capital per worker, out-
put per worker and the growth rate of the economy following an increase
in the rate of depreciation, 𝛿𝛿.
𝛿𝛿 ′ · (𝐾𝐾𝑡𝑡 ⁄𝑁𝑁)
𝛿𝛿 · (𝐾𝐾𝑡𝑡 ⁄𝑁𝑁)
(𝑌𝑌⁄𝑁𝑁)∗ 𝑓𝑓(𝐾𝐾𝑡𝑡 ⁄𝑁𝑁)
(𝑌𝑌⁄𝑁𝑁)∗′ 𝑠𝑠 · 𝑓𝑓(𝐾𝐾𝑡𝑡 ⁄𝑁𝑁)
𝐸𝐸
𝐸𝐸 ′
Following the increase in δ, the line representing depreciation per worker be-
comes steeper. At point E, the initial steady state, investment per worker is
now smaller than depreciation per worker, and capital per worker starts to
fall. This process continues until the economy reaches the new steady state E’,
where both capital per worker and output per worker are once again constant
(i.e., the growth rate of the economy is zero), but at a level lower than before.
425
Macroeconomics. Problems and Questions
Question 10
a. Assuming that there is no technological progress and that both the private
saving rate and the population of the country are constant, show in the
graph below the impact of the emergence of a budget deficit (that is, of the
increase in 𝜌𝜌 from zero to a positive value) on output per worker and capi-
tal per worker in the Solow growth model. Explain.
𝛿𝛿 · (𝐾𝐾𝑡𝑡 ⁄𝑁𝑁)
(𝑌𝑌⁄𝑁𝑁 )∗ 𝑓𝑓(𝐾𝐾𝑡𝑡 ⁄𝑁𝑁)
(𝑌𝑌⁄𝑁𝑁)∗′ 𝑠𝑠 · 𝑓𝑓(𝐾𝐾𝑡𝑡 ⁄𝑁𝑁)
𝐸𝐸 (𝑠𝑠 − 𝜌𝜌) · 𝑓𝑓(𝐾𝐾𝑡𝑡 ⁄𝑁𝑁)
𝐸𝐸 ′
With a government that needs not to balance its budget, but that can now run
surpluses or deficits, national saving is, in this economy, the following func-
.................................................................................................................
tion of output:
.................................................................................................................
𝑆𝑆𝑡𝑡 = 𝑠𝑠𝑌𝑌𝑡𝑡 − 𝜌𝜌𝑌𝑌𝑡𝑡 ,
where 𝑠𝑠𝑌𝑌𝑡𝑡 is private saving, and (−𝜌𝜌𝑌𝑌𝑡𝑡 ) public (government) saving.
..................
426
Government debt and economic growth
.................................................................................................................
Since, as always, 𝐼𝐼𝑡𝑡 = 𝐾𝐾𝑡𝑡+1 − 𝐾𝐾𝑡𝑡 + 𝛿𝛿𝐾𝐾𝑡𝑡 , by substituting in the goods market
equilibrium condition (𝑆𝑆𝑡𝑡 = 𝐼𝐼𝑡𝑡 ) the expressions for 𝑆𝑆 and 𝐼𝐼 written above, di-
.........
viding by the number of workers 𝑁𝑁, and finally rearranging terms, one gets:
.................................................................................................................
𝐾𝐾𝑡𝑡+1 𝐾𝐾𝑡𝑡 𝐾𝐾𝑡𝑡 𝐾𝐾𝑡𝑡
− = (𝑠𝑠 − 𝜌𝜌)𝑓𝑓 � � − 𝛿𝛿 , (∗)
𝑁𝑁 𝑁𝑁 𝑁𝑁 𝑁𝑁
.................................................................................................................
where 𝑓𝑓(𝐾𝐾 ⁄𝑁𝑁) = 𝑌𝑌 ⁄ 𝑁𝑁.
𝑡𝑡 𝑡𝑡
.................................................................................................................
The first and the second term on the right-hand side of the equilibrium condi-
tion (∗) are drawn in the graph above.
...........................
Initially, 𝜌𝜌 = 0 (the government budget is balanced) and the economy is in
.................................................................................................................
the steady state equilibrium E, with capital per worker (𝐾𝐾 ⁄𝑁𝑁)∗ and output per
worker (𝑌𝑌⁄𝑁𝑁)∗ . When 𝜌𝜌 rises from zero to a positive value, the effect on the
.................................................................................................................
economy is similar to that of a fall in the private saving rate, 𝑠𝑠: capital and
.................................................................................................................
output per worker start to decrease, and the economy converges over time to a
new steady state (point E’ in the graph) where both capital and output per
.................................................................................................................
worker are permanently lower.
b. Will the budget deficit permanently affect the growth rate of the econo-
my? Explain.
The fact that now the government runs a budget deficit leads to a permanent
decrease in the saving rate of the economy. We know that, in the Solow model:
..........................................................................................................................
1) a change in the saving rate changes, temporarily and in the same direction,
...........................................................................................................................
the growth rate of the economy;
...........................................................................................................................
2) however, the change in the saving rate does not affect the growth rate of
output per worker in the long run; given the assumptions made about the
...........................................................................................................................
economy, this growth rate will always be zero in the steady state, no matter
...........................................................................................................................
what the saving rate is (and therefore, no matter whether the government is
running a budget deficit, a surplus, or has a balanced budget).
...........................................................................................................................
We therefore conclude that the deficit does not change the rate at which this
...........................................................................................................................
economy will grow in the long run − this growth rate will remain equal to ze-
..........................................................................................................................
ro. However, as discussed before, the budget deficit causes the economy to
converge to a new steady state where the levels of capital per worker and out-
..........................................................................................................................
put per worker will be permanently lower.
427
Macroeconomics. Problems and Questions
Question 11
True or False?
Explain whether the following statements are true or false. Motivate your answer
in a brief but rigorous way, by making explicit reference to the relevant theory.
Lack of proper explanations will result in zero points.
The statement is false. As it can be verified for instance by using the graph
employed in the Solow model to analyse the evolution of capital per capita ad
income per capita over time, an increase in the saving rate always leads to an
increase in the steady state levels of capital and output per capita. [To first
increase and then decrease as the saving rate increases from 0 to 1 is the
steady state level of consumption, and not capital or output per capita].
428
Government debt and economic growth
b.1 an increase in the saving rate 𝑠𝑠 will always raise steady state output
per worker;
b.2 an increase in the saving rate 𝑠𝑠 will always raise steady state con-
sumption per worker.
b.1 True. An increase in the saving rate leads to a higher investment per
worker, and thus to an increase in capital per worker ̶ at least for a
while, that is, during the transition to the new steady state. Since output
per worker is an increasing function of capital per worker, an increase in
𝑠𝑠 will lead to a steady state in which both capital and output per worker
are permanently higher.
b.2 False. An increase in the saving rate will increase consumption per work-
er only if, in the initial steady state, capital per worker was less than the
golden rule level (the ratio K/N that maximizes steady state consump-
tion per worker). In the opposite case, an increase in the saving rate will
reduce consumption per worker in the steady state.
429
Macroeconomics. Problems and Questions
Question 12
a. Using the Solow model with technological progress, and assuming the
economy was initially in a steady state equilibrium, study in the graph be-
low the effects of a decrease in the saving rate on capital and output per ef-
fective worker, briefly explaining the reasons for the observed changes in
these variables.
𝐾𝐾
[𝛿𝛿 + 𝑔𝑔𝐴𝐴 + 𝑔𝑔𝑁𝑁 ] · ( )
𝑁𝑁𝑁𝑁
𝐾𝐾
∗
𝑓𝑓( )
(𝑌𝑌/𝑁𝑁𝑁𝑁) 𝑁𝑁𝑁𝑁
𝐾𝐾
(𝑌𝑌/𝑁𝑁𝑁𝑁)∗′ 𝑠𝑠 · 𝑓𝑓( )
𝐸𝐸 𝑁𝑁𝑁𝑁
𝐾𝐾
𝑠𝑠 ′ · 𝑓𝑓( )
𝑁𝑁𝑁𝑁
𝐸𝐸 ′
The saving rate decreases from 𝑠𝑠 to 𝑠𝑠 ′ < 𝑠𝑠. Since in goods market equilibrium
savings equal investment, a lower saving rate implies less investment per effec-
tive worker. Since at point E, the initial steady state, investment per effective
...........................................................................................................................
