SOLUTION MANUAL FOR MACROECONOMICS

CANADIAN 5TH EDITION BLANCHARD JOHNSON

0132164361 9780132164368
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Chapter 5
Goods and Financial Markets: The IS-LM Model

1. True/False/Uncertain

a. True.

b. True.

c. False.

d. False. The balanced budget multiplier is positive (it equals one), so the IS curve
shifts right.

e. False.

f. Uncertain. An increase in G leads to an increase in Y (which tends to increase

investment), but an increase in the interest rate (which tends to reduce investment).

g. True.

h. True

i. False

2. Investment and the Interest Rate

Firms deciding how to use their own funds will compare the return on bonds to the return
on the physical investment, the new piece of capital. When the interest rate on bonds

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increases, they become more attractive, and firms are more likely to use their funds to
purchase bonds, rather than to finance physical investment projects.

3. The Multiplier Revisited

a. Y=[1/(1-c1)]*[c0-c1T+I+G]
The multiplier is 1/(1-c1).

b. Y=[1/(1-c1-b1)]*[c0-c1T+ b0-b2i +G]

The multiplier is 1/(1-c1-b1). Since the multiplier is larger than the multiplier in
part (a), the effect of a change in autonomous spending is bigger than in part (a).
An increase in autonomous spending now leads to an increase in investment as
well as consumption.

c. Substituting for the interest rate in the answer to part (b):

Y=[1/(1-c1-b1+ b2d1/d2)]*[c0-c1T+ b0+(b2*M/P)/d2 +G]
The multiplier is 1/(1-c1-b1+ b2d1/d2).

d. The multiplier is greater (less) than the multiplier in part (a) if (b 1- b2d1/d2) is
greater (less) than zero. The multiplier is big if b1 is big, b2 is small, d1 is small,
and/or d2 is big, i.e., if investment is very sensitive to Y, investment is not very
sensitive to i, money demand is not very sensitive to Y, money demand is very
sensitive to i.

4. The Response of Investment to Fiscal Policy

a. The IS curve shifts left. Output and the interest rate fall. The effect on investment
is ambiguous because the output and interest rate effects work in opposite
directions: the fall in output tends to reduce investment, but the fall in the interest
rate tends to increase it.

b. From 3c: Y=[1/(1-c1-b1+ b2d1/d2)]*[c0-c1T+ b0+(b2*M/P)/d2 +G]

c. From the LM relation: i= Y*d1/d2 – (M/P)/d2

To obtain the equilibrium interest rate, substitute for equilibrium Y from part (b).

d. I= b0+ b1Y- b2i= b0+ (b1- b2d1/d2)*Y+ b2(M/P)/d2

To obtain equilibrium investment, substitute for Y from part (b).

e. From parts b and d, holding M/P constant, I increases by (b1- b2d1/d2)/ (1-c1-b1+
b2d1/d2), in response to a one-unit increase in G. So, if G decreases by one unit,
investment will increase when b1<b2 d1/d2.

f. A fall in G leads to a fall in output (which tends to reduce investment) and to a fall
in the interest rate (which tends to increase investment). Thus, for investment to
increase, the output effect (b1) must be smaller than the interest rate effect (b2
d1/d2). Note that the interest rate effect contains two terms: (i) d 1/d2, the slope of

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the LM curve, which gives the effect of a one unit change in equilibrium output on
the interest rate, and (ii) b2, which gives the effect of a one unit change in the
equilibrium interest rate on investment.

5. Monetary and Fiscal Policies: An Example

a. Y=C+I+G=200+.25*(Y-200)+150+.25Y-1000i+250
Y=1100-2000i

b. M/P=1600=2Y-8000i
i=Y/4000-1/5

c. Substituting b into a: Y=1000

d. Substituting c into b: i=1/20=5%

e. C=400; I=350; G=250; C+I+G=1000

f. Y=1040; i=3%; C=410; I=380. A monetary expansion reduces the interest rate and
increases output. The increase in output increases consumption. The increase in
output and the fall in the interest rate increase investment.

g. Y=1200; i=10%; C=450; I=350. A fiscal expansion increases output and the
interest rate. The increase in output increases consumption.

h. The condition was b1 must be less that b2 d1/d2 for a contraction in G to increase I.

For the model above 0.25 is equal to (1000)x( 2/8000). The condition is not
satisfied and the reduction in G will not increase I. In fact, this particular set of
parameters, where
b1 =b2 d1/d2 is the set where the change in G leaves I unchanged.

6. Monetary and Fiscal Policy with an Interest Rate Target

a. The LM curve is horizontal. The slope is zero.

b. The intercept of the LM curve is the value of the target rate of interest.
c. Your drawing of the IS-LM should show a large decline in output as you move up the IS
curve when the target interest rate is increased. Monetary policy, in this case a change in
the target and actual interest rate, will reduce output a lot.
d. See Figure 5-12 in the text. Fiscal policy has a much larger impact on output if the
central bank has a target rate of interest.

7. Policy Recommendations

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a. Fall in T shifts IS right. Increase in M shifts LM right. Output could increase

without an increase in the interest rate

b. A contractionary fiscal policy (IS left) would decrease the deficit either by
reducing G or increasing T. If there was an expansionary monetary policy at the
same time (LM down ) then output could remain the same at a lower interest rate.
Thus investment would increase.

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