Macroeconomics. Problems and Questions - VII Ed.

Now in its seventh edition, the manual includes more than one hun-
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Giuseppe Ferraguto MACROECONOMICS

dred questions, most in multiple parts and drawn from several years
of exams at Bocconi University, on the models (IS-LM, IS-LM-PC etc.)
and topics (the macroeconomic equilibrium of a closed economy, the
labor market and unemployment, inflation, the open economy, gover-
nment debt, economic growth) covered by most introductory courses
on Macroeconomics.
The main objective of the problems is to help readers grasp the eco-
MACROECONOMICS
nomic reasoning and intuition underlying the main conclusions of the
discipline – the aspect of Macroeconomics, and more in general of
Economics, that students find the most difficult to master, but that will
turn out to be the most useful in their future.
Problems and questions
GIUSEPPE FERRAGUTO is Associate Professor of Economics at Bocconi Universi-
ty, and director of the course on Macroeconomics offered at the same institution.
7th EDITION
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Table of Contents
Introduction VII
Part I. Problems and Questions
1. The goods and financial markets 3

2. The IS-LM model 37
3. The labor market, the IS-LM-PC model, and inflation 67
4. Expectations, financial markets, and economic policies 105
5. The open economy 139
6. Government debt and economic growth 187
Part II. Solutions
1. The goods and financial markets 219

2. The IS-LM model 255
3. The labor market, the IS-LM-PC model, and inflation 285
4. Expectations, financial markets, and economic policies 323
5. The open economy 357
6. Government debt and economic growth 405
Introduction
A good exam question should test a range of abilities,

so that the very best students are stretched to the limit,
but the weaker students can still get part of it right.
(…) Good exam questions are like a scarce natural

resource. There are only so many you can mine, and
you can't keep on using the best ones year after year.
(…) Maybe the depressing job of grading exams is

still better than the stressful job of writing them.
Nick Rowe, “The depressing job of grading exams”,

Worthwhile Canadian Initiative - A mainly Canadian
economics blog, December 31, 2012.
http://worthwhile.typepad.com
This exercises and solutions manual includes the exam questions for recent editions
of the course ‘Introduction to Economics − Macroeconomics’ offered at Bocconi
University. In addition to those questions, it also presents an updated, and sometimes
drastically revised, version of some of the exercises and problems discussed during
the tutorials for the same course in recent, and not so recent, years.
The questions and problems in the following pages aim not only at familiarizing
readers with the subject matter of Macroeconomics, but also at deterring students
from a mechanical approach to the discipline and to the test. Their main objective is
to help readers grasp the economic reasoning and intuition underlying the results
derived in class – the aspect of Macroeconomics, and more in general of Economics,
that at first students find the most difficult to master, but that eventually will turn out
to be the most useful and rewarding in their future, academic and extra-academic,
careers.
VII
Macroeconomics. Problems and Questions
The manual is divided into two parts. In the first one, readers are encouraged to work
out on their own problems having exactly the same format as those included in the
final exam (a great training for the test!); the second part provides students with so-
lutions and answers, thus giving them a sense of what they ought to know.
This seventh edition also includes some questions − marked with an asterisk − that
are more difficult than those typically included in a final examination. While students
are encouraged to arrive on their own to an answer, even just a partial one, to those
questions, they are also invited to read very carefully the solutions to these more
difficult, or longer, problems which are contained in the second part of the book. The
concepts discussed there, often not covered in the textbook, are in fact needed to
answer some of the other questions presented in this manual, as well as possible
exam questions for the course.
Although this book is being published to my name, the list of people entitled to be
regarded as its co-authors is very long; at the very least, it should include the many
colleagues responsible for each of the twenty or so classes of Bocconi undergradu-
ates to which the course on Macroeconomics has been taught each year. However, I
cannot but explicitly mention Elisa Borghi, Maria Giovanna Bosco and Antonella
Mori (who in recent years have acted as referees of the exams I have prepared before
they were submitted to our students, and/or helped identify the optional readings on
the topics addressed by the course), and Francesca Garbin (who read very carefully
and gave suggestions on a preliminary version of this seventh edition); thanks to all
of them, this book is much better than it would otherwise have been. Needless to say,
all the remaining weaknesses and errors are my own responsibility.
The list of debts I have incurred would not be complete without an explicit mention
of the many students who, after sitting the exam, found the time to give (in writing,
during my office hours, or in other ways) their feedback – sometimes positive, some-
times negative – on the questions it included. Their suggestions have always been
taken seriously, although not always followed; in any case, all of them have helped
make our course better. Finally, a special thanks goes to Alessandra Startari for all
she does for the students and the instructors of the course on Macroeconomics.
Giuseppe Ferraguto
For additional questions and problems, go to
http://mybook.egeaonline.it.
VIII
Part I
Problems and Questions
Chapter 1 - The goods and financial markets
Question 1
In the economy there are only two firms, firm A and firm B. Their operations in a
given year can be summarized as follows (all figures are in thousands of Euros):
Firm A
Costs Revenues
Wages Sales to B
170 300
Purchases from B Sales to consumers

50 400
Indirect taxes
30
Firm B
Costs Revenues
Wages Sales to A
230 50
Purchases from A Sales to consumers

300 500
Indirect taxes Exports

20 100
Compute the economy’s Gross Domestic Product (GDP) using all the definitions of
this variable that it is possible to employ in this case.
4
The goods and financial markets
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Question 2
a. What is meant by ‘GDP deflator’? How is the GDP deflator computed, and how
is it used?
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b. Compared to the previous year (𝑡 − 1), in year 𝑡 the economy’s GDP defla-
tor has gone down by 1% and the real GDP growth rate has been equal to
−2%.
b.1 Compute the growth rate of nominal GDP for this economy in year 𝑡.
b.2 What is the rate at which the economy under consideration has been growing
in year 𝑡 ?
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Question 3
A closed economy in which only the goods market exists is described by the follow-
ing system of equations:
𝐶 = 𝑐𝑜
𝐼 = 𝐼̅
𝐺 = 𝐺̅
𝑇 = 𝑇̅ + 𝑡𝑌
where, as always, the positive constant 𝑐𝑜 is autonomous consumption, 𝑡 (a constant
between zero and one) is the tax rate, the positive constant 𝑇̅ is the portion of net
taxes that does not depend on income, and the other symbols have the usual meaning.
Which of the following three figures provides the correct graphical representation of
the impact on equilibrium production, initially equal to 𝑌̂1, of an increase in 𝑇̅?
Why? Explain.
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Question 4
The economy of a country in which only the goods market exists is described by the
following system of equations:
𝐶 = 𝑐0
𝐼 = 𝐼̅
𝐺 = 𝐺̅
𝑇 = 𝑡𝑌
where, as always, the positive constant 𝑐0 is autonomous consumption, 𝑡 (a constant
between zero and one) is the tax rate, and the other symbols have the usual meaning.
the impact on equilibrium production, initially equal to 𝑌̂1, of a decrease in the tax
rate? Why? Explain.
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Question 5
𝐶 = 𝑐0
𝐼 = 𝐼 ̅ + 𝑑1 𝑌
𝐺 = 𝐺̅ − 𝑔1 𝑌
𝑇 = 𝑇̅ + 𝑡𝑌

between zero and one) is the tax rate, 𝐺̅ and ̅𝑇 (both greater than zero) are the por-
tions of government spending and net taxes that do not depend on income, and the
parameters 𝑑1 and 𝑔1 , with 0 < 𝑑1 − 𝑔1 < 1, are both positive.
a. Having determined graphically in the figure below the equilibrium level of pro-
duction (𝑌̂) for this economy, derive the analytical expressions of 𝑌̂, of auton-
omous spending 𝐴 and of the multiplier implied by the model specified above.
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b. Suppose that the government raises, at the same time and by the same
amount, both 𝐺̅ and 𝑇̅, so that ∆𝐺̅ = ∆𝑇̅ > 0. Show in the graph the effects
of these changes and, using the results derived when answering the previous
point of this question, derive the analytical expressions of the changes in
equilibrium production, private saving, government saving and national sav-
ing caused by the increases in 𝐺̅ and in 𝑇̅. In your answer, make sure to
discuss in each case why reaching a definite conclusion about the direction
in which those variables will change is possible, or not possible.
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Question 6
The goods market of a nation is described by the following equations:

𝐶 = 𝑐0 + 𝑐1 (𝑌 − 𝑇)
𝑇 = 𝑇̅ + 𝑡𝑌
𝐼 = 𝐼̅
𝐺 = 𝐺̅
𝑌 = 𝐶 + 𝐼 + 𝐺,
where the parameter 𝑡 is greater than zero (so that net taxes are increasing in the level
of income), but smaller than one.
a. Derive the expression for the equilibrium level of income and that of the
multiplier for this economy.
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b. Two economists, Mary and Paul, debate on the effects of an increase in the
autonomous component of government spending 𝐺̅ on the government defi-
cit, 𝐷𝑒𝑓 = 𝐺̅ − 𝑇. According to Mary, since an increase in 𝐺̅ leads to a
higher income, and net taxes are increasing in 𝑌, raising 𝐺̅ has an uncertain
effect on the deficit. For sufficiently high values of 𝑡, the increase in tax
revenues could be so large that the government deficit could end up falling.
Economist Paul, on the other hand, believes that an increase in 𝐺̅ would still
increase the deficit, for any 𝑡 < 1. Derive the expression for the change in
the deficit, 𝛥𝐷𝑒𝑓, when 𝐺̅ varies by 𝛥𝐺̅ > 0. Which of the two economists
is right?
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Question 7
True or False?
Explain whether the following statement is true or false. Motivate your answer in a
brief but rigorous way, by making explicit reference to the relevant theory. Lack of
proper explanations will result in zero points.
“In a country where only the goods market exists, and in which 𝐺 = 𝐺̅ , 𝑇 = 𝑇̅, 𝐶 =
𝑐0 + 𝑐1 (𝑌 − 𝑇̅) and 𝐼 = 𝐼 ̅ + 𝑑1 𝑌, where 𝑑1 is a positive constant and the other sym-
bols have the usual meaning, the decrease in public (government) saving caused by
a tax cut necessarily leads to higher equilibrium national saving (the sum of private
and public saving)”.
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Question 8
Consider a country consisting of the goods market only, where 𝐶 = 𝑐0 , 𝐺 = 𝐺̅ − 𝑔𝑌,

𝑇 = 𝑇̅, and 𝐼 = 𝐼 ,̅ with 𝑔 a positive constant and the remaining symbols having the
usual meaning. Write the expression of the multiplier for this economy, and then
assume that government purchases of goods and services and net taxes are raised by
the same amount and at the same time, so that ∆𝐺̅ = ∆𝑇̅ < 0. By making explicit
reference to the goods markets equilibrium condition written as an equality between
national saving and investment, explain if, and why, it is possible to say something
about the direction in which private saving will have changed in the new equilibrium
[N.B.: you are not expected to derive the analytical expression for the change in
private saving, but just to explain whether it is possible to conclude that, in the new
equilibrium, it will have gone up, gone down, or remained constant].
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Question 9
𝐶 = 𝑐0
𝐼 = 𝐼̅
𝐺 = 𝐺̅ − 𝑔𝑌
𝑇 = 𝑇̅ + 𝑡𝑌
between zero and one) is the tax rate, 𝑔 (> 0) is the sensitivity to income of govern-
ment spending on goods and services, and the other symbols have the usual meaning.
a. Write down the analytical expressions of autonomous spending, equilibrium in-

come, and the multiplier for this economy.
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b. Suppose that the autonomous components of government purchases of goods

and services and of net taxes are cut at the same time and by the same amount,
so that ∆𝐺̅ = ∆𝑇̅ > 0. Determine the effect of this change on the government
deficit, 𝐷𝑒𝑓 = 𝐺 − 𝑇, prevailing when the goods market is in equilibrium.
Make sure to explain if, and why, the sign of the change in government deficit
will, or will not, depend on the fact that, in this economy, the parameter 𝑡 is
larger or smaller than the parameter 𝑔.
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Question 10
The goods market of a country is described by the following model:
𝐶 = 𝑐0 + 𝑐1 (𝑌 − 𝑇)
𝑇 = 𝑇̅ + 𝑡𝑌
𝐼 = 𝐼 ̅ + 𝑑1 𝑌
𝐺 = 𝐺̅
𝑌 = 𝐶 + 𝐼 + 𝐺,
where the parameter 𝑡 (the tax rate) is positive, but smaller than one, 𝑑1 (> 0) is the
sensitivity of investment to income, 𝑐1 + 𝑑1 < 1, and the other symbols have the
usual meaning.
a. Derive the expressions of equilibrium income and of the multiplier for this
economy.
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b. Suppose that autonomous consumption and the autonomous component of net

taxes rise at the same time and by the same amount, so that 𝛥𝑐0 = 𝛥𝑇̅ > 0. By
how much will equilibrium income and national saving (the sum of private and
public saving) change? Derive the expressions for the changes in those two var-
iables, and explain if and why they will rise, fall or remain unchanged.
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Question 11
Country Macro, where only the good market exists and prices are constant, is
described by the following model:
̅̅̅̅̅̅̅
𝐶 = 𝑐0 + 𝑐1 (𝑌 − 𝑇) + 𝑎 𝑊𝐹𝐻
𝑇 = 𝑇̅
𝐼 = 𝐼 ̅ + 𝑑1 𝑌
𝐺 = 𝐺̅
𝑌 = 𝐶 + 𝐼 + 𝐺.
In the equations above, 0 < 𝑐1 < 1, 𝑑1 > 0, 0 < 𝑐1 + 𝑑1 < 1, the parameter 𝑎 (>
0) is the sensitivity of consumption to the financial and housing wealth 𝑊𝐹𝐻
(assumed to be exogenous, so that 𝑊𝐹𝐻 = ̅̅̅̅̅̅̅
𝑊𝐹𝐻 ), and the other symbols have the
usual meaning.
a. Derive the expressions of equilibrium income and that of the multiplier for this
economy.
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b. Suppose that individuals experience an increase in their financial and hous-

̅̅̅̅̅̅̅ > 0. Write down the expression of the change
ing wealth, so that 𝛥𝑊𝐹𝐻
in equilibrium private saving caused by this change. In particular, explain if,
and why, private saving will rise, fall, or remain constant.
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Question 12
The economy of a country consisting of the goods market only is described by the
following equations:
𝐶 = 𝑐1 (𝑌 − 𝑇)
𝑇 = 𝑇̅ + 𝑡𝐶
𝐼 = 𝐼̅
𝐺 = 𝐺̅ ,
where the parameters 𝑐1 and 𝑡 are positive but smaller than one. In this country,
autonomous consumption 𝑐0 is therefore equal to zero, government purchases of
goods and services and investment are entirely exogenous, and net taxes depend on
consumption – as they include not just an exogenous component (𝑇̅), but also a por-
tion that is increasing in consumption (𝑡𝐶).
a. Plugging the expression for net taxes given by the second equation into the first
one, and solving for 𝐶, derive the expression that the consumption function
takes on in this economy. Next, using the definition of (private) saving and the
consumption function you have just derived, write down the (private) saving
function. In this economy, is private saving still increasing in income, 𝑌, as it
is in the standard case? Why, or why not? Explain.
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b. Using the results derived when answering the previous point, write down the
expression of the government deficit (𝐷𝑒𝑓) for this economy. Is the coun-
try’s government deficit increasing or decreasing in the level of income, 𝑌?
Why? Provide the economic intuition for your answer.
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Question 13
a. The goods market of country Zeta is described by the following equations:

𝐶 = 𝑐0 + 𝑐1 (𝑌 − 𝑇)
𝑇 = 𝑇̅
𝐼 = 𝐼 ̅ + 𝑑1 𝑌
𝐺 = 𝐺̅
𝑌 = 𝐶 + 𝐼 + 𝐺,
where 0 < 𝑐1 < 1, 𝑑1 > 0 and 𝑐1 + 𝑑1 < 1. Economist Cher thinks that, in
this economy, one could simultaneously change 𝐺̅ and 𝑇̅ so as to decrease the
government deficit 𝐷𝑒𝑓 = 𝐺̅ − 𝑇̅ without changing at the same time the equilib-
rium level of income. Economist Sonny holds a different opinion: in Zeta, cut-
ting the government deficit will always lead to a fall in equilibrium income.
Which of the two economists is right? Why? [Hint: (i) write the expression for
equilibrium income, 𝑌̂; (ii) use it to find out how the change in 𝐺̅ , 𝛥𝐺̅ , and the
change in net taxes, 𝛥𝑇̅, must be related to one another for equilibrium income
to remain constant (𝛥𝑌̂ = 0); (iii) verify whether it is possible that, for the val-
ues of 𝛥𝐺̅ and 𝛥𝑇̅ so determined, the change in the deficit 𝛥𝐷𝑒𝑓 is going to be
negative and, if so, under what circumstances this could be the case. Explain].
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24
b. Consider now a different country, one in which there is only a goods market de-
scribed by the same set of equations specified above. Write down the goods market
equilibrium condition as an equality between national (private plus public) saving
and investment, and assume that the country’s government decides to raise net taxes,
𝑇̅. In the new equilibrium, national and private saving will be larger or smaller than
before? [N.B.: you are NOT being asked to compute the expressions for the change
in private and national saving, but just to provide the economic intuition that helps
determine the direction in which they will change].
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25
* Question 14
[Equilibrium in the money market and equilibrium in the market for the
monetary base]
a. Define what is meant by “monetary base”, also known as “central bank money”,
𝐻. Assuming that individuals hold money both in the form of currency and in
that of checkable deposits, show in the graph an equilibrium position in the mar-
ket for the monetary base and discuss how the interest rate prevailing in such an
equilibrium changes following a decrease in 𝐻, an increase in 𝑐 (the fraction of
their money individuals want to hold as currency) and a rise in 𝜃 (the reserve
ratio).
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26
b. Using the diagram below, show how the same changes just considered (decrease
in 𝐻; rise in 𝑐 or 𝜃) will affect the money market equilibrium. Based on the
results of your analysis, what can you conclude about the relationship between
the value of the interest rate for which the market for the monetary base is in
equilibrium, and the value of the interest rate for which the money market is in
equilibrium?
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27
* Question 15
[Endogenous money supply]
a. Write down the money market equilibrium condition. Assuming that money de-
mand, 𝑀𝑑 , is increasing in the general price level 𝑃 and in real income 𝑌, and
decreasing in the interest rate 𝑖, represent in the graph below a position of equi-
librium in the money market, denoting by 𝑖̅ the value that the interest rate takes
on in that equilibrium.
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28
b. Suppose that the central bank aims at keeping the interest rate constant at the
level 𝑖 = 𝑖̅ and that, starting from an initial equilibrium like the one you have
just described, there is a rise in 𝑌, or in 𝑃. What should the central bank do, to
prevent such a change from leading to an equilibrium interest rate different from
𝑖̅? Explain.
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29
Question 16
True or false?
Explain whether the following statements are true or false. Motivate your answer in
a brief but rigorous way, making explicit reference to the relevant theory. Lack of
a. “Consider a simultaneous rise in the reserve ratio, θ, and in the fraction of

their money individuals want to hold in the form of currency, 𝑐. Since, for a
given monetary base 𝐻, they push money supply in opposite directions, the
two changes will have an ambiguous impact on 𝑀”.
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30
b. “A new law banning cash transactions above €500 induces individuals to

reduce the fraction of the money they hold as currency (that is, the parameter
𝑐), and to increase that held in the form of bank deposits. It follows that one
effect of the new law will be a fall in money supply, 𝑀”.
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31
Question 17
True or False?
a brief but rigorous way, by making explicit reference to the relevant theory. Lack
of proper explanations will result in zero points.
“An increase in the price of bonds in the bond market makes bonds more attractive
and induces individuals to hold a smaller share of their financial wealth in the form
of money – the demand for money falls”.
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32
Question 18
In country Alpha, the central bank chooses, and wants to keep constant at the chosen
level, the interest rate, while in country Beta the central bank chooses the money
supply 𝑀 (and, once again, keeps it constant at the level it has chosen). The figure
below depicts the money market equilibrium in the two countries. As you can see,
in this initial equilibrium position money supply is the same in both, and the same is
true about the money demand curve and the equilibrium interest rate. Explain if you
agree, or do not agree, with the following statement: “If, in both countries, income
𝑌 falls by the same amount, the central bank of Alpha will have to decrease the
money supply to keep the interest rate constant, while in Beta – whose central bank
wants to prevent the money supply from changing – the interest rate will fall”.
1
𝑀𝑑
𝑀 𝑀, 𝑀𝑑
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33
Question 19
a. Define, briefly but rigorously, the following concepts:
a.1 ‘liquidity trap’;

a.2 contractionary open market operation (make sure to explain why the
intervention you are describing is ‘contractionary’).
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34
b. Explain why, when the economy is in a liquidity trap, an increase in money sup-
ply does not lower the interest rate.
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35
Chapter 2 - The IS-LM model
* Question 1
[An analytical version of the IS-LM model − (I) The standard case
(endogenous money supply)]
In a closed economy, consumption, investment, government purchases of goods and

services and net taxes are described by the following equations:
𝐶 = 𝑐0 + 𝑐1 (𝑌 − 𝑇)
𝐼 = 𝐼 ̅ + 𝑑1 𝑌 − 𝑑2 𝑖
𝐺 = 𝐺̅
𝑇 = 𝑇̅
where 𝐼 ̅ is autonomous investment, the coefficients 𝑑1 and 𝑑2 , both positive, have

the interpretation of sensitivity of investment to income and to the interest rate, re-
spectively, and the other symbols have the usual meaning. Furthermore, assume that
the sum 𝑐1 + 𝑑1 (the “propensity to spend”) is positive but less than one, and that
nominal money demand (𝑀𝑑 ) depends positively on the general price level (𝑃) and
on real GDP (𝑌), and negatively on the interest rate (𝑖), as implied by the following
functional form:
𝑀𝑑 = 𝑃(𝑓1 𝑌 − 𝑓2 𝑖).
In the previous equation, that we have met already when answering Question 15 of
Chapter 1, the coefficients 𝑓1 and 𝑓2, both positive, have the interpretation of sensi-
tivity of (real) money demand 𝑀𝑑 ⁄𝑃 to income and to the interest rate, respectively.
Finally, suppose that the central bank sets the money supply so as to make sure that
the interest rate always takes on the value 𝑖 = 𝑖̅.
a. Derive the analytical expression of the IS curve for this economy, and draw the
IS in the (𝑌, 𝑖) plane. What determines the slope of the curve? And what causes
parallel shifts of the IS curve in the plane? Explain, using the graphs below and
providing the economic intuition underlying your answers.
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38
The IS-LM model
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39
b. Derive the analytical expression of the LM curve for this economy, and draw
the LM in the (𝑌, 𝑖) plane.
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40
The IS-LM model
c. Derive the equilibrium values of 𝑌 and 𝑖. By how much will equilibrium

output change if autonomous demand changes by 𝛥𝐴? And by how much,
following a change 𝛥𝑖̅ in the level of the interest rate chosen by the central
bank?
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41
* Question 2
[An analytical version of the IS-LM model − (II) Exogenous money supply]
Consider an economy different from the one studied in the previous question only
for the fact that, rather the interest rate, its central bank chooses a value for the nom-
inal money supply 𝑀, and then lets the interest rate take on any value that turns out
to be consistent with the macroeconomic equilibrium for that given 𝑀.
a. Denoting by 𝑀̅ the value of 𝑀 chosen by the central bank, derive the analytical
expressions of the IS and LM curves for this economy.
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42
The IS-LM model
b. Draw the portion of the LM curve entirely lying in the first quadrant of the (𝑌, 𝑖)
plane (that is, the portion of the curve corresponding to positive values of both
output and the interest rate).1 What determines its slope? Which are the causes
of parallel shifts of the LM curve in that plane? Explain, using the following
graphs and providing the economic intuition underlying your results.
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1 The assumption that the nominal interest rate cannot take on negative values allows us to disregard
the portion of the LM curve lying in the second quadrant. We shall discuss later on the shape of the LM
curve when the nominal interest rate is zero (that is, when it is at its "zero lower bound") and − as
assumed in the present question − the central bank chooses the nominal money supply.
43
c. Derive the equilibrium values of 𝑌 and 𝑖. By how much will equilibrium output
change if autonomous demand changes by 𝛥𝐴? And by how much, following a
change 𝛥𝑀 ̅ in the nominal money supply?
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The IS-LM model
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45
Question 3
a. Gamma is a closed economy described by a standard IS-LM model,,1 given by

the following system:
𝐴 1 − 𝑐1 − 𝑑1
𝑖= − ·𝑌
𝑑2 𝑑2
𝑖 = 𝑖̅ .
In the equations above, 𝑖̅ is the value of the interest rate chosen by the central
bank, and the other symbols have the usual meaning. As discussed in the answer
to Question 1 of this Chapter, in this model the fiscal policy multiplier is:
𝛥𝑌̂ 1
= . (∗)
𝛥𝐴 (1 − 𝑐1 − 𝑑1 )
What does the ‘fiscal policy multiplier’ measure? Knowing that, in Gamma, it
equals 2, by how much will equilibrium output change if government spending
on goods and services 𝐺̅ goes up by 200 and, at the same time, autonomous con-
sumption 𝑐0 falls by 100? Explain.
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1
From now on, by "a standard IS-LM model" we shall mean a model like the one studied in Question
1 of this Chapter, and therefore based on the following assumptions:
 consumption function of disposable income, investment function of 𝑌 and 𝑖, nominal money
demand function of 𝑃, 𝑌 and 𝑖;
 𝐺 and 𝑇 both exogenous;
 the central bank chooses a value 𝑖 = 𝑖̅ for the interest rate, and sets nominal money supply to
whatever level is consistent with the attainment of this target value for 𝑖;
 constant prices, and therefore current and future expected inflation rates equal to zero.
46
The IS-LM model
b. Consider now two different countries, Delta and Epsilon, whose IS curves
are drawn in the graphs below. Suppose that the different slopes of the two
curves only reflect differences in the value that the parameter 𝑑2 , the sensi-
tivity of investment to the interest rate, takes on in the two countries. All the
remaining parameters take on identical values in Delta and in Epsilon. Ex-
plain what is meant by “monetary policy multiplier”,
𝛥𝑌̂ 𝑑2
=−
𝛥𝑖̅ (1 − 𝑐1 − 𝑑1 )
and, making explicit reference to this concept (discussed in the answer to
Question 1 of this Chapter), discuss if the central bank's decision of changing
the interest rate by the same 𝛥𝑖̅ in the two countries will change equilibrium
output more in Delta or in Epsilon.
𝐷𝐸𝐿𝑇𝐴 𝐸𝑃𝑆𝐼𝐿𝑂𝑁
𝑖 𝑖
𝐼𝑆𝐷𝑒𝑙𝑡𝑎
𝐼𝑆𝐸𝑝𝑠𝑖𝑙𝑜𝑛
𝑌 𝑌
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Question 4
a. In country Macro, described by the IS-LM model, government purchases of

goods and services, net taxes and investment are exogenous (𝐺 = 𝐺̅ , 𝑇 = 𝑇̅ and
𝐼 = 𝐼 )̅ , while the consumption function is 𝐶 = 𝑐0 + 𝑐1 (𝑌 − 𝑇̅) − ℎ2 𝑖, where the
parameter ℎ2 > 0 is the sensitivity of consumption to the interest rate. In this
economy, will the slope of the IS curve in the (𝑌, 𝑖) plane be negative, zero or
positive? Explain. [Hint: no formal derivation of the IS curve is required – just
provide the economic intuition underlying your answer]. Next, represent the
initial equilibrium of Macro in an IS-LM diagram, denote it by ‘0’ and study the
effects of a decrease in net taxes. In particular, denote by ‘1’ the new equilibrium
the economy will reach and explain the reasons for the changes in equilibrium
income, consumption and investment that will take place in the move from ‘0’
to ‘1’. As the economy goes from the first to the second equilibrium, how must
the changes in consumption and in income be related to one another?
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The IS-LM model
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b. Suppose now that Macro’s central bank intends to bring back equilibrium in-
come to its initial level, 𝑌0 . To achieve its goal, should it raise or lower the inter-
est rate? Show in the graph the new equilibrium that will be reached following
the monetary policy intervention that you are proposing, denoting it by ‘2’. Fi-
nally, compare the composition of aggregate demand at ‘2’ with that prevailing
in the initial equilibrium ‘0’.
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Question 5
True or false?
a. “In an IS-LM model that departs from the standard case only for the fact that,
rather than the interest rate, the central bank chooses the nominal money supply,
keeping it constant at the level 𝑀 = 𝑀 ̅ , the higher the sensitivity of investment
to the interest rate, the larger the increase in equilibrium income caused by an
expansionary fiscal policy”.
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The IS-LM model
b. “In a standard IS-LM model, in which the central bank chooses the interest rate
and keeps it constant at the level deemed appropriate given the state of the econ-
omy (for instance, at 𝑖 = 𝑖̅), the higher the sensitivity of investment to the interest
rate, the larger the increase in equilibrium income caused by an expansionary
fiscal policy”.
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51
Question 6
a. Gamma is a closed economy initially in goods and in money markets equilib-

rium. A wave of optimism about the economic future of the country leads to an
increase in autonomous consumption, 𝑐0 . Using a standard IS-LM model,
graphically represent the effects of such a change on equilibrium income. In ad-
dition, discuss the effects on equilibrium consumption, investment, private sav-
ing and national saving, explaining the reasons for the observed changes in these
variables.
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The IS-LM model
b. Consider now country Delta. The only difference between Gamma and Delta
lies in the policy rule followed by their central banks. While, as we already
know from the first part of this question, Gamma's central bank chooses a
level for the interest rate, Delta's central bank chooses a level for the nominal
supply of money 𝑀 and, given that level, lets the interest rate take on any
value that turns out to be consistent with the macroeconomic equilibrium.
Suppose now that, when the two countries are in an initial equilibrium with
identical values of 𝑌 and 𝑖, Delta experiences the same increase in 𝑐0 dis-
cussed in the previous point of this question. Compared with what happened
in Gamma, will income change more or less in Delta? Represent graphically,
and explain.
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Question 7
a. Consider the economy of country Epsilon, described by an IS-LM model depart-

ing from the standard case only because the (private) saving function is 𝑆 =
−𝑐0 + (1 − 𝑐1 )(𝑌 − 𝑇̅) + ℎ2 𝑖, where ℎ2 > 0 is the sensitivity of savings to the
interest rate and the other symbols have the usual meaning.
a.1 Write down the consumption function for this economy.
a.2 Assuming that all the other behavioral functions (investment, money demand,
etc.) are standard, explain if and why, following an expansionary monetary pol-
icy, when ℎ2 > 0 equilibrium income increases more or less than in the stand-
ard case (ℎ2 = 0) [Hint: no formal derivation of the IS and LM curves is re-
quired – just provide the economic intuition underlying your answer].
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The IS-LM model
b. If, rather than a monetary expansion, to be implemented is going to be a fiscal

expansion (consisting for instance in an increase in government purchases of
goods and services, 𝐺̅ ), how will your answer to the previous point a.2 change?
In particular, compare the change in equilibrium output in Gamma (where ℎ2 >
0) with the change that would prevail in the standard case (ℎ2 = 0). Illustrate in
the graph below, and explain.
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Question 8
True or false?
a. “The government of an economy described by a standard IS-LM model decides

to implement an expansionary fiscal policy. To keep the interest rate at its target
value 𝑖 = 𝑖̅, the central bank will have to raise money supply by an amount that
is going to be larger the more sensitive is money demand to changes in income”.
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56
The IS-LM model
b. “When the economy is in a liquidity trap, with the nominal interest rate at its
‘zero lower bound’, an expansionary fiscal policy cannot influence the equilib-
rium level of output”.
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57
Question 9
Consider a country described by an IS-LM model departing from the standard one only
for the fact that, rather than the interest rate, the central bank chooses the nominal
money supply and, given the level selected for 𝑀, allows the interest rate to take on
any value is consistent with the macroeconomic equilibrium. We are therefore in the
case considered in Question 2 of this Chapter. In particular, and as it was assumed
there, real money demand is 𝐿(𝑌, 𝑖) = 𝑓1 𝑌 − 𝑓2 𝑖.
a. Suppose that the country is in a ‘liquidity trap’. Represent in the graph its
initial equilibrium, denoting it by ‘1’, and by 𝑖1 and 𝑌1 the values that the
interest rate and production take on in that equilibrium position. Assume
now that autonomous consumption 𝑐0 and net taxes 𝑇̅ fall at the same time
and by the same amount, so that 𝛥𝑐0 = 𝛥𝑇̅ < 0. Show in the graph, and
explain, how these changes affect the levels of the country’s interest rate and
output, denoting by 𝑖2 and 𝑌2 the values these variables will take on in the
new equilibrium (‘2’). In this new equilibrium position, investment will be
higher or lower? And what about national saving (the sum of private and
public saving)? Motivate your answer.
58
The IS-LM model
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b. Suppose now that the central bank of the country attempts to return income
to the initial level, 𝑌1 , by implementing a conventional monetary policy −
for instance, an open market operation. Show in the graph the equilibrium
that will prevail after the central bank’s intervention. Explain.
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59
Question 10
True or false?
Define the concept of real interest rate (𝑟), and write the equation that shows how 𝑟
and nominal interest rate (𝑖) are related to one another. Use this equation to explain
if you agree, or do not agree, with the following statements:
a. “If individuals expect positive inflation, then the real interest rate will be greater
than the nominal one.”
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60
The IS-LM model
b. “The zero lower bound for the nominal interest rate implies that the real interest rate
cannot be greater than minus the expected inflation rate, −𝜋 𝑒 ”.
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61
Question 11
The economy is described by an "extended" IS-LM model − that is, by an IS-LM

model based on the following additional assumptions:
− the central bank can set the real rate 𝑟, that therefore becomes the “policy
rate“ determined by monetary policy, and keep it at the chosen level, let's
call it 𝑟̅ ;
− spending decisions (in particular, investment decisions by firms) depend on
the “real borrowing rate” 𝑟 + 𝑥, sum of the (real) policy rate and the risk
premium (𝑥).
Starting from an initial equilibrium position, suppose that the risk premium 𝑥 goes
up, and government purchases 𝐺̅ down. The central bank changes the policy rate to
prevent these changes in 𝑥 and 𝐺̅ from affecting equilibrium production, that there-
fore remains unchanged. In the move from the initial equilibrium to the one that will
be reached following the changes in 𝑥, 𝐺̅ and 𝑟 described above, the “real borrowing
rate” 𝑟 + 𝑥 will have gone up, down, or will have remained unchanged? Why? Ex-
plain.
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62
The IS-LM model
Question 12
Consider an economy with constant prices described by an “extended” IS-LM

model, with a central bank that chooses the interest rate. How will a decrease in the
degree of risk aversion prevailing in the country’s financial markets affect the posi-
tion in the plane and/or the slope of the curves represented in the IS-LM diagram?
Say the central bank is determined to keep income constant even in face of this
change. To achieve its aim, should it buy or sell bonds in the open market? And what
if it decides to prevent income from varying by means of a change in the reserve
ratio θ? In this case, should it try to cause an increase or a decrease in θ? Why?
Explain.
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63
Question 13
Consider a country described by an ‘extended’ IS-LM model that differs from the
one described in the previous question only for the fact that consumption takes on
the following functional form:
𝐶 = 𝑐0 + 𝑐1 (𝑌 − 𝑇̅) + 𝑎 𝑊𝐹𝐻
̅̅̅̅̅̅̅ .
In the equation above, 𝑊𝐹𝐻 is the individuals’ financial and housing wealth,
assumed to be exogenous, and the parameter 𝑎 is greater than zero.
a. In this economy, will the slope of the IS curve differ from that prevailing in
the standard case, where consumption is a function of disposable income
only (𝑎 = 0)? If so, will the IS curve be steeper or flatter than in the standard
case? If not, why? Explain. [Hint: you are not being asked to derive the
analytical expression of the IS curve and of its slope, but just to discuss
whether this slope will be different from the one prevailing in the standard
case, and to provide the economic intuition underlying your answer.]
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64
The IS-LM model
b. Due to a stock market crash, individuals experience a fall in their financial and
housing wealth. In addition, an increase in financial market participants’ de-
gree of risk aversion leads to a marked rise in the risk premium 𝑥. Assuming
that it was initially in an equilibrium that you will denote by ‘1’ in the graph
below, show the new equilibrium to which the economy will converge fol-
lowing the two changes mentioned before (fall in 𝑊𝐹𝐻̅̅̅̅̅̅̅; rise in 𝑥), and denote
it by ‘2’. In the move from ‘1’ to ‘2’, how will the composition of aggregate
demand have changed? Explain.
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65
Chapter 3 - The labor market, the IS-LM-PC
model, and inflation
Question 1
Consider an economy that is initially in medium run equilibrium, with an unemploy-

ment rate at the natural level.
a. A new law that increases unemployment benefits is passed. Show in the graph
the effects of such a change on the real wage and on the natural rate of unem-
ployment. Provide the economic intuition behind the results you get.
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68
The labor market, the IS-LM-PC model, and inflation
b. Realizing that the law just passed has an impact on employment, but still deter-
mined to provide income support for those who lose their job, the government
implements measures aiming at increasing the degree of competition in the
goods market. Assuming that such measures succeed in returning the unemploy-
ment rate to the natural level − that is, to the level prevailing before the increase
in unemployment benefits −, show the effects of this second policy intervention
in the same graph used to answer the previous point of this question.
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69
Question 2
a. Define briefly, but rigorously, the following concepts:
a.1 “accelerationist” (sometimes also referred to as “expectations-

augmented”) Phillips curve;
a.2 stagflation.
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b. Explain if and why you agree or disagree with the following statement:
“In order to increase the natural level of production 𝑌𝑛 , policy-makers can follow
two alternative strategies: (i) they can try to increase the demand for goods per-
manently, for example by opting for a permanent increase in either the money
supply or in government purchases of goods and services, or (ii) they can decide
to implement ‘supply-side’ policies, such as those leading to an increase in the
degree of competition in the goods market. The difference between the two strat-
egies above is that the first one will lead not just to an increase in 𝑌𝑛 , but also to
a permanently higher level of prices, while the second strategy will push the
economy towards an equilibrium characterized by a higher 𝑌𝑛 and a lower gen-
eral price level.”
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Question 3
True or False?
a. “The zero lower bound for the nominal interest rate implies that the real in-
terest rate cannot be smaller than minus the expected inflation rate, −𝜋 𝑒 ”.
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b. If 𝜋𝑡𝑒 = 𝜋𝑡−1 , from the accelerationist Phillips curve it follows that, to bring the
unemployment rate below its natural level, policymakers must be willing to tol-
erate an increase in the inflation rate.
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Question 4
True or False?
a. “A decrease in firms' market power leads to a fall in the inflation rate”.
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b. “From the Phillips curve, 𝜋𝑡 = 𝜋𝑡𝑒 − 𝛼(𝑢𝑡 − 𝑢𝑛 ), it follows that, for a given
natural rate of unemployment 𝑢𝑛 , the current inflation rate 𝜋𝑡 can fall if and
only if the current rate of unemployment 𝑢𝑡 increases”.
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Question 5
True or False?
a. “In country Alpha 𝜋𝑡𝑒 = 𝜋𝑡 , while in country Beta 𝜋𝑡𝑒 = 2%. It follows that, to
keep the rate of unemployment at the natural level (𝑢𝑡 = 𝑢𝑛 for each time 𝑡), the
rate of inflation must remain constant in Alpha, and increase at a rate greater
than 2% in Beta”.
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b. “In country Gamma 𝜋𝑡𝑒 = 3%, while in country Delta 𝜋𝑡𝑒 = 𝜋𝑡−1 . It follows that,
to keep the rate of unemployment at the natural level (𝑢𝑡 = 𝑢𝑛 for each time 𝑡),
in both countries the rate of inflation must remain constant over time ”.
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77
* Question 6
[The natural rate of interest - Monetary policy and fiscal policy in the
medium-run]
Consider an economy described by the following equations:

