Professor Christiano

Economics 311, Winter 2004

Solutions to First Midterm

1. Multiple Choice.

(a) v.
(b) ii.
(c) v.
(d) iv.
(e) ii.
(f) ii.
(g) iv.
2.
(a) The goods market is in equilibrium when total demand equals total production, i.e. Y = Z. In
the standard IS-LM model, Z = C d + I d + Gd = c0 + c1 (Y T ) + I b i + G: So using the
equilibrium condition, the equilibrium output as a function of the exogenous parameters and of
the rate of interest, i is:
1
Y =
c0 c1 T + I + G b i :
1 c1
(b) For a given interest rate, the total desired spending curve is:
Z(Y ) = c0 + c1 (Y

T) + I

i + G;

so that the vertical intercept is c0 c1 T + I b i + G; while the slope is c1 : (In the gure,
goods market equilibriumis indicated by Y (i), to remind ourselves it is determined for a given
interest rate.)
(c) The nancial market is in equilibrium when money demand equals money supply, i.e.:
Solving the equilibrium condition:
Ms
=Y +L
P

L1

Md
P

Ms
P .

for i, i = L11 Y + L MP ; where all variables on the right hand side are parameters but for the
level of output Y . (In the gure, the money market equilibrium interest rate is indicated by
i (Y ), to remind ourselves that it is determined for a given level of income).
(d) The demand for money, expressed in terms of the interest rate is: i =
the vertical intercept is:

1
L1

Y + L while the slope is

1
L1 .

1
L1

Y +L

Md
P

; so that

(e)
i. The IS curve represents combinations (Y; i) such that the goods market is in equilibrium.
The IS curve has a negative slope because, as the interest rate increases, desired investment
decreases and so does goods market equilibrium output (with the latter change being larger
in absolute value than the former, because of the multiplier eect).
The LM curve represents combinations (Y; i) such that nancial markets are in equilibrium.
The LM curve has a positive slope because as income increases, money demand increases and
bond demand decreases for a given interest rate. But since money supply and bond supply
are xed, equilibrium in nancial markets requires an increase in the interest rate to increase
bond demand and reduce money demand back to their initial equilibrium levels.
ii. Above (below) the IS there is excess supply (demand) in the goods market.
For a given Y; the interest rate is higher (lower) than required for Y = Z. Because desired
investment is decreasing in the interest rate, desired investment is low (high), and so Y > Z
(Y < Z). The stock of unintended inventory investment is positive (negative).
iii. Above (below) the LM there is excess supply (demand) in the money market.
s
d
For a given Y; the interest rate is higher (lower) than required for MP = MP . Because money
demand is decreasing in the interest rate (bonds are more attractive), real money demand is
s
d
smaller (greater) than money supply, MP < MP .
iv. If G increases by G > 0; the IS curve shifts rightward. The magnitude of the rightward
shift is given by the change in equilibrium Y in the goods market for a given interest rate.
In the standard IS/LM model, this change is always bigger than the equilibrium change in
Y , since as Y increases, the equilibrium interest rate must also increase to guarantee market
clearing in nancial markets, inducing a decrease in investment demand. However, when
calculating the rightward shift of the IS-curve, we are not requiring nancial markets to
be in equilibrium: The interest rate is taken as given. From the previous answers: Y =
1
c1 T + I + G b i ; so that the rightward shift is: 1 Gc1 for any value of the
1 c1 c0
interest rate (parallel shift).
v. Disequilibrium dynamics involves two things: which market variable adjusts and how fast.
Output shifts slowly in the goods market and the interest rate shifts extremely quickly in the
nancial market. As a result of these assumptions along the adjustment path (i; Y ) is
always on the LM -curve, i.e. nancial markets are always in equilibrium.
Because of the expansionary scal shock, the IS shifts rightward by 1 Gc1 to IS 0 ; intersecting
the LM at (Y ; i ) where Y < Y < Y + 1 Gc1 and i > i : Because of the slow adjustment in the goods market, the economy does not jump directly to (Y ; i ):
Immediately after the shock, Z = Y + G > Y : There is excess demand in the goods market and hence a decrease in inventories. Firms adjust their production upwards accordingly.
As they do so, income increases, and this in turn increases money demand, requiring interest
rate to increase at the same time in order to maintain equilibrium in nancial markets This
process of output and interest rate adjustment continues until output and interest rates reach
(Y ; i ) : (Along the adjustment path, the rise in the interest rate reduces desired investment demand, but there remains a (decreasing) excess aggregate desired demand as we are
always at (Y; i) pairs below the new IS-curve.).

c0 c1T + I + G bi

intercept

intercept

1 / L1 Y + L

c1
pe=
slo

Ms
P

)
slo
p

e=
-1/
L

i * (Y )

45

Md
P

Y (i )
*

Goods Market

Money Market

LM
i **
i*

IS '
IS
Y

Y **

Y*

1
G
1 c1

"IS-LM" Diagram
3.
(a) The equilibrium condition in the Keynesian Cross model is
!

Y =Z

c0 + c1 Y

T +I +G

Solving this equation for equilibrium Y yields

1
1 c1

c0

c1 T + I + G

The multiplier on investment is

1
1
1 c1 [c0 c1 T +I+ I+G] 1 c1 [c0 c1 T +I+G]
I

1
1 c1 :

(b) The equilibrium condition in the Keynesian Cross model with t1 > 0 is
!

