ECON2123

Macroeconomics
Problem Set 2 *Solution*
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100 marks total

Part I: Multiple Choice Questions. Choose the best answer. (10 marks, 2 marks each)
(e) 1. The money demand curve will shift to the left when which of the following occurs?
a. a reduction in the interest rate
b. an increase in the interest rate
c. an open market sale of bonds by the central bank
d. an increase in income
e. none of the above
(a) 2. At the current interest rate, suppose the supply of money is more than the demand for money.
Given this information, we know that:
a. the price of bonds will tend increase.
b. the price of bonds will tend to fall.
c. production equals demand.
d. the goods market is also in equilibrium.
e. the supply of bonds also equals the demand for bonds.
(e) 3. The LM curve shifts down (or, equivalently, to the right) when which of the following occurs?
a. an increase in taxes.
b. an increase in output.
c. an open market sale of bonds by the central bank.
d. an increase in consumer confidence.
e. none of the above.
(b) 4. Suppose policy makers decide to reduce taxes. This fiscal policy action will cause which of the
following to occur?
a. the LM curve shifts and the economy moves along the IS curve.
b. the IS curve shifts and the economy moves along the LM curve.
c. both the IS and LM curves shift.
d. neither the IS nor the LM curve shifts.
e. output will change causing a change in money demand and a shift of the LM curve.
(a) 5. For this question, assume that investment spending depends only on the interest rate and no longer
depends on output. Given this information, a reduction in the money supply
a. will cause investment to decrease.
b. will cause investment to increase.
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 c. may cause investment to increase or to decrease.
d. will have no effect on output.
e. will cause a reduction in output and have no effect on the interest rate.

Part II: Financial Markets (Chapter 4) (35 marks)

1. Given the following conditions: (all units are trillions of US $) (13 marks)
Money Demand: Md = $Y (0.2 – i)
Nominal Income: $Y = 2000
Money Supply: Ms = 300
(a) Find Md for i = 10% and i = 5%. (2 marks)

(b) What is the relationship between i and Md. (2 mark)

(c) Graph Ms and Md and calculate the equilibrium i. (3 marks)

(d) Now decreases Ms from 300 to 250. What happens to money market equilibrium? (solve & graph ) (4
marks)

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(e) Describe how the central bank can increase/decrease interest rate i. (2 marks)
The central bank can increase (decrease) i by decreasing (increasing) money supply. For example:

2. Bond prices and interest rate (7 marks)

Consider a bond that promises to pay $100 in one year.
(a) What is the interest rate on the bond if its price today is $75? $85? $95? (3 marks)
i=100/$PB –1; i=33%; 18%; 5% when $PB =$75; $85; $95.
(b) What is the relation between the price of the bond and the interest rate? (2 mark)
When the bond price rises, the interest rate falls. And vice versa.
(c) If the interest rate is 8%, what is the price of the bond today? (2 mark)
$PB =100/(1.08) ≈ $93

3. ATMs and Credit Cards (10 marks)

a.  $16 is withdrawn on each trip to the bank.     
        Money holdings are $16 on day one; $12 on day two; $8 on day three; and $4 on day   
four. 
   
b.  Average money holdings are ($16+$12+$8+$4)/4=$10. 
   
c.     $8 is withdrawn on each trip to the bank. 
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    Money holdings are $8, $4, $8, and    $4. 
     
d.  Average money holdings are $6. 
 
e.  $16 is withdrawn on each trip to the bank.    Money holdings are $0, $0, $0, and $16.   
 
f.  Average money holdings are $4. 
 
g.  Based on these answers, ATMs and credit cards have reduced money demand. 

4. Use the balance sheets to analyze the effects of open market operations. (5 marks)
(a) Suppose a central bank bought a $10,000 bond from a commercial bank, and to finish this transaction,
the central bank put a credit of $10,000 into the commercial bank’s account with the central bank in
exchange for bonds. What changes happen to the central bank’s balance sheet? What changes happen to
the commercial bank’s balance sheet?
Central bank:
Assets liabilities
bonds +$10,000 reserves +$10,000

Commercial bank:
Assets liabilities
bonds -$10,000
reserves +$10,000

(b) Suppose a central bank bought a $10,000 bond from the public (any nonbank), and that nonbank
seller of bonds keeps the proceeds as cash. What happens to the central bank’s balance sheet? What
happens to the nonbank’s balance sheet?
Central bank:
Assets liabilities
bonds +$10,000 currency (in circulation) +$10,000

Nonbank (the public):

Assets liabilities
bonds -$10,000
currency (or cash) +$10,000

(d) Explain the difference between these two situations in terms of overall money supply.
In both cases, the supply of central bank money is the same, $10,000. If this money is injected to the
public as cash, the money supply increases by the same amount (money supply = central bank
supply). However, if the central bank injects this money to a bank by increasing its reserve, as the
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 bank’s reserve increases, the bank can lend out more of its deposits to the public, and through the
money multiplier effect, the overall supply of money is larger than the original $10,000 (money
supply > central bank supply). So the presence of banks enlarges the overall money supply due to
the fractional reserve banking system.

Part III: The IS-LM Model (55 marks)

1. Now consider the following IS-LM model:
C = 200 +0.25 YD
I = 150 + 0.25 Y - 1000 i
G = 250
T = 200
(M/P)d = 2 Y -8000 i
(M/P)s = 1600

(a) Derive the IS relation. (hint: You want an equation with Y on the left side and everything else on the
right). (2 marks)

Y=C+I+G=200+.25(Y-200)+150+.25Y-1000i+250
Y=1100-2000i
(b) Derive the LM relation. (Hint: It will be convenient for later use to rewrite this equation with i on
the left side and everything else on the right.) (2 marks)
M/P=1600=2Y-8000i
i=Y/4000-1/5
(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.) (2 marks)
Substituting from part (b) into part (a) gives Y=1000.
(d) Solve for the equilibrium interest rate. (Hint: Substitute the value you obtained for Y in part (c) into
either the IS or LM equations and solve for i. If your algebra is correct, you should get the same
answer from both equations.) (2 marks)
Substituting from part (c) into part (b) gives i=5%.
(e) Solve for equilibrium values of C and I, and verify the value you obtained for Y by adding C, I, and
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 G. (2 marks)
C=400; I=350; G=250; C+I+G=1000

Part (c), (d), (e):

(f) Graph IS-LM diagram of above with correct labels. (Hint: You need to correctly label the x and y
axis, and denote the value of the equilibrium Y and i.) (1 mark)

(g) Now consider monetary expansion. Suppose money supply increases to (M/P)s = 1840. Solve for
equilibrium Y, i, C and I, and describe in words the effects of an expansionary monetary policy on
Y, i, C and I. (3 marks)
Y=1040; i=3%; C=410; I=380. A monetary expansion reduces the interest rate and increases
output. Consumption increases because output increases. Investment increases because
output increases and the interest rate decreases.

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(h) Set M/P equal to its initial value 1600. Now consider fiscal expansion. Suppose that government
spending G increases to G =400. Find equilibrium Y, i, C and I. Summarize the effects of an
expansionary fiscal policy on Y, i, C and I. (3 marks)
Y=1200; i=10%; C=450; I=350. A fiscal expansion increases output and the interest rate.
Consumption increases because output increases. Investment is affected in two ways: the
increase in output tends to increase investment, and the increase in the interest rate tends to
reduce investment. In this example, these two effects exactly offset one another, and
investment does not change.

(i) There is a sudden drop in consumer confidence and c0 drops from 200 to 100. How can the
government counterbalance the drop in GDP using fiscal policy as a policy instrument? (3 marks)

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2. Textbook Question 3, part (a)-(e), in Chapter 5. (15 marks)
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.  Combine the IS and LM equations and solve for Y, 
Y=[1/(1‐c1‐b1+b2d1/d2)][c0‐c1T+b0+(b2/d2)(M/P)+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/d2)(M/P) 
    To obtain equilibrium investment, substitute for equilibrium Y from part (b). 
 
e.  From part (b), holding M/P constant, equilibrium Y decreases by [1/(1‐c1‐b1+b2d1/d2)] when G 
decreases  by  one  unit.    From  part  (d),  holding  M/P  constant,  I  decreases  by  (b1‐ 
b2d1/d2)/(1‐c1‐b1+b2d1/d2)  when  G  decreases  by  one  unit.    So,  if  G  decreases  by  one  unit, 
investment will increase when b1<b2d1/d2.     

3. Policy mix (10 marks)

a.     The reduction in T shifts the IS curve to the right.    The increase in M shifts the LM curve down.   
Output increases. This is an example of two policies used in the same direction. 
 
b.     The  Clinton‐Greenspan  policy  mix  was  (loosely)  contractionary  fiscal  policy  (IS  left)  and 
expansionary  monetary  policy  (LM  down).  This  is  an  example  of  two  policies  used  in  opposite 
directions. 

4. “If investment is more sensitive to changes in the interest rate (suppose investment is a linear function
of output and interest rate, I = b0 + b1 Y – b2 i), the IS curve is flatter and fiscal policy is more effective.”
Is this statement true or false? Why? Please draw a diagram and use equations/algebra to explain. (10
marks)

Ans: False. When investment is really sensitive to changes in the interest rate (i.e, b2 large), then IS is
flatter but fiscal policy is less effective.
(1) Derive the slope of IS curve: i= - (1-c1-b1)/b2 Y +…; slope is smaller  IS curve is flatter. The
first half of the statement is correct.
(2) The effect of fiscal policy:
 Y=[1/(1-c1-b1+b2d1/d2)]
[c0-c1T+b0+(b2/d2)(M/P)+G].
 The multiplier is 1/(1-c1-b1+b2d1/d2). When b2 is larger, the multiplier is smaller (so exogenous
changes have smaller impact on Y).
(3) You should also draw a diagram to show the effect of fiscal policy is weaker when the IS curve is
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 flatter. The flatter the IS curve, the smaller the shift induced by fiscal policy shocks. The picture
should look something like this.

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