worker was at the level needed to keep 𝐾𝐾 ⁄𝑁𝑁𝑁𝑁 constant, the reduction in in-
vestment caused by the decrease in the saving rate implies that now 𝐾𝐾⁄𝑁𝑁𝑁𝑁 −
...........................................................................................................................
and, with it, 𝑌𝑌⁄𝑁𝑁𝑁𝑁 − will start to decrease. Over time, the economy will con-
...........................................................................................................................
verge to a new steady state (point E’ in the graph) in which both capital and
income per effective worker are permanently lower, and their rate of growth is
...........................................................................................................................
once again zero (and the growth rate of these variables measured in ‘per
...........................................................................................................................
worker’ − or ‘per capita’ − terms is equal to the rate of technological pro-
gress, as in the initial steady state).
...........................................................................................................................
430
Government debt and economic growth
b. How would capital and output per effective worker change following an
increase in the rate of technological progress?
𝐾𝐾
[𝛿𝛿 + 𝑔𝑔𝐴𝐴′ + 𝑔𝑔𝑁𝑁 ] · � � 𝐾𝐾
𝑁𝑁𝑁𝑁 [𝛿𝛿 + 𝑔𝑔𝐴𝐴 + 𝑔𝑔𝑁𝑁 ] · ( )
𝑁𝑁𝑁𝑁
𝐾𝐾
∗
𝑓𝑓( )
(𝑌𝑌/𝑁𝑁𝑁𝑁) 𝑁𝑁𝑁𝑁
𝐾𝐾
𝑠𝑠 · 𝑓𝑓( )
(𝑌𝑌/𝑁𝑁𝑁𝑁)∗′ 𝐸𝐸 𝑁𝑁𝑁𝑁
𝐸𝐸 ′
If, when the economy was in a steady state like point E in the graph above, the
..................................................
rate of technological progress rises from 𝑔𝑔𝐴𝐴 to 𝑔𝑔𝐴𝐴′ > 𝑔𝑔𝐴𝐴 , investment per ef-
fective worker falls below the level needed to keep capital per effective worker
constant over time. Exactly as discussed before in connection with a fall in the
saving rate, capital and output per effective worker will fall for some time, un-
til the economy reaches a new steady state (point E’) in which both variables
are once again constant, but at a level permanently lower than in the initial
steady state.
Notice that, in this economy, the balanced growth path (along which all vari-
ables in ‘per worker’, or ‘per capita’, terms grow at the rate of technological
progress) is now steeper. Take, for instance, output per worker. Although
𝑌𝑌⁄𝑁𝑁 𝐴𝐴 is lower in the new steady state, the growth rates of 𝑌𝑌 and of 𝑌𝑌⁄𝑁𝑁
will be higher – since, in balanced growth, 𝑔𝑔𝑌𝑌 = 𝑔𝑔𝑁𝑁 + 𝑔𝑔𝐴𝐴 , 𝑔𝑔𝑌𝑌⁄𝑁𝑁 = 𝑔𝑔𝐴𝐴 and 𝑔𝑔𝐴𝐴
has gone up.
431
Macroeconomics. Problems and Questions
Question 13
𝐾𝐾
[𝛿𝛿 + 𝑔𝑔𝐴𝐴 + 𝑔𝑔𝑁𝑁 ] · ( )
𝑁𝑁𝑁𝑁
𝐾𝐾
𝑓𝑓( )
𝑁𝑁𝑁𝑁
(𝑌𝑌/𝑁𝑁𝑁𝑁)∗
𝐾𝐾
𝑠𝑠 · 𝑓𝑓( )
𝑁𝑁𝑁𝑁
(𝐶𝐶/𝑁𝑁𝑁𝑁)∗
(𝐼𝐼/𝑁𝑁𝑁𝑁)∗
(𝐾𝐾/𝑁𝑁𝑁𝑁)∗ 𝐾𝐾 ⁄𝑁𝑁𝑁𝑁
In the graph, the steady state value of the variables is indicated with an aster-
isk.
432
Government debt and economic growth
b. Explain if and why you agree, or do not agree, with the following state-
ments:
b.2 the Solow model implies that, if the growth rate of population
𝑔𝑔𝑁𝑁 increases, the economy will reach a new steady state where
the growth rate of aggregate output 𝑌𝑌 is unchanged, and the
growth rate output per worker 𝑌𝑌⁄𝑁𝑁 is lower.
433
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