Yt1 >0 = Z = c0 + c1 Yt1 >0

t1 Yt1 >0 + I + G

Solving this equation for equilibrium Y yields

1
1 c1 (1 t1 )

c0

c1 T + I + G

M
P

The multiplier on investment is now

1 >0

1
1 c1 (1 t1 ) :

1
1
Since 0 < t1 < 1; 1 c1 (1
t1 ) < 1 c1 , i.e. the investment multiplier is smaller if t1 > 0 (and it is
decreasing in t1 ).
Intuition: Taxes reduce consumption and hence demand. If taxes increase with income (t1 > 0),
they will also decrease the eect of a change in income on consumption and hence demand. This
will dampen the multiplier eect of a change in autonomous expenditure on equilibrium output.

(c) The equilibrium condition in the Keynesian Cross model with q > 0 (and t1 = 0) is
!

Yq>0 = Z = c0 + c1 Yq>0

T +I +q Y +G

Solving this equation for equilibrium Y yields

1
1 c1 q

c0

c1 T + I + G

The multiplier on investment is now

1
1 c1 q :

Since q > 0, 1 c11 q > 1 1c1 (as long as q < 1 c1 ), i.e. the investment multiplier is larger for
q > 0 (and increasing in q).
Intuition: If investment increases with income (q > 0), the multiplier process is amplied. The
multiplier eect on equilibrium income of an increase in autonomous expenditures will work
through not only consumption but also investment. Hence the investment multiplier YI is larger
for q > 0 (Accelerator Eect).
(d) The magnitude of the horizontal shift of the IS curve is always equal to the product of the corresponding Keynesian Cross-Multiplierand the change in autonomous expenditure. This would
be the eect for a given interest rate. Equilibrium changes in output will however involve changes
in the interest rate as nancial markets must also be in equilibrium.
If b = 0;investment and hence aggregate demand does not depend on the interest rate. Equilibrium output is solely determined in the goods market: The IS curve is vertical. Even though the
equilibrium interest rate rises in response to I > 0 to restore equilibrium in nancial markets at
a higher Y; the investment multiplier YI is identical to the one of the Keynesian Cross model.
If investment depends negatively on the interest rate if b > 0, the equilibrium response of output
to I will be smaller than in the case b = 0;because higher output requires a higher interest rate
for the nancial markets to clear.
(In the gure, initial equilibrium is drawn at the same (i; Y ) pair to simplify the exposition)

I
IS b=0

IS b = 0

LM

ib**=0
ib**>0

i*

Yb >0
Y*

Yb*>*0 Yb*=*0

IS b > 0

I
IS b>0

Yb =0 = 11c1 I

"IS-LM" Diagram
4.
(a) In deciding whether to invest in a given project, rms have to decide on what rate of return the
project will generate. This in turn depends on how active the economy is. If rms expect the
level of activity in the economy to be high, then they will expect a high rate of returnin other
words, they form their expectation of how high economic activity will be by looking at current
output. So, the reason q > 0 is that in this case, a higher Y causes rms to revise upward their
assessment of the rate of return on all projects.
(b) Each rm has a bunch of potential projects laying around, each with an expected rate of return.
To invest in a project, they have to convince someone to give them the cash. That person has
other stu to do with the cash (this is measured by i), and so the rm manager wont even make
an attempt at a project if its rate of return is less than i. For any rm, the investment demand
curve is a downward sloped step function. As you aggregate over the whole economy the steps
become ner until its just a smooth downward sloped curve. So aggregate investment negatively
depends on the interest rate, i.e. b > 0:
5.
(a) A decrease in the money supply (or a positive shock to the liquidity demand parameter L) would
shift the LM curve upward. The new equilibrium in the goods and nancial market involves a
higher interest rate (i > i ) and lower output (Y < Y ). The direction of the adjustment

reects the assumptions on the disequilibrium dynamics.

LM '
LM

i **
i*

IS
Y

Y ** Y *

"IS-LM" Diagram
(b) A decrease in any component of autonomous expenditure would shift the IS curve leftward and the
new equilibrium would involve both a lower interest rate (i < i ) and lower output (Y < Y ).
The direction of the adjustment reects the assumptions on the disequilibrium dynamics.
i
LM

i*
i **

IS '
Y ** Y *

IS

"IS-LM" Diagram
6. In the IS-LM model (a model of the short run), equilibrium output is determined by the demand
side of the economy (how much households, businesses and governments want to buy). It is assumed
that rms do whatever it takes to produce the output that demand requires. Now suppose that
a positive technology shocks increases productivity in the production sector. The technology shock
does not aect total demand (it does not appear anywhere in our desired consumption, investment or
government consumption equations). As productivity increases and aggregate demand is unaected,
the number of workers shrinks, reducing employment (holding hours per-worker xed).
7. Desired saving is St = Yt Ct Tt = c0 + (1 c1)(Yt T ): As the loss of consumer condence is
unexpected by rms, Y1 = Y0 ; so that,as a consequence of the fall in c0 : S1 = S1 S0 =
c0 = $10:
As the economy is in equilibrium in period 0, total demand, which falls by 10$ relative to Z0 ; is
Z1 = Z0 10$ = Y0 10$ = Y1 10$: So unintended inventory investment in period one is Iu1 =
Y1 Z1 = 10$: As the economy is in equilibrium in the period 0 Iu1 = Iu1 Iu0 = Iu1 0 = 10$. As
desired investment is unchanged, the change in actual investment is Ia = 10$:

8. The equilibrium interest rate is found by equating money demand and money supply: M s = 100$ =
M d = $100 (1:05 i), so that i = :05 or i = 5%: Assuming that there are no assets other than money
and bonds, wealth is invested in either of the two that is: W = M d + B d . From this, and the fact that
the equilibrium level of nominal money is 100$; the equilibrium demand for bonds is 900$: