14.

02 - Fall 2017

Week 3
1 The Liquidity Trap
The first three parts of this problem ask you to solve for the money market equilibrium taking output as
given. The last three parts will ask you to solve for general equilibrium (equilibrium in the goods and
d
money markets). Suppose that money demand is given by MP = Y · (0.25 − i), as long as interest rates are
nonnegative and P = 1. Assume Y = 80.

(a)
If the Federal Reserve (from now on referred to as the Fed) sets an interest rate target of i = 0.05, what is
the required money supply?
Answer: The Fed needs to set the money supply so that

M s = M d (Y, i) = M d (80, .05) = 20 − 80 · .05 = 16

(b)
What is the money supply if the target rate is i = 0? Call this money supply M̄ s .
Answer: Money supply is
¯M s = M d (80, 0) = .25 · 80 = 20

(c)
If the Fed creates a money supply M s > M̄ s , what will the equilibrium interest rate be? Why?
Answer: The interest rate will bei = 0 because the interest rate cannot be negative. When M s > ¯M s ,
the marginal investor will be indifferent between holding bonds (which pay zero interest) and holding cash
(which pays zero interest). If interest rates were negative, then no one would hold bonds (because they are
illiquid and pay lower interest than cash). In this case, the demand for bonds would be zero. Although not
explicitly modeled in the problem, we can think of the supply of treasury bonds as fixed and non-zero. Thus,
the market for bonds would not be in equilibrium if interest rates were negative.

1
(d)
So far we have taken output as given. We now introduce an IS curve to solve for output endogenously:

IS : Y = 100 − 400 · i
If the Fed sets a target rate of i = 0.05, what will be the equilibrium value of output? Call this value Y ∗ .
Answer: Y ∗ = 100 − 400 · 0.05 = 80

(e)
Suppose the IS curve shifts to the left (for example, because of a drop in autonomous consumption c 0 ), so
that we get a new IS curve
IS 0 : Y = 80 − 400 · i
If the Fed sets a target rate of i = 0.05, what will be the equilibrium value of output? Can the Fed make
the economy “recover” so that the equilibrium level of output is Y ∗ again?
Answer: The equilibrium value of output will be Y 0 = 80 − 400 · .05 = 60. The Fed can lower interest
rates to i = 0 to obtain a new equilibrium value of output Y 00 = 80 − 400 · 0 = 80 = Y ∗ . To achieve this, the
Fed must set money supply to:

M s = M d (Y ∗ , 0) = M d (80, 0) = 20

(f )
Suppose the IS curve shifts further to the left (for example, because of a deep drop in autonomous consump-
tion c 0 ), so that we get a new IS curve

IS 00 : Y = 40 − 400 · i
If the Fed sets a target rate of i = 0.05, what will be the equilibrium value of output? Can the Fed make
the economy “recover” so that the equilibrium level of output is Y ∗ again?
Answer: The new equilibrium value of output will be Y 0 = 40 − 400 · 0.05 = 20. Even if the Fed reduces
the interest rate to i00 = 0, equilibrium output will equal Y 00 = 40 − 40 · 0 = 40. Since the interest rate cannot
be lower than zero, the Fed cannot make equilibrium output return to its original value Y ∗ = 80.

2 Quantitative Easing
Consider an extended IS-LM model with a risk premium x:

IS : Y = 100 − 400 · (i + x)

LM : i = ī

Md
M oney Demand : = Y (0.25 − i)
P

P =1

2
(a)
If x = .1 and ī = 0.05, solve for equilibrium output. Call this level of equilibrium output Y ∗ . What is the
equilibrium money supply?
Answer:
Y ∗ = 100 − 400 · .15 = 40

Ms = Md
= Y (.25 − i)
= 40(.25 − .05)
= 40(.2)
=8

(b)
Suppose the IS curve shifts to the left:

IS 00 : Y = 40 − 400 · (i + x)

Suppose the Fed cannot change x, but can change i. What is the maximum possible level of output that
the Fed can induce in the economy if x = 0.1?
Answer: The Fed sets i = 0, so that Y = 40 − 400 · .1 = 0.

(c)
Suppose the interest rate is set as in (b). Solve for the equlibrium level of the money supply as a function
of x.
Answer:

Ms = Md
= (40 − 400 · (i + x))(.25 − i)
= (40 − 400x)(.25)
= 10 − 100x

(d)
Now suppose the Fed can influence both i and x as well. Can it return the economy to Y ∗ ? If so, what
value of xdoes it choose, and what is the equilibrium level of the money supply? Show graphically using the
IS-LM model.
Answer: Yes, it can, by setting i = 0 and x = 0:

Y = 40 − 400 · (0 + 0) = 40

3
 This implies that the money supply is equal to:

M s = 10 − 100(0) = 10
Graphically, the lower interest rate shifts the LM curve down and the lower risk premium shifts the IS
curve to the right.

(e)
In lecture we learned that the Fed can reduce the nominal interest rate i by buying treasury bonds (and
exchanging them for the newly created money supply). Explain an analogous mechanism through which the
Fed can reduce the risk premium.
Answer: In the standard IS-LM model, the Fed can reduce the interest rate by increasing the money
supply, and using the newly created money to buy government bonds. This increases the price of government
bonds, and reduces the yield (remember that 1 + i = P1 b where P b is the price of government bonds and i is
the nominal interest rate).
Analogously, the Fed can use the expanded money supply to buy risky non-government bonds (e.g.
mortgage backed securities). This increases the price of these non-government bonds and reduces the amount
of interest that investors must receive to hold these bonds. Intuitively, if you are an investor, you will demand
a higher interest rate i+x on riskier bonds, such as mortgage backed securities. If the Fed promises they will
buy your mortgage backed securities at a given price, then the risk from holding these risky assets (e.g. the
risk the asset will have 0 value) is lower. Since the bonds have lower risk, the investors willing to hold that
bond will require that the bond pay a lower interest rate i + x0 < i + x. This reduces the risk premium.

4
3 Labor Market Calculations
Suppose that the non-institutional civilian population is 500 million, of which 300 million are employed, 30
million are unemployed, and the rest don’t have a job and are not actively looking for one.

(a)
How is the labor force defined? What is the labor force?
Solution: the labor force is defined as the total count of employed and unemployed people. Hence, if L is
expressed in millions of people:
L = 30 + 300 = 330

(b)
Define and compute the unemployment rate.
Solution: Unemployment rate is computed as ratio of unemployed to the labor force.
30
u= ≈ 9%
330

(c)
Define and compute the employment rate.
Solution: The employment rate is defined as the ratio of employment to total non-institutional civilian
population.
300
e= = 60%
500

(d)
Define and compute the labor force participation rate.
Solution: The labor force participation rate is defined as the ratio of labor force to total non-institutional
civilian population.
330
lf p = = 66%
500

(e)
Suppose that some unemployed people are fed up with the state of the labor market and stop actively
looking for a job. In particular, suppose now there are only 10 million people looking for a job. Compute
the unemployment and employment rates. Comment.
Solution:
10
u= ≈ 3%
300 + 10

5
 300
e= = 60%
500
We can see that it seems that the state of the labor market has improved from the unemployment rate, even
though this may not signal an improvement in the state of the labor market. The employment rate is not
affected by this phenomenon.

(f )
Suppose we wish to examine the determinants of the equilibrium real wage and equilibrium level of employ-
ment N . In a graph with the real wage on the vertical axis, and the level of employment on the horizontal
axis, draw the price-setting and wage-setting relations.
What happens when the markup increases? What happens when unemployment benefits increase? Draw
the change in the equilibria in two separate graphs and comment.
Solution: Draw graphs. If markup increases, then price setting equation is lower. This means that, all
else equal, employment and the real wage will be lower (movement along the wage-setting curve).
Conversely, if unemployment benefits increase, then at any given real wage, there will be less people willing
to work. This means that the wage-setting equation shifts to the left. While the equilibrium real wage does
not change, we see a decrease in employment.