ECON 2123: Macroeconomics

Problem Set #2
Due Date: October 14, 2019

Instructions:
 Please upload your answers to Gradescope by 10:00 pm.
 Late submissions will not be accepted.
 The following clip on how to submit your homework may be useful. (LINK)
 Please put your name, section, and your TA’s name at the upper right corner of the first
page.

1. ATMs and credit cards (Blanchard (2017), #7 on p.104)

This problem examines the effect of the introduction of ATMs and credit cards on money
demand. For simplicity, let us examine a person’s demand for money over a period of four
days.
Suppose that before ATMs and credit cards, this person goes to the bank once at the
beginning of each four-day period and withdraws from her savings account all the money
she needs for four days. Assume she needs $4 per day.
(a) How much does this person withdraw each time she goes to the bank? Compute this
person’s money holdings for days 1 through 4 (in the morning, before she needs any of
the money she withdraws).

Day 1: $16, Day 2: $12, Day 3: $8, Day 4: $4.

(b) What is the amount of money she holds in the morning, on average?

$16+$12+$8+$4
= $10.
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Suppose now that with the advent of ATMs, this person withdraws money once every
two days
.
(c) Recompute your answer to part (a).
Day 1: $8, Day 2: $4, Day 3: $8, Day 4: $4.

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(d) Recompute your answer to part (b).

$8+$4+$8+$4
= $6.
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Finally, with the advent of credit cards, this person pays for all her purchases using
her card. She withdraws no money until the fourth day, when she withdraws the whole
amount necessary to pay for her credit card purchases over the previous four days.
(e) Recompute your answer to part (a).

Day 1: $0, Day 2: $0, Day 3: $0, Day 4: $16.

(f) Recompute your answer to part (b).

$0+$0+$0+$16
= $4.
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(g) Based on your answers to parts (b), (d), and (f), what do you think has been the effect
of ATMs and credit cards on money demand? How about velocity?

𝑀𝑑 decreases as transactions technology develops. That is, with a better transaction

technology, a smaller amount of 𝑀𝑑 can support the same amount of transaction $𝑌.
𝑌
Therefore, the velocity 𝑉 = 𝑀𝑑 increases.

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2. The velocity of money
Here, you will check your conclusion from the above question using real world data.
Specifically, we will look at the US data which can be downloaded from the FRED
(https://fred.stlouisfed.org/), which is maintained by the FRB of the St. Louis.
(a) Download annual data on nominal GDP and money stock M1 in the US from 1959 to
2018. For the nominal GDP, you can use the following link
(https://fred.stlouisfed.org/series/GDPA). For the money stock, use this link
(https://fred.stlouisfed.org/series/M1SL). Make sure that the data are at the annual
frequency before you download. You can click ‘EDIT GRAPH’ and modify the
frequency to ‘Annual’ by taking an ‘Average’ of the monthly data in each year. Create
a chart showing both GDP and M1 on the same graph. Add legend, specify the name
of variables, and clarify the unit of measurement.

Nominal GDP and M1 in the US (1959-2018)

25,000
Units: Billions of Dollars

20,000

15,000

10,000

5,000

0
1959

1964

1969

1974

1979

1984

1989

1994

1999

2004

2009

2014

M1 Money Stock Nominal GDP

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 (b) Calculate the velocity of M1 money stock in the US from 1959 to 2018. Draw a figure
showing the evolution of this variable from 1959 to 2018. Add the title “Velocity of
M1 Money Stock in the US (1959-2018).”

Velocity of M1 Money Stock in the US (1959-2018)

12

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(c) Do you find the historical pattern in the velocity before 2008 is consistent with your
prediction in 1.(g)? (The reason why the velocity starts to decrease since 2008 is
because the Fed started to increase money supply dramatically as a form of the
unconventional monetary policy. Interested students may want to read Section 23.4,
although this section is beyond the coverage of this course.)

Yes. The velocity based on M1 Money stock and the nominal GDP in the US shows an
upward sloping trend since the 1960s until the beginning of the Great Recession in
2008. This is consistent with the result in 1.(g). As transaction technology improves,
the velocity also rises.

3. Accommodative monetary policy and the government spending multiplier

“The evidence for higher government spending multipliers during periods in which
monetary policy is very accommodative, such as zero lower bound periods, is somewhat

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stronger. Recent time series estimates for the United States and Japan suggest that
multipliers could be 1.5 or higher during those times.” – Ramey, Valerie (2019), “Ten
Years After the Financial Crisis: What Have We Learned from the Renaissance in Fiscal
Research?” Journal of Economic Perspectives 33(2), 89-114.
In this question, you will illustrate using the IS-LM model that the government spending
multiplier depends on the stance of the monetary policy.
(a) Draw an IS-LM diagram. Suppose that the government increases 𝐺. Specify the new
equilibrium on the diagram when the central bank does not change the money supply.
(b) Now, suppose that the central bank wants to maintain the equilibrium interest rate at
the previous level. Given the same increase in 𝐺, what will be the new equilibrium
output 𝑌? Show your result on the IS-LM diagram and compare the results from that in
(a). Do you see that the spending multiplier can be higher when the monetary policy is
more accommodative (expansionary)?

(a) Initially, the economy is at point A. The related output and interest rate are denoted
by 𝑌𝐴 and 𝑖𝐴 . When 𝐺 increases, the IS curve shifts to the right. The new curve is
denoted by IS’. When 𝑀 𝑠 does not change, the LM curve does not shift. As a result,
the new equilibrium is represented by point B.
(b) On the other hand, when the central bank wants to maintain the original interest rate
𝑖𝐴 , it increases 𝑀 𝑠 to shift the LM curve downward. The new LM curve is denoted by
LM’. This curve intersects with the IS’ at point C, where the interest rate is equal to 𝑖𝐴 .
Comparing 𝑌𝐶 and 𝑌𝐵 , it becomes clear that the spending multiplier can be higher
when the monetary policy is more accommodative (expansionary).

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4. Policy mixes
Suggest a policy mix to achieve the following objectives:
(a) Reduce 𝑖 while keeping 𝑌 constant. What happens to investment?

A contractionary fiscal policy combined with an expansionary monetary policy can

reduce 𝑖 while keeping 𝑌 constant. The contractionary fiscal policy shifts the IS curve
to the left, and the expansionary monetary policy shifts the LM curve to the right. As
a result, 𝐼(𝑌, 𝑖) increases.
While the question stops here, further analysis is possible. Because 𝑌 = 𝐶 + 𝐼 + 𝐺
stays at the same level, either 𝐶 or 𝐺, or both should decline. If the contractionary
fiscal policy involves a decline in 𝐺 , 𝐺 decreases. If the government increases 𝑇
instead, then 𝑌𝐷 = 𝑌 − 𝑇 decreases; therefore, 𝐶 decreases.

(b) Reduce 𝑌 while keeping 𝑖 constant. What happens to investment?

A contractionary fiscal policy combined with a contractionary monetary policy can

reduce 𝑌 while keeping 𝑖 constant. The contractionary fiscal policy shifts the IS curve
to the left, and the contractionary monetary policy shifts the LM curve to the left. As
a result, 𝐼(𝑌, 𝑖) decreases.

5. (A version of Blanchard (2017), #5 on pp. 127-128.)

Consider the following numerical example of the IS-LM model:

𝐶 = 300 + 0.4𝑌𝐷
𝐼 = 180 + 0.2𝑌 − 1000𝑖
𝑇 = 125
𝐺 = 50
𝑀𝑠
= 300
𝑃
𝑀𝑑
= 𝑌 − 5000𝑖
𝑃
(a) Derive the IS relation (HINT: You want an equation with 𝑌 on the left side, all else on
the right.)

