Chapter 3

The Short Run Macroeconomy

ˆ In the long run, price and wages fully adjust, the output in the economy is purely determined by the
supply side of the economy (i.e. how much capital, labor that we have; how fast is the growth of technology;
and how obstructing government and government regulations are). We discuss these issues in depth using
the insights from the Solow Growth Model, and the Solow-Romer Model.

ˆ In the short run, price and wages are sticky, firms have the opportunity to adjust their production without
raising costs (at least substantially) because wage contracts, input supply contracts and the level of capital
are fixed in the short run. At the same time, demand is volatile because the economy faces constant shocks:
consumer confidence, domestic government policies, foreign demands and exchange rate policies, etc.

ˆ As apparent in equation (3.1), the interest rate, the cost of current consumption or the return on saving,
is a determinant of three out of 4 demand components. Also, the exchange rate works, together with the
interest rate, to determine the last component, i.e. imports and exports. Luckily, the central bank has the
power to set the interest/exchange rates, and therefore, capable of influencing the demand in the short run,
even though to what extent such policy can improve economic outcome is still open to debate.

ˆ A general short-run macroeconomic model is of the form:

Y
|{z} = C0 + Cy · (Y − T ) − Cr · r + I0 − Ir · r + G0 + Gy · (Ȳ − Y )
| {z } | {z } | {z }
Output produced/Supply Household Consumption Firms’ Investment Government Spending
(3.1)
+ T B0 + T Bex · (Y − T ) − T Bim · (Y − T ) + T B [0 − r (r − r∗ )] .
∗ ∗
| {z }
Trade Balance

ˆ Thus, it is important for us to understand the mechanism through which firms and households make
their consumption/investment decisions, governments decide their spending levels, and how the trade balance
varies with the changes in the interest rates and the exchange rate. Such understanding will pave the way
for us to build suitable short run macroeconomic models capable of explaining the short-run fluctuations,
thus enabling us to devise suitable countering policies. In the followings, we will step by step discuss all of
the four components of demand.

3.1 A Simple Theory of Household Consumption - C(Y-T,r)

By the household, we mean a typical household in the economy, which is endowed with certain level of
resources. For simplicity, we assume that the household only lives in two periods: now and the future. There
are three sources of wealth the household may possess, namely accumulated wealth at the beginning of period
1 (F W1 ); labor income during period 1 (Y1 ); and labor income during period 2 (Y2 ). If the household does
not have the motive to save at the end of the future, they will consume everything they have in period 2.
Instead, if they want to give some bequest F W2 to their future generation, they will leave certain amount
of wealth at period 2. Suppose that the real interest rate is r, the present value of all resources that the
household possesses is:
Y2 F W2
P V R = (1 + r)F W1 + Y1 +
1+r 1+r
− fw: financial wealth
29
30 CHAPTER 3. THE SHORT RUN MACROECONOMY

ˆ Given this resources, the household face the problem of allocating consumption between now and the
future so that its level of utility obtained is maximized. Let’s denote C1 and C2 as the level of consumption
at the current and future period respectively. The decision by the household is constrained by the level of
resources, which could be formally expressed as:

C2
C1 + = PV R
1+r

ˆ By consuming C1 and C2 , the utility the household obtaining can be modeled as:

U (C2 )
U (C1 , C2 ) = U (C1 ) + ,
1+ρ

ρ is a positive term between 0 and 1, included in the model to account for the fact that households value
consumption now more than the postponed. The more impatient the household is, the larger the value of ρ.
0
U (C1 ) is assumed to be a concave function, with U (C) > 0 and U ” (C) < 0. Marginal utility from one more
unit of consumption is positive, however, the magnitude of the marginal effect decreases as consumption
increases.

ˆ The allocation facing the household is:

U (C2 )
V ≡ max U (C1 , C2 ) = U (C1 ) +
C1 ,C2 1+ρ

C2
s.t. C1 = P V R − 1+r

If you are so diligent, you may start setting up the Lagrangian and take the F.O.C. However, the simpler
C2
trick works here. Plugging C1 = P V R − 1+r into the maximized function V , and take the differentiation
w.r.t C2 to see the miracle:

C2 U (C2 )
V ≡ max U (C1 , C2 ) = U (P V R − )+
C2 1+r 1+ρ

0
∂V 0 −1 U (C2 )
= U (C1 ) +
∂C2 1+r 1+ρ
∂V
setting ∂C2 = 0, we obtain the optimal condition as:

0
U (C1 ) 1+r
= (3.2)
U 0 (C2 ) 1+ρ

ˆ This equation is known as the Euler Equation. Some further discussion here is guaranteed:
0 0
ˆ U (C1 ) and U (C2 ) are the marginal utility obtained by consuming one more unit of C1 , and one more
unit of C2 , respectively; and (1 + r) and (1 + ρ) are the marginal cost of consuming one more unit of
C1 and C2 , respectively. Intuitively, equation (3.2) states that the price of utility should be equalize,
i.e. U1+ρ
0
(C2 )
= U1+r
0
(C1 )
. Let’s imagine that you buy two chickens, weighing 1.5 and 2 kg, respectively;
you pay 30,000 VND for the smaller one and 40,000 for the bigger. The price per kilogram should be
0 0
the equal, i.e. 30,000
1.5 =
40,000
2 . Think of U (C1 ) and U (C2 ) as two chickens.

ˆ The optimal condition does not depend on Y1 and Y2 , which means that households smooth out their
consumption between now and the future, given their present value of resources and the ability to
borrow freely. In other words, what is important is the PVR, not when the PVR is earned. The
allocation of consumption between now and the future depends on the subjective discouting rate ρ and
the interest rate r. Given the same level of PVR, some households choose to be borrowers if their
subjective discount rate is higher than the interest rate (ρ > r), others choose to be lenders, when their
subjective discount rate is lower than the interest rate (ρ < r).
3.2. A SIMPLE THEORY OF FIRM’S INVESTMENT - I(R) 31

Figure 3.1: Optimal Consumption: Borrower

Figure 3.2: Optimal Consumption: Lender

ˆ Some other points to remember:

– Households may face credit constraints, preventing them from maximizing utility by borrowing
against the future. This leads to the empirical finding that consumption is closely related to
current disposable income.
– When utility function is strictly concave, consumption smoothing implies that a temporary in-
crease in income will lead household to consume only part of the increase and save part of it. A
permanent increase will lead the household to increase their consumption proportionately.
The aggregate consumption function is, therefore, specified as:

C= C0 + Cy ·(Y − T ) − Cr ·r
| {z } | {z } | {z }
Intercept: Cr > 0
capturing
Cy ∈ (0, 1)
all factors
other
than Y,
T, and r

3.2 A Simple Theory of Firm’s Investment - I(r)

The purpose of this section is to highlight the key principle of firms’ investment, equalizing marginal cost
and benefit of investment. Consider a two-period model, the periods being the current and a future period,
in which a firm considers at the beginning of the current period to purchase one additional unit of capital
so as to:
- Increase the amount of output produced in the future period (we assume that capital purchased in
the current period can only be used to produce output in the future period (it takes time to install
capital)), and
32 CHAPTER 3. THE SHORT RUN MACROECONOMY

- Sell that portion of the additional capital that has not depreciated at the end of production in the
future period.

To keep notation as simple as possible, we also assume that the prices of:

- One unit of capital, and of

- One unit of output in the current and future periods are equal to one.

The firm will purchase the additional unit of capital if the marginal (extra) revenue (MR) from doing so
exceeds the marginal cost (MC):
 

   
1  
| M{zR } = | {z
0 }+ · | M{zPK −δ
} + | 1 {z
 
current
1+r  }

in }  additional
amount
portion of 
current period
| {z of output additional
period current capital that
value of ad- has not
values depreciated
ditional unit
of future | {z }
revenue future period
 
1
| M{zC } = | {z
1 }+ · | {z
0 }
current
1+r
in future
current period period
| {z }
period current
values value of
additional
unit of
future cost
The firm will purchase the additional unit of capital if:

M P K+1−δ
MR = 1+r ≥ 1 = MC

⇔ MR
MC = T obin0 sq = M P K+1−δ
1+r ≥1

This idea can be represented graphically as:

An increase in the interest rate r lower the present value of the marginal revenue of the additional in-
vestment unit, raising the opportunity cost of investment, leading firms to cut back on their purchases of
additional capital. This idea can be formalized by taking the derivative of the the Tobin’s q with respect to
the interest rate:

The aggregate investment function is, therefore, specified as:

3.3. GOVERNMENT SPENDING 33

I= I − I ·r
| {z0 } | {zr }
Intercept: Ir > 0
capturing
all factors
other
than Y,
T, and r

3.3 Government Spending

Government spending is the least complicated of the four components of aggregate demand:

G = G0 + Gy · (Ȳ − Y ). (3.3)

Equation (3.3) reads that government spending includes an autonomous factor (G0 ) representing the rigid
part of government spending that cannot adjust easily, at least in the short run such as minimum defense,
education, health care and employee compensation spending. The term Gy · (Ȳ − Y ) represents the counter-
cyclical nature of government spending in the sense that the government will cut its spending when the
economy shows too much demand, inflation is picking up to prevent the economy from getting overheated.
On the contrary, as the economy heads into recession, consumer confidence plummets, the government will
increase in spending to stimulate the economy, increase demand with the hope of bringing the economy back
to its long-run growth path. Of course, this theory mainly reflects the best practice. Government spending
in Vietnam in the last decades has always been increasing, regardless of the business cycle. Perhaps, we need
some VGU graduates to join the Ministry of Finance so change could be initiated.

ˆ Another important factor influencing government spending is government debt, especially government
external (in foreign currency) debt. We are all aware of the Greek public debt crisis, while the threat to
Vietnam is widely discussed on the mass media recently. However, to keep things simple, we will ignore
government debt for now and will come back in later sections.

3.4 The Trade Balance

As is apparent from the lecture, the trade balance is the difference between export and import. Export
represents foreign demand, which depends on how much income foreigners have to buy our products. Import,
on the contrary, depends on how much income domestic consumers have and how fancied of foreign (by this I
mean Japanese, American or German) made products. On top of that, both import and export are strongly
influenced by the level of the exchange rate. The income you have at this point of your life mainly comes from
your parents’ subsidy, mostly in VND of course. The current exchange rate is 22,800 VND/USD. If you want
to buy an Iphone priced at 599 USD, you have to pay 13,657,200 VND. The price will be 14,076,500 VND,
14,975,000, and 17,970,000 VND if the exchange rate increase to 23,500 VND/USD, 25,000 VND/USD, and
30,000 VND/USD respectively. Given your parents’ income are mostly in VND, and thus yours, the price
of the Iphone keeps increasing even though its price in USD stays constant. The Iphone is becoming more
expensive because the VND depreciates. The reverse is true to an American who loves Vietnamese Pho
noodle.

ˆ To capture such insights, the trade balanced in this course is modeled as:
T B = T B0 + T Bex · (Y ∗ − T ∗ ) − T Bim · (Y − T ) + T B [0 − r (r − r∗ )]

The parameters T Bex , T Bim , and T B respectively captures the impact of an increase in foreign disposable
income (on export (+)), domestic disposable income (on import(+)), and the real effective exchange rate
(on both import (-), and export (+)).

3.4.1 The Interest Rate Parity Theory

While the impact of (Y ∗ − T ∗ ) and (Y − T ) is obvious, it is important to understand the mechanism through
which we postulate the relationship between r and r∗ , and the real effective exchange rate. Let’s start with
a question constantly asked by financial investors: should I invest in my own country’s financial market and
earn the return of 1 + rt or should I invest in the international market to earn 1 + rt∗ , and then convert
the earnings back to my own country’s currency to earn the investment return of 1t · (1 + rt∗ )t+1 . At any
34 CHAPTER 3. THE SHORT RUN MACROECONOMY

given point in time, if 1 + rt > 1t · (1 + rt∗ )t+1 , investors will sell their assets in the international market
and buy the domestic assets, raising the demand for domestic currency. The domestic currency appreciates,
depressing the 1t term in 1t · (1 + rt∗ )t+1 . The reverse is true if 1 + rt < 1t · (1 + rt∗ )t+1 . The process of
adjustment will keep going until:
1
1 + rt = · (1 + rt∗ )t+1 . (3.4)
t
Rearranging terms in (3.4) to get:
1 + rt∗
t = t+1 . (3.5)
1 + rt
Equation (3.5) states that the current real effective exchange rate t depends on the domestic and interna-
tional interest rate, and the expectation of future exchange rate. If the central bank increase the interest
rate rt , t becomes smaller, the domestic currency appreciates. Keep replacing s by s+1 recursively to get:

1 + rt∗
t = t+1 .
1 + rt
∗
1 + rt∗ 1 + rt+1
t = t+2 .
1 + rt 1 + rt+1
∗ ∗
1 + rt∗ 1 + rt+1 1 + rt+2
t = t+3 .
1 + rt 1 + rt+1 1 + rt+2
∗ ∗ ∗
1 + rt∗ 1 + rt+1 1 + rt+2 1 + rt+3
t = t+4 .
1 + rt 1 + rt+1 1 + rt+2 1 + rt+3
s=3
Y ∗ 
1 + rt+s
t = t+s+1 .
s=0
1 + rt+s

finally,
s=∞
Y  ∗ 
1 + rt+s
t = ∞ .
s=0
1 + rt+s

In the long run, the nominal exchange rate fully adjust to align with the price level at home and abroad,
ensuring that ∞ = 1. Thus the interest rate parity condition:
s=∞  ∗ 
1 + rt∗ Y 1 + rt+s
t = , (3.6)
1 + rt s=1 1 + rt+s

Given no information on future domestic and foreign interest rates, equation (3.6) states that if the domestic
interest rate r increases, the domestic currency will appreciate. If international interest rate is higher than
the domestic interest rate, the domestic currency will depreciate. This insight is formalized as:

 = 0 − r · (r − r∗ ), 0 < r < 1

3.4.2 The Balance of Trade Function Form

The above discussion allows for the specification of a simple function form relating the trade balance with
its determinants as:
T B = T B0 + T Bex · (Y ∗ − T ∗ ) − T Bim · (Y − T ) + T B 
with
 = 0 − r (r − r∗ )

3.5 Exercises
Problem 3.1
Consider a household that makes consumption decisions for two periods, t = 1, 2. The household’s real
financial wealth at the beginning of period 1 amounts to 5,000 Euro; its real disposable income amounts to
25,000 Euro in period 1 and to 30,000 Euro in period 2. The household at the end of period 2 wishes to
3.5. EXERCISES 35

have real financial wealth in the amount of 4,000 Euro. The real interest rate between period 1 and period
2 is r = 0.01. The household maximizes utility from consumption according to the objective function
U (C2 ) (C1 )1−κ 1 (C2 )1−κ
U (C1 ) + = +
1+ρ 1−κ 1+ρ 1−κ
where ρ = 0.02 denotes the subjective rate of discounting, and κ = 0.5 denotes a coefficient in the instanta-
neous utility function u(C).

a) Obtain the ratio at which this household wishes to consume in period 1 relative to period 2. Also
obtain this household’s optimal levels of consumption in periods 1 and 2.

b) How does your answer to (a) change if the household in period 1 had real disposable income amounting
to 30,000 Euro? What therefore is this household’s marginal propensity to consume?

c) How would your answer to (b) change if the household’s subjective rate of discounting increased?

d) How does your answer to (a) change if the real interest rate increased to r = 0.015? What does this
answer suggest concerning the relative strengths of the substitution and income effects?

Problem 3.2
Consider the aggregate consumption function:
C = C0 + Cy · (Y − T ) − Cr · r
a) Which parameter refers to the marginal propensity to consume? Assuming a strictly concave utility
function, set up the household’s consumption maximization problem and explain why the marginal propen-
sity to consume is assumed to be positive and smaller than one.

b) Using the terms substitution effect and income effect to explain how a consumer who inter-temporally
maximizes consumption reacts to an increase in the interest rate. Does it matter whether the consumer is a
creditor or a borrower? What is the reaction when the interest rate decreases?

c) Based on your reasoning in part b), explain why the parameter Cr in the aggregate consumption
function is assumed to be positive.

Problem 3.3
Suppose that the utility function of a representative household could be represented by: u(C) = log(C).
Assuming that households maximize their utility by smoothing between consumption now (C1 ), and con-
sumption in the future (C2 ).

a) Derive the Euler equation for this household and show that current consumption, C1 could be ex-
pressed as C1 = α · P V R.

b) Suppose that the subjective discount factor ρ = 0.02, r = 0.01, Y1 = Y2 = 10, 000, T1 = T2 = 2000,
determine the value of consumption now, and consumption in the future.

b) What is the effect of a decrease in PVR on C1 ?

c) Does it matter whether the decrease in PVR today results from a decrease in current and/or future
disposable income?

d) Suppose the individual receives an announcement today that income in the future might be lower than
previously expected. What is the effect on consumption today?

Problem 3.4
A representative household maximizes its strictly concave utility by smoothing consumption between now
(C1 ), and the future (C2 ). Financial wealth at the beginning of period 1 is W1 , and at the end of period 2
is W2 . Its labor income in periods 1 and 2 are Y1 and Y2 respectively. It’s utility function is defined as:
36 CHAPTER 3. THE SHORT RUN MACROECONOMY

1
U = u(C1 ) + 1+ρ u(C2 ),

where ρ is the subjective discounting factor, and the prevailing interest rate is r.

a) Setting up the household’s maximizing problem of smoothing consumption between periods 1 and 2.

b) Derive the impact of a change in the present value of resources on current consumption, C1 .