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 𝑌 = 𝐶 + 𝐼 + 𝐺 = 300 + 0.4(𝑌 − 125) + 180 + 0.2𝑌 − 1000𝑖 + 50
⇒ 0.4𝑌 = 530 − 0.4 × 125 − 1000𝑖
⇒ 𝑌 = 1325 − 125 − 2500𝑖 = 1200 − 2500𝑖
∴ The IS Relation: 𝑌 = 1200 − 2500𝑖.
Note that the IS curve is downward sloping in the (𝑖, 𝑌) plane.

(b) Derive the LM relation (HINT: It will be convenient for later use to rewrite this equation
with 𝑖 on the left side, all else on the right.)

𝑀 𝑠 𝑀𝑑
300 = = = 𝑌 − 5000𝑖
𝑃 𝑃
1 300
⇒ 𝑖 = 5000 𝑌 − 5000
1
∴ The LM Relation: 𝑖= 𝑌 − 0.06.
5000
Note that the LM curve is upward sloping in the (𝑖, 𝑌) plane.

(c) Solve for equilibrium real output. (HINT: Substitute the expression for the interest rate
given by the LM equation into the IS equation, and solve for output.)

𝑌 = 1200 − 2500𝑖 ∵ the IS relation

1
= 1200 − 2500 ( 𝑌 − 0.06) ∵ the LM relation
5000
= 1200 − 0.5𝑌 + 150.
⇒ 1.5𝑌 = 1350.
∴ 𝑌 = 900.

(d) Solve for the equilibrium interest rate. (HINT: Substitute the value you obtained for 𝑌
in part (c) into either the IS equation or the LM equation, and solve for 𝑖. If your algebra
is correct, you should get the same answer from both equations.)

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(i) Using the IS equation: 900 = 𝑌 = 1200 − 2500𝑖 ⇒ 𝑖 = 25 = 12%.
1 900
(ii) Using the LM equation: 𝑖 = 5000 𝑌 − 0.06 = 5000 − 0.06 = 0.18 − 0.06 = 12%

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(e) Solve for the equilibrium values of 𝐶 and 𝐼, and verify the value you obtained for 𝑌 by
adding up 𝐶, 𝐼, and 𝐺.

𝐶 = 300 + 0.4𝑌𝐷 = 300 + 0.4(900 − 125) = 610.

𝐼 = 180 + 0.2𝑌 − 1000𝑖 = 180 + 180 − 120 = 240.
900 = 𝑌 = 𝐶 + 𝐼 + 𝐺 = 610 + 240 + 50.

𝑀𝑠
(f) Now suppose that the money supply decreases to = 150. Solve for 𝑌, 𝑖, 𝐶, and 𝐼,
𝑃

and describe in words the effects of a contractionary monetary policy.

Similarly, one can show that

𝑌 = 850, 𝑖 = 0.14 = 14%, 𝐶 = 590, 𝐼 = 210.
In response to the contractionary monetary policy, the LM curve shifts to the left. As
a result, the economy moves along the IS curve. The equilibrium output decreases and
the equilibrium interest rate increases. As 𝑌 decreases, 𝑌𝐷 decreases, and then 𝐶 also
decreases. Finally, both a decrease in 𝑌 and an increase in 𝑖 have a negative effect on
𝐼. Thus, 𝐼 decreases.

𝑀
(g) Set equal to its initial value of 300. Now, suppose that government spending increases
𝑃

to 𝐺 = 80. Summarize the effects of an expansionary fiscal policy on 𝑌, 𝑖, and 𝐶. What

is the value of the associated government spending multiplier?

In this case,
𝑌 = 950, 𝑖 = 0.13 = 13%, 𝐶 = 630.
Given an expansionary fiscal policy, the IS curve shifts to the right. Thus, the economy
moves along the LM curve. The equilibrium output and interest rate increase. As 𝑌
increases, 𝑌𝐷 increases; therefore, 𝐶 increases. Because changes in the values of 𝑌
and 𝑖 have the opposite implication on the change in 𝐼 , it is not clear whether 𝐼
increases or decreases. In this numerical example, 𝐼 = 𝑌 − 𝐶 − 𝐺 = 240, which is the
Δ𝑌 50
same as the value in the previous case. Finally, Δ𝐺 = 30 = 1.6.