Answer Rewrite the Euler equation as:

0 0
U (C1 )(1 + ρ) = U (C2 )(1 + r),

and take notice of the budget constraint: C2 = (P V R − C1 ) · (1 + r), taking the total differentiation of (3.23)
to get:
00 00 ∂C2 ∂C2 ∂C2 0
(1 + ρ)U (C1 )dC1 = U (C2 )[ dC1 + dP V R + dr] + U (C2 )dr
∂C1 ∂P V R ∂r
00 00 0
(1 + ρ)U (C1 )dC1 = (1 + r)U (C2 )[−(1 + r)dC1 + (1 + r)dP V R + (P V R − C1)dr] + U (C2 )dr.
Rearranging terms:
00 00 00 00 0
[(1 + ρ)U (C1 ) + (1 + r)2 U (C2 )]dC1 = (1 + r)2 U (C2 )dP V R + [(P V R − C1 )(1 + r)U (C2 ) + U (C2 )]dr
00 00 0
(1 + r)2 U (C2 ) (P V R − C1 )(1 + r)U (C2 ) + U (C2 )
dC1 = dP V R + dr (3.7)
(1 + ρ)U 00 (C1 ) + (1 + r)2 U 00 (C2 ) (1 + ρ)U 00 (C1 ) + (1 + r)2 U 00 (C2 )
Set dr = 0, we can solve for the impact of a change dPVR on current consumption C1 as:
00
dC1 (1 + r)2 U (C2 )
=
dP V R (1 + ρ)U 00 (C1 ) + (1 + r)2 U 00 (C2 )
00
By assumption, U (C) < 0, which means that: dPdCV1R > 0. The result also indicates that dC1
dP V R < 1.
c) Derive the impact of a change in the interest rate on current consumption, C1 .

Answer
The impact of a change in the interest rate r on current consumption can be decomposed into two separate
effects:

dC1 dC1 ∂C1 ∂P V R

= |dP V R=0 + ,
dr |dr {z } ∂P V R ∂r
∂C1
∂r

the first effect, dC dC1 P V R

dr |dP V R=0 is known as the substitution effect, while dP V R dr is called the income effect,
1

i.e. because r changes, PVR changes, thus changing the consumption behavior. To compute dC dr |dP V R=0 ,
1

dC1
we first set dP V R = 0 in (3.7) and solve for dr to get:
0 00
dC1 U (C2 ) + (P V R − C1 )(1 + r)U (C2 )
|dP V R=0 = . (3.8)
dr (1 + ρ)U 00 (C1 ) + (1 + r)2 U 00 (C2 )

Different from the case of dPdCV1R , we cannot say unambiguously the sign of dC1
dr |dP V R=0 . To proceed, we
separate the right hand side of (3.8) into two different components:
0 00
dC1 U (C2 ) (P V R − C1 )(1 + r)U (C2 )
|dP V R=0 = + .
dr (1 + ρ)U 00 (C1 ) + (1 + r)2 U 00 (C2 ) (1 + ρ)U 00 (C1 ) + (1 + r)2 U 00 (C2 )

Take notice that:

0 0 00
U (C2 ) U (C2 )(1 + r)2 U (C2 )
00 00 =
2
(1 + ρ)U (C1 ) + (1 + r) U (C2 ) [(1 + ρ)U (C1 ) + (1 + r)2 U 00 (C2 )](1 + r)2 U 00 (C2 )
00

0 0
U (C2 ) U (C2 ) dC1
=
(1 + ρ)U 00 (C1 ) + (1 + r)2 U 00 (C2 ) (1 + r)2 U 00 (C2 ) dP V R
3.5. EXERCISES 37

and
00
(P V R − C1 )(1 + r)U (C2 ) (P V R − C1 ) dC1
=
(1 + ρ)U 00 (C1 ) + (1 + r)2 U 00 (C2 ) (1 + r) dP V R
so
0
dC1 U (C2 ) dC1 (P V R − C1 ) dC1
|dP V R=0 = +
dr (1 + r)2 U 00 (C2 ) dP V R (1 + r) dP V R
0
Now consider the elasticity of the marginal utility of C2 , U (C2 ), with respect to C2 :
00
U (C2 )C2
C 2
U 0 (C2 )
= ,
U 0 (C2 )

which shows how the marginal utility of consuming one more unit of C2 decreases as the amount of C2
increases, and define:
0
U (C2 )
σ = − 00
U (C2 )C2
dC1
as the elasticity of inter-temporal substitution, dr |dP V R=0 becomes:

dC1 P V R − C1 σC2 dC1

|dP V R=0 = [ − ] .
dr 1+r (1 + r)2 dP V R

C2
Replacing (1+r) = P V R − C1 into (3.38),

dC1 P V R − C1 σ(P V R − C1 ) dC1

|dP V R=0 = [ − ] .
dr 1+r (1 + r) dP V R

or
dC1 1−σ dC1
|dP V R=0 = (P V R − C1 ) .
dr 1+r dP V R
When PVR is kept constant (no wealth effect), the substitution effect depends on σ. If σ > 1, equivalently,
00
0
C 2
U 0 (C2 )
= U U(C
0
2 )C2
(C2 )
< 1, meaning that U (C2 ) is inelastic with respect to C2 , the household does not have a
problem saving more for the future consumption, an increase in the interest rate r will have a strong negative
impact on current consumption. However, when the household put a high price on future consumption, a
large increase in future consumption will have a small reduction in the marginal utility of consumption (con-
0
sumption in the second period is extremely high), U (C2 ), a change in the interest rate will have a negative
impact on current consumption. In other words, when current consumption is very high, C2 is very low, the
elasticity of marginal utility of future consumption is very large, a change in the interest rate induces the
family to save more and move consumption from now to the future. Thus, the substitution effect dC dr |dP V R=0
1

is ambiguous, it depends on the characteristics of the household and their current level of consumption.

Y2
Recall that P V R = (1 + r)F W1 + Y1 + 1+r − F1+r
W2
, the effect on PVR due to a change in the interest
rate is:
∂P V R Y2 F W2
= F W1 − 2
+
∂r (1 + r) (1 + r)2

If the household is very rich (F W1 is large), or wants to give everything to their children (hence F W2 is
large), ∂P∂rV R > 0. In contrast, if the household is a debtor, (F W1 is negative)and they don’t have a sin-
gle hope of helping their children, (hence F W2 =0), the ∂P∂rV R < 0. As we have in the previous section,
dC1 dC1 P V R
dP V R > 0, thus dP V R dr is also ambiguous.

It is for this reason we concluded during the lecture, graphically, that the impact of a change in the
interest rate on current consumption

dC1 dC1 dC1 P V R

= |dP V R=0 + ,
dr dr dP V R dr

is ambiguous.
38 CHAPTER 3. THE SHORT RUN MACROECONOMY

Problem 3.5
Assume a simple economy with only one representative household that owns a firm and that there is no
capital to begin with (in the metaphor of Robinson Crusoe, there are no trees on the island). The key
decision is: how much investment today (I1 ) (coconuts to plant). This will give rise to productive capital
tomorrow K2 = I1 . Let Yi denotes period i’s labor income, i =1,2, and r denotes the interest rate.

a) Define the budget constraint facing this household.

b) Formulate the maximization problem facing the household so that the present value of resources is
maximized.

Problem 3.6
Consider a firm that operates only for two periods, t = 1, 2. The firm produces output, Yt , with the
production function Yt = Alog(Kt ), t = 1, 2, where A is the level of technology, log denotes the natural
logarithm, and Kt the firm’s capital stock. Suppose that the firm’s revenue and cost in period 1 are given
by Revenue1 = Y 1, and Cost1 = p1 .I1 , where I1 is the firm’s investment in the physical capital stock of
period 2, and K1 is exogenously given. At the end of each period, a fraction δ of the firm’s capital stock
depreciates. The firm discounts future profits at the market rate of interest, denoted r.

a) Given investment I1 and capital stock K1 in period 1, what is the firm’s capital stock in period 2?

Answer: The firm’s capital stock in period 2 includes the capital from period 1, K1 , minus the depreciation
δK1 , and plus the new investment I1 :
K2 = (1 − δ)K1 + I1
b) Determine for general parameter values the period 1 present value of revenue as well as period 1
present value of cost, if the firm can sell its remaining capital after production in period 2 at real price p2
and if the real interest rate between periods 1 and 2 is r.

Answer:

ˆ The present value of costs is:

P V C = p1 .I1

ˆ The present value of revenue is:

Alog((1 − δ)K1 + I1 ) p2 (1 − δ) [(1 − δ)K1 + I1 ]

P V Rev = Alog(K1 ) + +
1+r 1+r

c) Derive for general parameter values the condition for the firm’s optimal investment in period 1.

Answer:

The present value of wealth of the firm is:

P V W = P V Rev − P V C

Alog((1 − δ)K1 + I1 ) p2 (1 − δ) [(1 − δ)K1 + I1 ]

P V W = Alog(K1 ) + + − p1 .I1
1+r 1+r
The firm’s maximization problem is:

Alog((1 − δ)K1 + I1 ) p2 (1 − δ) [(1 − δ)K1 + I1 ]

V ≡ max P V W = Alog(K1 ) + + − p1 .I1
I1 1+r 1+r

The F.O.C is:

∂V A p2 (1 − δ)
= + − p1
∂I1 (1 + r)(1 − δ)K1 + I1 ) 1+r
or
∂V A p2 (1 − δ)
= + − p1 .
∂I1 (1 + r)(1 − δ)K1 + I1 ) 1+r
3.6. THE IS CURVE 39

∂V
Set ∂I1 = 0, we find the optimal level of investment must satisfied:

A p2 (1 − δ)
+ = p1 .
(1 + r)(1 − δ)K1 + I1 1+r

A p2 (1 − δ)
= (1 + r)p1 − .
(1 − δ)K1 + I1 1
A
(1 − δ)K1 + I1 =
(1 + r)p1 − p2 (1 − δ)
A
I1 = − (1 − δ)K1
(1 + r)p1 − p2 (1 − δ)

Problem 3.7
Suppose the following interest parity relationship holds:
1
1 + rt = · [1 + (1 − τ ∗ ) · rt∗ ] · t+1
t
where τ ∗ denotes the rate at which capital returns are taxed (for all financial investors, irrespective of their
nationality) in the foreign economy. Also suppose that purchasing power parity holds for the long-run ahead
value of the real exchange rate. Now consider an increase of τ ∗ . Derive algebraically the impact of this
increase. Provide a detailed economic rationale this has on the current value of the real exchange rate
between the domestic and the foreign currencies.
Answer:

Rewrite the above equation as:

s=∞ 
1 + (1 − τ ∗ ) · rt∗ Y (1 + (1 − τ ∗ )rt+s
∗ 
t =
1 + rt s=1
1 + rt+s

Qs=∞ h (1+(1−τ ∗ )rt+s

∗ i
Given no information on the future interest rates and capital tax, the term s=1 1+rt+s is best
guessed to be a constant, denoted as CONST, CON ST > 0. The equation becomes:

1 + (1 − τ ∗ ) · rt∗
t = CON ST
1 + rt
Take the partial differentiation of t w.r.t τ ∗ and get:
∂t −rt∗
∗
= CON ST,
∂τ 1 + rt
which is unambiguously negative. We can conclude that an increase in the foreign tax on capital will reduce
the real effective exchange rate.

Economic Rationale: Higher tax rate τ ∗ in the foreign country reduces the return on foreign assets.
Financial investors will sell their foreign assets and buy domestic assets until the interest rate parity condition
is restored. The domestic currency appreciates, leading the real exchange rate between the domestic and the
foreign currencies to also decrease.

3.6 The IS Curve

Having gone through so much pain, it is now time bring all components of demand into one bag and name
it Desired Demand or DD.

| DD
{z } = C0 + Cy · (Y − T ) − Cr · r + I0 − Ir · r + G0 + Gy · (Ȳ − Y )
| {z } | {z } | {z }
Desired demand Household Consumption Firms’ Investment Government Spending
40 CHAPTER 3. THE SHORT RUN MACROECONOMY

+ T B0 + T Bex · (Y ∗ − T ∗ ) − T Bim · (Y − T ) + T B [0 − r (r − r∗ )]

| {z }
Trade Balance

As we have emphasized class after class, total supply (what all of us produced) must be equal to total
desired demand (what all of us consume plus the consumption by foreign people and minus the proportion
of consumption imported). Put it differently, Y must be equal to DD, so:

| Y
{z } = | C0 + Cy · (Y{z− T ) − Cr · r }
+
|
I0 − Ir · r
{z }
+
|
G0 + Gy · (Ȳ − Y )
{z }
Output/GDP/Supply Household Consumption Firms’ Investment Government Spending
in the short run

+ T B0 + T Bex · (Y ∗ − T ∗ ) − T Bim · (Y − T ) + T B [0 − r (r − r∗ )]

| {z }
Trade Balance

as we boldly postulate at the beginning of the story of the macroeconomy in the short run. Rearrange
terms to group exogenous and endogenous components together to get:

Y }
| {z = C0 + I0 + G0 + T B0 + T B · 0 − (Cy − T Bim ) · T + Gy · Ȳ + T Bex · (Y ∗ − T ∗ ) + T B · r · r∗
| {z }
Output/GDP/Supply A (autonomous component of desired aggregate demand)
in the short run

+ (Cr + Ir + T B · r ) · r + (Cy − T Bim − Gy ) · Y

| {z } | {z }
Interest rate - sesitive components of aggregate demand Income - sesitive components of aggregate demand

The autonomous components bunch together the exogenous (roughly means: outside the model) sub-
components that the model does not try to determine, rather we take them for granted, as if they are given
to us by a natural superior. We do not know their exact value. Macroeconomists try to collect data from
the real world and make the estimation of these terms. Moving the income-sensitive term to the left yields:

[1 − (Cy − T Bim − Gy )] · Y = A − (Cr + Ir + T B · r ) · r

Dividing both sides by [1 − (Cy − T Bim − Gy )] yields:

A (Cr + Ir + T B · r )
Y = − ·r (3.9)
1 − (Cy − T Bim − Gy ) 1 − (Cy − T Bim − Gy )

Equation (3.9) is the famous IS curve. We derive this equation by setting aggregate supply equal aggregate
demand, and therefore, the IS curve represents the combination of output, Y, and the interest rate, r, so
that the goods market is in equilibrium.
3.6. THE IS CURVE 41

The IS curve divides the (r, Y) plane into the excess supply and excess demand half-planes.

If for some reason, the central bank judges that there are signs of overheating in the economy, it might
raise the interest rate from R to R1 . The economy suddenly find its self operating at a disequilibrium be-
cause aggregate demand falls to Y1 while supply is still at point Y. There will be excess supply, indicated
0
by the gap E1 E1 , firms cannot sell their product and find their inventory increases. They are forced to cut
42 CHAPTER 3. THE SHORT RUN MACROECONOMY

down the current level of production and output falls from Y to Y1 , the new equilibrium is now point E1 .
Suppose further that the economy is now operating at the new equilibrium E1 thanks to the change in the
interest rate. However, the central bank recognizes that it has made a mistake and that the economy is now
heading to a recession as the interest rate is too high. The central bank is forced to cut the interest rate
from R1 to R2 to save the economy from an unnecessary slowing down due to the central bank’s mistake.
0
At the new interest level, the economy once more find itself operating at an unsustainable pont E2 . At such
a low level of the interest rate, demand is as much as Y2 , however, supply is still at Y1 . Firms will find
that their inventory is depleted quickly, therefore, they will increase their output from Y1 to Y2 . The story
can go on as the central bank again realizes that it has cut the interest rate by too much and the econ-
omy now is operating over its potential output, a new rate hike is called for, and it may make a mistake again.

The above discussion seems to be lighthearted. However, it highlights two important points, one is the
IS does divides the (r, Y) space into excess demand and excess supply half-planes. The other is it is really a
hard job for the central bank to correctly judge the level of actually output relative to its potential. Mistake
is not an abnormal but a norm at many old-style central banks which lack well train economists and experts.

3.6.1 Exercises on the IS curve

Problem 3.8
Assume the following specific functions for C, I , G and TB:

C = 100 + 0.7 · (1 − t) · Y

I = 80 − 500 · r

G = 200

T B = 0.2 · (1 − t∗ ) · Y ∗ − 0.3 · (1 − t) · Y + 20 · 
Furthermore, assume that the interest rate equals 5%, the real exchange rate equals 2 and foreign income
equals 1,000. The tax rates t and t∗ are 0.2 and 0.1, respectively.

a) Derive the analytical expression of Desired Demand as a function of income.

b) Plot Desired Demand as a function of income. How do you interpret the slope?

c) Calculate the Goods Market Equilibrium.

Problem 3.9
The real sector of an economy under fixed prices (for which foreign variables are exogenous) is described by
the following relations:
Y = DD = C + I + G + T B;

C = C0 + Cy [(1 − t) · Y + GT ] ;

I = I0 − Ir · r;

G = G0 ;

T B = T B0 + T Bex · [(1 − t∗ ) · Y ∗ + GT ∗ ] − T Bim · [(1 − t) · Y + GT ] + T B · ;

 = 0 − r (r − r∗ )
where t (t∗ ) denotes the domestic (foreign) rate of income taxation and GT (GT ∗ ) denotes transfer payments
by the domestic (foreign) government to domestic (foreign) private households; all other notation is as in
the lectures on the macroeconomy in the short run. When numerical answers are asked for, you may assume
the following parameter values: C0 = 1.45; Cy = 0.75; t = 0.15; GT = 0.25; I0 = 3.25; Ir = 15; r = 0.03; G0 =
2.8; T B = 0; T Bex = 0.15; t∗ = 0.1; Y ∗ = 11; GT ∗ = 0.05; T Bim = 0.15; T B = 1; 0 = 1; r = 1; r∗ = 0.03.

a) Derive (for general parameter values) the Keynesian multiplier describing how changes of the au-
tonomous component of aggregate output demand affect short-run output.
3.6. THE IS CURVE 43

Answer: First, it is best to expand all the products to separate the endogenous and exogenous components
from each equation:

Y = DD = C0 + Cy · GT + Cy (1 − t) · Y + I0 − Ir · r + G0 + T B0 + T Bex · (1 − t∗ ) · Y ∗ + T Bex · GT ∗

−T Bim · (1 − t) · Y − T Bim · GT + T B · 0 − T B · r · r + T B · r · r∗
Next, group the terms into groups according to exogenous, Y, and r terms:

Y = C0 + I0 + G0 + T B0 + T Bex · (1 − t∗ ) · Y ∗ + T Bex · GT ∗ − T Bim · GT + T B · 0 + T B · r · r∗

+Cy · GT + Cy (1 − t) · Y − T Bim · (1 − t) · Y − Ir · r − T B · r · r.
Then, move the Y terms to the left to get:

[1 − Cy (1 − t) + T Bim · (1 − t)] · Y = C0 + Cy · GT + I0 + G0 + T B0 + T Bex · (1 − t∗ ) · Y ∗ + T Bex · GT ∗

−T Bim · GT + T B · 0 + T B · r · r∗
−(Ir + T B · r ) · r
Finally, the model could be written in the IS form:
C0 + Cy · GT + I0 + G0 + T B0 + T Bex · (1 − t∗ ) · Y ∗ + T Bex · GT ∗ − T Bim · GT + T B · 0 + T B · r · r∗
Y =
1 − Cy (1 − t) + T Bim · (1 − t)
Ir + T B · r
− ·r
1 − Cy (1 − t) + T Bim · (1 − t)

Therefore, the general values of the Keynesian multiplier is:

1
KM =
1 − Cy (1 − t) + T Bim · (1 − t)

b) Derive (for general parameter values) the IS curve. Provide a detailed economic rationale as to how
the slope of the IS curve depends on (i) T Bim and (ii) r

Answer: From question a), the IS curve is defined by the equation:

C0 + Cy · GT + I0 + G0 + T B0 + T Bex · (1 − t∗ ) · Y ∗ + T Bex · GT ∗ − T Bim · GT + T B · 0 + T B · r · r∗

Y =
1 − Cy (1 − t) + T Bim · (1 − t)

Ir + T B · r
− ·r
1 − Cy (1 − t) + T Bim · (1 − t)
c) The short run economic output is 19.65816327.
ˆ The slope of the IS curve is defined as − 1−Cy (1−t)+T
Ir +T B ·r
Bim ·(1−t) . T Bim enters the nominator of the slope
formula with a positive sign, and because (1-t) is positive, the higher the value of T Bim , the steeper
the IS curve.The rational for this is that the multiplier effect decreases when T Bim rises and therefore
a change in the interest rate following a change in the autonomous component has a smaller effect on
output.
ˆ r enters to the nominator of the slope. The higher the value of r , the flatter the IS curve. Output
responses more strongly to a change in the interest rate. The economic rationale for this interpretation
is that the higher values of r means the exchange rate appreciate more strongly in response to an
increase in the interest rate, thus in combination with the decreases in consumption and investment
having a strong negative impact on output.

d) Provide a detailed economic rationale as to how the size of the Keynesian multiplier depends on (i)
T Bim and (ii) T Bex .

Answer:
ˆ The parameter T Bim represents the propensity to import consumption. The higher the value of T Bim ,
the lower the value of the KM due to import leakage. When T Bim is high, stimulus economic policy
will be less effective.
44 CHAPTER 3. THE SHORT RUN MACROECONOMY

ˆ An increase in the propensity to export T Bex leaves the Keynesian Multiplier unaffected because de-
mand of domestic citizen for home output is not affected by foreign demand decisions.

e) Calculate and compare the short-run output effects of (a) an increase in domestic government transfer
payments to domestic private households, GT, by 0.1 with (b) an increase in domestic government expendi-
ture through an increase of G0 , also by 0.1. Provide a detailed economic rationale for your comparison.

Answer: The short run output following the increase by 0.1 in GT and G0 are 20.36183673 and
20.28020408 respectively. The increase in G0 has a stronger impact on short run output because G0 en-
ter the autonomous aggregate demand directly, while GT enters indirectly via the impact on consumption
and import. Analytically, it could be shown that:
∂Y
∆Y GT = ∆GT
∂GT
∂A
= ∆GT
∂GT
1
= ∆GT · (Cy − T Bim ) ·
1 − Cy (1 − t) + T Bim · (1 − t)
= 0.1 · 1.22 = 0.122
Meanwhile,
∂Y
∆Y G0 = ∆G0
∂G0
∂A
= ∆G0
∂G0
1
= ∆G0
1 − Cy (1 − t) + T Bim · (1 − t)
= 0.1 · 2.04 = 0.204

Problem 3.10
Assume the economy can be described by the following system of linear equations:

C = C0 + Cy · (1 − t) · Y
I = I0 − Ir · r
G = G0
T B = T Bex · (1 − t ) · Y ∗ − T Bim · (1 − t) · Y + T B · 
∗

 = 0 − r · (r − r∗ )
a) Derive the Keynesian Multiplier.

b) If t = 0.25; Cy = 0.6, and T Bim = 0.25, What will be the effect on output Y if the government
increases its expenditure G by 5 billion? Explain the intuition behind your result.

Problem 3.11
Assume
Y = C + I + G + TB
with
C = C0 + Cy · (Y − T ) − Cr · r
I = I0 − Ir · r
G = G0 + Gy · (Ȳ − Y )
T B = T Bex · (1 − t∗ ) · Y ∗ − T Bim · (1 − t) · Y + T B · 
3.7. IS-TR 45

 = 0 − r · (r − r∗ )
a) Derive the Keynesian Multiplier in this framework.

b) Derive how the Multiplier depends on Cy , T Bim and Gy . What does it mean, if, respectively, Cy ,
T Bim or Gy increase? Explain in each case why the Multiplier increases or decreases.

3.7 IS-TR
3.7.1 Monetary Policy Rate
The IS curve above depicts a simple relationship between output in the short run and the interest rate. It’s
now the time for us to discuss how the interest rate is determined in the economy. As noted during the
lecture, the old approach excellently described in Jone’s book says that the interest rate is the result of the
money demand in the economy and the quantity of money supply by the central bank. The central bank
controls the money supply and adjust the quantity of this supply to change the interest rate in the economy.

However, reality shows that it is inherently difficult for the central bank to control the quantity of money
supply. In practice, the central set the interest rate and supply whatever amount of money needed to
maintain that interest rate. Therefore, it is best to describe the interest setting activity by modern central
banks by using the Taylor Rule formula which states that:
 
Y − Ȳ
RM P = MP
r̄|{z} +π e + φy +φπ · (π − πT )
Ȳ |{z}
neutral real rate > 0 | {z } inflation target
(relative) ouput gap

Furthermore, we are only concerned with the short run in this chapter, therefore, price is constant, and
π = π T = π e = 0. Defining rM P = RM P − π e , the real monetary interest rate. The Taylor rule reduces to:
 
Y − Ȳ
rM P = r̄M P + φy (3.10)
Ȳ

3.7.2 The lending rate

Commercial banks are firms. Their ultimate goal is to obtain funding (deposits, loans, equity, ect.) at some
interest rate, say rdeposit , and lend the fund to investors/consumers at the rate of rdeposit + r̄RP , where RP
stands for risk premium and r̄RP > 0. For simplicity, we assume that banks can mobilize the fund at the
rate rM P , and offer loans at a single rate rM P + r̄RP .

3.7.3 The TR curve

The TR curve is, thus, defined as:

 
Y −Ȳ
r = rM P + rRP = r̄M P + φy Ȳ
+ r̄RP

Problem 3.12
Consider two central banks that both use the following Taylor rule to set their monetary policy rate:
 
MP MP Y − Ȳ
R = r̄ + φy
Ȳ

Suppose the parameter φy is larger for the first of these two central banks than for the second one. Provide
a detailed economic rationale as to how the two central banks’ monetary policy rate decisions differ when (i)
Y > Ȳ and (ii) Y < Ȳ . Answer: The parameter φy represents how sensitive the central bank is to a shock
that deviates the economy from its potential output. The higher the value of φy , the stronger the change in
the interest rate in the face of a shock to the economy. When (i) Y > Ȳ , the first central bank will raise the
interest rate by a amount that is higher than the react of the second central bank to a shock of the same
magnitude. Similarly, when Y < Ȳ the first central bank will cut the interest rate more than the second
one.
46 CHAPTER 3. THE SHORT RUN MACROECONOMY

Problem 3.13

Consider the real interest rate prediction of the model of commercial bank lending considered in the lectures:

rM P − ν · ALo
r=
1 + ν · Lor

where
V ar(lrp) · χ
ν=
Eq

How does the real interest rate respond to a decrease of Eq? Derive this effect algebraically. (Hint: Calculate
the partial derivative of r with respect to Eq, and then re-write this partial derivative in such form that
you can invoke the condition that the loan demand must be strictly positive.) Provide a detailed economic
rationale for your result.

Answer:
∂r ∂r ∂ν
=
∂Eq ∂ν ∂Eq

ALo · (1 + νLor ) − Lor (rM P + νALo V ar(lrp)

= ·χ
(1 + νLor )2 Eq 2

rM P + νALo
 
−1 Lo V ar(lrp)
= A − Lor · χ (3.11)
1 + νLor 1 + νLor Eq 2
| {z }
Loan Demand

∂r
It can be seen from 3.11 that ∂Eq is negative and,

∂r
∆r = · ∆Eq.
∂Eq

When ∆Eq is negative, ∆r is, therefore, positive. When Eq is smaller, the ratio of loan to equity also
increases. Therefore, banks start charging a higher interest rate because their operation becomes more risky.

3.7.4 The IS-TR model

The IS curve represents the equilibrium on the goods/services market:

A (Cr + Ir + T B · r )
Y = − ·r
1 − (Cy − T Bim − Gy ) 1 − (Cy − T Bim − Gy )

The TR curve represents the equilibrium on the financial market where the amount of loans supplied is equal
to the amount of loan demanded:
 
Y − Ȳ
r = rM P + rRP = r̄M P + φy + r̄RP
Ȳ

Together, they determine the equilibrium in the interest rate - production/consumption space:
3.8. EXERCISES ON THE IS-TR MODEL 47

3.7.5 Quantitative analysis of the IS-TR

Given the TR curve, the full macroeconomic model in the short run is described by the IS curve:
A (Cr + Ir + T B · r )
Y = + ·r
1 − (Cy − T Bim − Gy ) 1 − (Cy − T Bim − Gy )
and the TR curve, rewritten in terms of output as:
 
Ȳ
· r − r̄M P − r̄RP


Y = Ȳ +
φy
Combining this equation with the IS equation yields:
 
Ȳ A (Cr + Ir + T B · r )
· r − r̄M P − r̄RP =


Ȳ + + ·r
φy 1 − (Cy − T Bim − Gy ) 1 − (Cy − T Bim − Gy )
r̄M P + r̄RP
   
Ȳ (Cr + Ir + T B · r ) A
+ ·r = − Ȳ · 1 −
φy 1 − (Cy − T Bim − Gy ) 1 − (Cy − T Bim − Gy ) φy
or  
A r̄ M P +r̄ RP
1−(Cy −T Bim −Gy ) − Ȳ · 1 − φy
r= (Cr +Ir +T B ·r )
Ȳ
φy + 1−(Cy −T Bim −Gy )
The interest rate is now determined solely by the model parameters. Having computed the interest rate, the
output can be estimated using the IS equation:
A (Cr + Ir + T B · r )
Y = − ·r
1 − (Cy − T Bim − Gy ) 1 − (Cy − T Bim − Gy )
 
A r̄ M P +r̄ RP
A (Cr + Ir + T B · r ) 1−(Cy −T Bim −Gy ) − Ȳ · 1 − φy
= − · (Cr +Ir +T B ·r )
1 − (Cy − T Bim − Gy ) 1 − (Cy − T Bim − Gy ) Ȳ
+
φy 1−(Cy −T Bim −Gy )

3.8 Exercises on the IS-TR model

3.8.1 Problem 3.14
Consider the ISTR model and an economy for which

A (Cr + Ir + T B · r )
Y = − ·r
1 − (Cy − T Bim − Gy ) 1 − (Cy − T Bim − Gy )
48 CHAPTER 3. THE SHORT RUN MACROECONOMY
 
Y − Ȳ
r = rM P + rRP = r̄M P + φy + r̄RP
Ȳ
with A = 10, cy = 0.7, T Bim = 0.1, Gy = 0.1, Ir = 15, Cr = 4, T B = 1, r = 1, r̄M P = 0 : 02, r̄RP = 0 : 02,
φy = 0.5, Ȳ = 16. (a) Determine the goods market equilibrium for r = 0.05.

(b) Determine the money market equilibrium for Y = 15.

(c) Determine the overall short run macroeconomic equilibrium. What are the values for Y and r?

3.8.2 Problem 3.15

In the standard IS-TR model presented in the subsection 3.7.5, suppose that A = 9.63, Cy = 0.6, Gy = 0.1,
T Bim = 0.1, T Bex = 0.1, Cr = 4, Ir = 16, Ȳ = 15, r̄M P = 0.02, r̄RP = 0.01, φy = 1, T B = 1, r = 1.

a) Determine the values of r and Y using the parameter values.

b) Determine the impact of an increase in foreign income by 5, i.e. ∆Y ∗ = 5.

3.8.3 Problem 3.16

On the IS - TR model: An economy under fixed prices (for which foreign variables are exogenous) is described
by the following model:

Y = DD = C + I + G + T B;
C = C0 + Cy · (Y − T ) − Cr · r;
I = I0 − Ir · r;
G = G0 − Gr · r;
T B = T B0 + T Bex · (Y ∗ − T ∗ ) − T Bim · (Y − T ) + T B · ;
 = 0 + r · (r − r∗) 
Y −Ȳ
r = r̄M P + φy · Ȳ
+ r̄RP .

When numerical calculations are asked for, assume the following parameter values: C0 = 1.6; Cy = 0.55; Cr =
3; T = 2.5; I0 = 3.25; Ir = 15; G0 = 2.8; Gr = 1; T B0 = 0; T Bex = 0.1; Y ∗ = 10; T ∗ = 3; T Bim = 0.15; T B =
1; 0 = 1; r = 1; r∗ = 0.03; r̄M P = 0.02; φy = 1; Ȳ = 15; r̄RP = 0.01.
a) Derive (for general parameter values) the IS - curve. Provide an economic rationale as to how the
slope of the IS - curve depends on the model parameters.

b) What is the value of output in the short-run macroeconomic outcome?

c) Calculate the effects on domestic short-run output of a decrease in the foreign interest rate, r∗ , by
0.01? Decompose the overall output effects into its components (that is, the Keynesian multiplier induced
effect and the domestic interest rate induced crowding out-in effects). Make sure to provide, in addition to
numerical results, a detailed economic rationale as to how the various effects arise.

Answer:

a) Again, the first step is to expand all the products to separate the exogenous from the endogenous.

Y = C0 + Cy · Y − Cy · T − Cr · r + I0 − Ir · r + G0 − Gr · r + T B0 + T Bex · (Y ∗ − T ∗ ) − T Bim · Y +
T Bim · T + T B · (0 + r r∗ ) − T B · r · r.

Next, group terms according to three categories: Autonomous, Y, and r:

Y = C0 + I0 + G0 + T B0 + T Bex · (Y ∗ − T ∗ ) + T B · (0 + r r∗ ) − Cy · T + T Bim · T + Cy · Y − T Bim ·

Y − Cr · r − Ir · r − Gr · r − T B · r · r.

Y · (1 − Cy + T Bim ) = A − (Cr + Ir + Gr + T B · r ) · r.

A Cr + Ir + Gr + T B · r
Y = − · r. (3.12)
1 − Cy + T Bim 1 − Cy + T Bim
3.8. EXERCISES ON THE IS-TR MODEL 49

Where A = C0 + I0 + G0 + T B0 + T Bex · (Y ∗ − T ∗ ) + T B · (0 + r r∗ ) − Cy · T + T Bim · T . The general IS

1−Cy +T Bim
curve is described by equation 3.12. The slope of the IS curve is Cr +Ir +G r +T B ·r
, which depends positively
on T Bim ; negatively on Cy , Cr , Ir ,T B , r and Gr .

b) What is the value of output in the short-run macroeconomic outcome?

The TR curve is given as:

 
Y −Ȳ
r = r̄M P + φy · Ȳ
+ r̄RP

Plugging r according to the Taylor rule to equation 3.12 yields:

   
A Cr + Ir + Gr + T B · r MP Y − Ȳ RP
Y = − · r̄ + φy · + r̄ .
1 − Cy + T Bim 1 − Cy + T Bim Ȳ
   
Y = IS0 − IS1 r̄M P + φy · Y Ȳ−Ȳ + r̄RP .

Y = IS0 − IS1 r̄M P − φy + r̄RP − IS1 · φy YȲ .

φy

Y (1 + IS1 Ȳ
) = IS0 − IS1 r̄M P − φy + r̄RP .

IS0 − IS1 r̄M P − φy + r̄RP
Y = φy
. (3.13)
1 + IS1 · Ȳ

Plugging the parameters into 3.13, the short run outcomes are:

ˆ Y = 14.36896552
 
ˆ r = r̄M P + φy · Y Ȳ−Ȳ + r̄RP = −0.012068966

c) Calculate the effects on domestic short-run output of a decrease in the foreign interest rate, r∗ , by
0.01? Decompose the overall output effects into its components (that is, the Keynesian multiplier induced
effect and the domestic interest rate induced crowding out-in effects). Make sure to provide, in addition to
numerical results, a detailed economic rationale as to how the various effects arise.

Recall that

A = C0 + I0 + G0 + T B0 + T Bex · (Y ∗ − T ∗ ) + T B · (0 + r r∗ ) − Cy · T + T Bim · T ,

therefore,

∆A = ∂A
∂r ∗ · ∆r∗ = T B · r ∆r∗ = 1 · 1 · −0.01 = −0.01

ˆ Total change in output, Y:

∂Y ∂Y ∂r
∆Y = ∂A · ∆A + ∂r · ∂A · ∆A

∂Y 1
∂A = 1−Cy +T Bim = 1.666666667

∂r
Note that we need to solve for r as a function of A so that ∂A can be computed:

 
Y −Ȳ
r = r̄M P + φy · Ȳ
+ r̄RP
r = r̄M P + φy · ȲY − φy + r̄RP
φy · ȲY = r − r̄M P − r̄RP + φy
Y = φȲy · r + Ȳ − φȲy · (r̄M P + r̄RP )
50 CHAPTER 3. THE SHORT RUN MACROECONOMY

Plugging this result into the IS equation 3.12 yields:

Ȳ Ȳ MP A Cr +Ir +Gr +T B ·r

φy · r + Ȳ − φy · (r̄ + r̄RP ) = 1−Cy +T Bim − 1−Cy +T Bim ·r
Ȳ C +I +G +T B · A Ȳ MP
φy · r +
r r r
1−Cy +T Bim
 r
· r = 1−Cy +T Bim + −Ȳ + φy · (r̄ + r̄RP )
A Ȳ MP RP
1−Cy +T B +−Ȳ + φy ·(r̄ +r̄ )
r= Ȳ
im
+ Cr +I r +Gr +T B ·r
φy 1−Cy +T B
im
1
∂r 1−Cy +T Bim
∂A = Ȳ Cr +Ir +Gr +T B ·r
φy + 1−Cy +T Bim

Plugging the parameters into this expression of r yields:

∂r
∂A = 0.034482759

Finally,

r +Gr +T B ·r
∂Y
∂r = − Cr +I
1−Cy +T Bim = −33.33333333.

Therefore,

∂Y
∆Y = ∂A · ∆A + ∂Y ∂r
∂r · ∂A · ∆A = 1.666666667 · −0.01 + −33.33333333 · 0.022550033 · −0.01 = −0.00517

ˆ Notice that income is lower due to the decrease in foreign interest rate. The central bank react to this
negative shock by lowering the
 interest
 rate, rM P following the Taylor rule in the short run, leading to
a change in r = r̄M P + φy · Y Ȳ−Ȳ + r̄RP , which is computed as:

∂r
∆r = ∂A ∆A = 0.034482759 · −0.01 = −0.000344828

ˆ Impacts through channels:

– A decrease in the foreign interest rate lead to a change in the autonomous components by ∆A =
T B · r ∆r∗ , through the KM effects, the contribution to ∆Y due to a change in ∆A is:
∂Y ∂A ∗ 1 ∂A ∗
∂A ∂r ∗ ∆r = 1−Cy +T Bim · ∂r ∗ ∆r = 1.666666667 · −0.01 = −0.01666666667

– Crowding in of consumption: A reduction in the interest rate leads to an increase in consumption

by: ∆C = − ∂C ∂r · ∆r = −Cr · ∆r, through the Keynesian Multiplier effects, resulting in the change
in output as:
1
1−Cy +T Bim · −Cr · ∆r = 1.666666667 · −3 · −0.000344828 = 0.001724138

– Similarly, the crowding-in of investment:

1
1−Cy +T Bim · −Ir · ∆r = 1.666666667 · −15 · −0.000344828 = 0.00862069

– Crowding-in of government spending

1
1−Cy +T Bim · −Gr · ∆r = 1.666666667 · −2.85 · −0.000344828 = 0.000574713

– Crowding-in of trade balance

1
1−Cy +T Bim · −T B · r · ∆r = 1.666666667 · −1 · 1 · −0.000344828 = 0.000574713

Economic Rationale: The decrease in the foreign interest rate leads to an increase
in the interest rate differential r − r∗ , whereby, following the uncovered interest rate
parity, the domestic currency appreciates against the foreign currency, leading to
less exports and therefore less output, amplified by the KM effects; the central bank
reacts to this decrease in output by lowering the monetary policy rate, whereby
there are crowding-in effects in consumption, investment, government spending and
the trade balance
3.9. THE EXTENDED IS-TR MODEL 51

3.8.4 Problem 3.17

In 2001, then U.S. President George W. Bush was concerned about the sluggish U.S. economy. To help
stimulate the U.S. economy, President Bush proposed a tax cut (suppose for this question that this tax cut
would occur in the form of an income tax cut). Using the IS - TR model, derive graphically the effects
on short-run U.S. output of the policy President Bush proposed. Make sure to provide, in addition to the
graphical analysis, a detailed economic rationale as to how the output effects arise.

Answer: The decrease in taxes leads to an increase in the autonomous component, A, shifting the IS-
curve outwards, as aggregate demand increases. This effect is amplified by the KM (movement from A to
B in the graph). As the output gap has widened,the central bank will increase the monetary policy rate
following its TR. This will lead to crowding-out effects in consumption, investment, government spending as
well as the trade balance via the exchange rate channel (movement from B to C in the graph). Overall, the
tax cut leads to an increase in output and higher interest rates in the economy.

3.9 The Extended IS-TR Model

3.9.1 The Model
In the previous
 section, the interest rate charged by the commercial bank on its customer isr = r̄M P +
Y −Ȳ
φy Ȳ
+ r̄ , which is the sum of the interest rate charge by the central bank r = r̄M P +φy Y Ȳ−Ȳ , plus
RP

a risk premium to account for the fact that commercial banks face the problem of information asymmetry,
i.e. they cannot know 100% sure how risky their customers are. The risk premium during normal time is
assumed to be a constant due to fierce competition in the banking market.

Following the Taylor rule, the central bank cut the interest rate when the economy is operating below
its potential output, and raise the interest rate when there are signs of overheating. However, during deep
economic crisis like the 2008 Global Recession, the centrals cut the interest rate to or very close to 0 but
the interest rate charged by commercial banks remained high. The link between central interest rate and
commercial bank lending rate broke down, and together with it, gone our then conventional wisdom that
the central could always use monetary policy tools to manipulate the economy.

The economic rationale for such a break-down between monetary policy rates and commercial bank lend-
ing rate is the fact that commercial banks loose trust on their customers during extremely bad economic
scenarios. During such time, lending is very risky because their are many customers who have solvency
problems that the banks cannot evaluate with certainty. To compensate for this problem, commercial bank
start charging a higher risk premium. The level of this higher risk premium depends on how bad the situation
of the economy is.
52 CHAPTER 3. THE SHORT RUN MACROECONOMY

To illustrate this point, we first set the Taylor monetary policy interest rate to equal zero to find out the
level of output below which the central bank cannot adjust their policy rate further downward because it is
already zero.
 ZLB 
r̄M P + φy · Y Ȳ −Ȳ = 0
ZLB
φy − r̄M P = φy Y Ȳ
Y ZLB = φȲy φy − r̄M P .

Once the economy hits the Y ZLB , commercial banks start raising the risk premium r̄RP , and the premium
is endogenous to how far the economy is below the Y ZLB . The commercial banks’ strategy of setting the
interest rate is formalized for both the normal time and the deep crisis time as:

rRP = r̄RP − ry · Y − Y ZLB · I Y < Y ZLB

(3.14)

The short-run macroeconomic model during deep crisis time has the same IS curve as in the IS-TR model
during the normal time.

C0 + Cy · (Y − T ) − Cr · r
| {z }
Household Consumption

+ I0 − Ir · r
| {z }
Firms’ Investment
Y = (3.15)
|{z} + G0 + Gy · (Ȳ − Y )
Output produced/Supply | {z }
Government Spending

+ T B0 + T Bex · (Y − T ) − T Bim · (Y − T ) + T B [0 − r (r − r∗ )]

∗ ∗
| {z }
Trade Balance

However, the interest rate is now determined by the extended TR curve:

  
MP Y − Ȳ
+ r̄RP − ry · Y − Y ZLB · I Y < Y ZLB



r = max 0, r̄ + φy · (3.16)
Ȳ

Figure 3.3: The Extended IS-TR Model

As illustrated in Figure (3.3), the extended TR curve becomes kinked and start sloping downward when
the economy’s output falls below the zero lower bound value Y ZLB . That means the risk premium is endo-
genized and depends on how serious the situation of the economy is.
3.9. THE EXTENDED IS-TR MODEL 53

Originally, the economy is operating at point A with the upward sloping part of the Extended TR curve
and the IS curve. With a strong shock of the magnitude of the Great Recession, the IS curve shift to the left
IS’ curve. The conventional monetary policy could still have been effective if their is no shock to the banking
system’s confidence. However, with such a strong shock, the banking system increased the independent part
of the risk premium, r̄RP , and start endogenizing the interest rate charged on customers. The Extended
TR curve shift to the Extended TR’ position, and the economy finds itself in a position where the lower the
ouput level, the higher the interest rate.

3.9.2 Problemset Exercises on the Extended IS-TR Model

Problem 3.18
An economy under fixed prices (for which foreign variables are exogenous) is described by the following
model:
Y = DD = C + I + G + T B;
C = C0 + Cy · (Y − T ) − Cr · r;
I = I0 − Ir · r;
G = G0 − Gr · r;
T B = T B0 + T Bex · (Y ∗ − T ∗ ) − T Bim · (Y − T ) + T B · ;
 = 0 − nr (r − r∗ )  o
r = max 0, r̄M P + φy · Y Ȳ−Ȳ



+ r̄RP − ry · Y − Y ZLB · I Y < Y ZLB .

When numerical calculations are asked for, assume the following parameter values: C0 = 1.6; Cy =
0.55; Cr = 3; T = 2.5; I0 = 3.25; Ir = 15; G0 = 2.8; Gr = 1; T B0 = 0; T Bex = 0.1; Y ∗ = 10; T ∗ = 3; T Bim =
0.15; T B = 1; 0 = 1; r = 1; r∗ = 0.03; r̄M P = 0.02; φy = 1; Ȳ = 15; r̄RP = 0.01; ry = 0.005.

a) Graph the Extended TR- curve (for general parameter values). Provide an economic rationale as to
how the slope of the Extended TR - curve depends on the level of output.

b) What is the value of output in the short-run macroeconomic outcome?

c) Calculate the effects on domestic short-run output of a simultaneous increase of the exogenous com-
ponent of the risk premium, r̄RP , by 0.02, and of the foreign real interest rate, r∗ , by 0.01? Decompose the
overall output effects into its components (that is, the Keynesian multiplier induced effect and the domestic
interest rate induced crowding out/in effects). Make sure to provide, in addition to numerical results, a
detailed economic rationale as to how the various effects arise.

a) Graph the Extended TR- curve (for general parameter values). Provide an economic rationale as to
how the slope of the Extended TR - curve depends on the model parameters.

Figure 3.4: The Extended TR Curve

Answer: In order to analyze how the slope of the extended TR-curve depends on the parameters we need
to consider two cases:
ˆ Case 1: Y > Y ZLB

When Y > Y ZLB , the extended TR curve is actually the TR curve. The slope of this segment of the
extended TR curve depends only on the parameter φy , which reflects how aggressively the central bank
reacts to a change in the deviation between actual output Y and long-term output Y . The larger the
54 CHAPTER 3. THE SHORT RUN MACROECONOMY

value of φy , the steeper, that is, the more positive the slope of the extended TR-curve in the range
Y > Y ZLB .

ˆ Case 2: Y < Y ZLB

When Y < Y ZLB , the slope depends only on the parameter ry reflecting how sharply the endogenous
risk premium changes once output changes. The larger the magnitude of ry , the steeper, that is, the
more negative the slope of the extended TR-curve in the range Y < Y ZLB .

b) What is the value of output in the short-run macroeconomic outcome?

Answer: The IS equation is (you have to derive it yourself!)

A Cr + Ir + Gr + T B · r
Y = − · r. (3.17)
1 − Cy + T Bim 1 − Cy + T Bim

Where A = C0 + I0 + G0 + T B0 + T Bex · (Y ∗ − T ∗ ) + T B · (0 + r r∗ ) − Cy · T + T Bim · T . Rewrite the IS

in a more compact form as:

Y = IS0 − IS1 · r

The definition of IS0 and IS1 should be clear from the context. First, we need to compute the zero-lower
bound output:

 
Y ZLB −Ȳ
r̄M P + φy Ȳ
=0
 MP

r̄
Y ZLB = 1 − φy Ȳ
ZLB
Y = 14.70

How to proceed from here? We do not really know if the level of actual output is below or above the Y ZLB .
The strategy here is to assume that initially Y < Y ZLB , using the extended TR-curve:


r = r̄RP − ry · Y − Y ZLB

Plugging r into the IS curve to get:

Y = IS0 − IS1 r̄RP − ry · Y − Y ZLB .


Y = IS0 − IS1 r̄RP + ry · Y ZLB + IS1 ry · Y.


(1 − IS1 ry ) · Y = IS0 − IS1 r̄RP + ry · Y ZLB

IS0 − IS1 r̄RP + ry · Y ZLB
Y = . (3.18)
1 − IS1 ry

Plugging the parameters, IS0 = 13.97; IS1 = 33.33; and Y ZLB = 14.70 into (2.133), the short run outcomes
are:

ˆ Y = 13.42
The results indeed show that the economy is in a deep crisis. The short run interest rate is computed
as:

ˆ r = r̄RP − ry · Y − Y ZLB = 0.0164

c) Calculate the effects on domestic short-run output of a simultaneous increase of the exogenous component
of the risk premium, r̄RP , by 0.02, and of the foreign real interest rate, r∗ , by 0.01? Decompose the overall
output effects into its components (that is, the Keynesian multiplier induced effect and the domestic interest
rate induced crowding out/in effects). Make sure to provide, in addition to numerical results, a detailed
3.9. THE EXTENDED IS-TR MODEL 55

economic rationale as to how the various effects arise.

Answer:
From question b), we know that the economy’s short run output is below Y ZLB . The simultaneous shocks
from r̄RP and r∗ are negative and positive, respectively. Again, using the extended IS-TR system to get:

IS0 − IS1 · r̄RP − IS1 · ry · Y ZLB

Y = (3.19)
1 − IS1 · ry

Plugging the parameter values into (2.134) to get: Y = 12.64. Using this value in (2.136) yields the value of
the new even deeper crisis interest rate as: r = 0.0403.

Now we need to decompose the impact of the composite shock that hit the economy.

To decompose the overall output effects into its components, first notice that:

∂Y ∂Y
∆Y = ∂A ∆A + ∂r ∆r,
∗
where ∆A = ∂r ∂A
∗ ∆r = T B r ∆r∗ and ∆r = ∆r̄RP − ry ∆Y . Further, we could compute the change in A,
and r using the available information as:

∆A = 1.1.0.01 = 0.01
∆r = 0.02 − 0.005(12.64 − 13.42) = 0.0239

The overall effect can now be decomposed as

ˆ The autonomous components, the KM effects:

∂Y
∂A ∆A = KM · ∆A = 1.666666667 · 0.01 = 0.1666666667

where the value of KM is taken from Problem (3.7).

ˆ Crowding-out of consumption:

− 1−CyC+T
r
Bim ∆r = −0.1195

ˆ Crowding-out of investment:

− 1−Cy I+T
r
Bim ∆r = −0.5975

ˆ crowding-out of government spending

− 1−CyG+T
r
Bim ∆r = −0.039833333

ˆ crowding-out of trade balance

1
1−Cy +T Bim · T B r ∆r = −0.039833333

Economic Rationale:
There is a notably rich set of adjustments. An increase of the foreign interest rate results in a right shift of
the IS-curve, reflecting the spot depreciation of the domestic currency, and the resultant improvement of the
trade balance. However, at the same time there is an increase in the exogenous component of the domestic
risk premium, that is, a parallel shift of the extended TR-curve upwards, which (from the calculations above)
more than offsets the effects induced by the increase of the foreign interest rate. As the economy is already
in a crisis and output is below the Y ZLB threshold the central bank cannot mitigate the negative effect of
the increase in the risk premium. As the interest rate at which households, firms and the government can
borrow increases a crowding-out will occur through the consumption, investment, government expenditure
and the exchange rate/trade balance channels. In addition, due to the decrease in output the endogenous
component of the risk premium rises as well which exacerbates the overall negative output effect.
56 CHAPTER 3. THE SHORT RUN MACROECONOMY

Problem 3.19
On the Extended IS-TR model: Suppose an economy is in a deep contraction, and features a large current
account deficit. The costs of borrowing for households and firms in this economy are high due to a high
overall risk premium. The central bank of this economy operates at the zero lower bound, and the fiscal
authorities of this economy do have fiscal space. The economy’s policy makers consider two options: (i) ex-
pansionary fiscal policy; (ii) unconventional monetary policy in the form of purchases of government bonds
at all maturities. Use an Extended IS-TR model of the form given in Problem (3.9) to contrast how the
different policies will affect the economy’s short-run output and current account. Make sure to provide, in
addition to a graphical analysis, a detailed economic rationale as to how the output and current account
effects under the different policy options arise. Can the sign of the output and current account effects be
predicted without knowledge of the numerical values of the model parameters? Explain your reasoning.

Answer:

ˆ Expansionary Fiscal Policy:

Figure 3.5: Expansionary Fiscal Policy

Fiscal Policy: An increase of government expenditure through an increase of G0 , thus shifting the
IS-curve to the right, would be particularly effective as long as output remains below its zero lower
bound level, Y ZLB , as then:

- No crowding out through the consumption, investment, government ex- penditure or exchange rate
channels takes place, and

- The endogenous component of the risk premium falls as output increases (reflecting lower rates of
default and increasing values of collateral as the economy is beginning to recover).

Output following an increase in government expenditure thus overall increases in such a setting even
more than the Keynesian multiplier would suggest.
ˆ Unconventional Monetary Policy:

Lowering the cost of borrowing for households, rms and the government through lowering the exogenous
component of the domestic risk premium, rRP , corresponds to a parallel shift of the extended TR-curve
3.9. THE EXTENDED IS-TR MODEL 57

downwards. Unconventional monetary policy will be even more effective as long as output remains
below its zero lower bound level, Y ZLB , as then the endogenous component of the risk premium falls
as output increases (reflecting again lower rates of default and increasing values of collateral as the
economy is beginning to recover), and the monetary policy rate stays at zero.

Figure 3.6: Expansionary Fiscal Policy