𝐶 = 𝐶(𝑌 − 𝑇̅)
𝐼 = 𝐼(𝑟 + 𝑥, 𝑌)
𝐺 = 𝐺̅
𝑌 =𝐶+𝐼+𝐺
𝑀𝑑 = 𝑃 ∙ 𝐿(𝑟 + 𝜋 𝑒 , 𝑌)
𝑀⁄𝑃 = 𝐿(𝑟 + 𝜋 𝑒 , 𝑌)
𝜋 − 𝜋 𝑒 = (𝛼 ⁄𝐿)(𝑌 − 𝑌𝑛 )
where 𝑀 is nominal money supply, the term 𝜋 𝑒 appearing in the Phillips curve (the
last equation) is expected inflation, and the other symbols have the usual meaning.
a. Define the concept of natural rate of interest, 𝑟𝑛 , and discuss its determinants
using a graph in which the real rate 𝑟 is measured along the vertical axis, and
goods' supply and demand along the horizontal one.
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b. Explain what is meant by “neutrality of money”. Using the graph you have
drawn to answer the previous point, and assuming that individuals expect
zero inflation (𝜋 𝑒 = 0), verify that money is neutral in the model considered
in this question.
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c. And what about fiscal policy? In the medium-run, is it neutral, too? To an-
swer, study the medium-run effects of a restrictive fiscal policy consisting
in a permanent decrease in 𝐺̅ using a graph similar to the one employed to
answer the previous point.
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Question 7
a. By making reference to the graph “supply of goods-demand for goods” used to

analyse the determination of the medium-run equilibrium, natural real interest
rate, 𝑟𝑛 , explain if and how 𝑟𝑛 will change if, following a change in preferences,
autonomous consumption 𝑐0 goes up. In addition, compare the composition of
aggregate demand prevailing in the new medium run equilibrium that will be
reached after this change with that prevailing before the increase in 𝑐0 .
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b. Using once again the graph “supply of goods-demand for goods”, explain if and
how 𝑟𝑛 will change following an increase in firms’ market power that leads to a
higher mark-up (a higher value of the parameter 𝑚 in the WS-PS model). In
addition, compare the composition of aggregate demand prevailing after this
change with that prevailing before the increase in the mark-up.
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* Question 8
a. Gamma is a closed economy with flexible prices described by an IS-LM-PC

model. Represent in the graphs below the medium-run equilibrium of Gamma
under the following two alternative assumptions about the way wage setters form
their expectations about this year’s inflation:
a.1 𝜋 𝑒 = 𝜋̅, where 𝜋̅ is a constant that does not depend on last year’s inflation
rate;
a.2 𝜋 𝑒 = 𝜋−1, where 𝜋−1 is last year’s inflation rate.
a.1: 𝜋 𝑒 = 𝜋̅ a.2: 𝜋 𝑒 = 𝜋−1
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b. One sometimes reads that, since over the past few decades central banks in sev-
eral major countries and regions of the world have been successful in hitting
their chosen target for the inflation rate, inflation expectations have become “an-
chored”, so that 𝜋 𝑒 = 𝜋̅, with 𝜋̅ the target set by the central bank. Does this make
the alternative case, 𝜋 𝑒 = 𝜋−1, irrelevant?
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Question 9
Consider a country where 𝜋 𝑒 = 𝜋̅, investment is entirely exogenous (𝐼 = 𝐼 )̅ , and

consumption depends not just on disposable income, but also on the real interest rate,
as implied by the consumption function 𝐶 = 𝑐0 + 𝑐1 (𝑌 − 𝑇̅) − ℎ2 𝑟, where the pa-
rameter ℎ2 > 0 is the sensitivity of consumption to the real interest rate. The rest of
the economy is described by an IS-LM-PC model based on the usual assumptions.
In particular, net taxes and government purchases of goods and services are exoge-
nous (𝑇 = 𝑇̅ and 𝐺 = 𝐺̅ ), and the central bank chooses the (real) policy interest rate,
𝑟.
a. Discuss how the IS curve will be sloped in this economy. Furthermore, suppose
that the economy was initially in a medium run equilibrium with 𝑌 = 𝑌𝑛 , 𝑟 =
𝑟𝑛 e 𝜋 − 𝜋−1 = 0, and that, in the attempt to offset a fall in autonomous con-
sumption by 𝛥𝑐0 < 0, the government of the country cuts net taxes by an equal
amount, so that 𝛥𝑐0 = 𝛥𝑇̅ < 0. Show in the graph below the new short-run
equilibrium that will be reached following the two, contemporaneous, changes
in autonomous consumption and net taxes just described, assuming that the cen-
tral bank decides to keep the policy rate at the initial level, 𝑟𝑛 . How will the
various components of aggregate demand change, in the move from the initial
medium-run equilibrium to the new short-run one?
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b. Suppose that, once the economy has reached the short run equilibrium you have
described when answering the previous point, the central bank decides to bring
income back to the natural level by implementing an open market operation. To
achieve its aim, should it buy or sell bonds in the open market? Show in the
graph the new equilibrium that will be reached following the central bank’s in-
tervention you consider appropriate. In this new equilibrium, how will the levels
of investment, consumption, private saving, public saving and national saving
compare to the levels of the same variables in the initial medium-run equilib-
rium (that is, the equilibrium prevailing before the changes in autonomous con-
sumption and the fiscal and monetary policy interventions described above)?
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Question 10
Consider an economy described by an IS-LM-PC model with 𝜋 𝑒 = 𝜋̅. For simplicity,

assume the constant value of expected inflation equals zero, so that 𝜋 𝑒 = 𝜋̅ = 0. In
an IS-LM-PC diagram, represent the initial medium-run equilibrium of the economy,
denoting it by 1, and assuming that the associated real interest rate is positive (that
is, 𝑟𝑛1 > 0).
a. Suppose that, due to a major, permanent fall in the autonomous components of

the demand for goods, the economy ends up in a new short-run equilibrium, to
be denoted by 1′ in the figure, in which output is below its natural level; further-
more, suppose that the natural interest rate associated with this lower demand,
let's call it 𝑟𝑛2 , is not only less than 𝑟𝑛1 , but also negative (𝑟𝑛2 < 0 < 𝑟𝑛1 ). In
this economy, can a “conventional” monetary policy − as the one consisting
in the decision to lower the policy rate − return output to its natural level?
Explain.
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b. To return output to its natural level, which economic policies would you
suggest?
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89
Question 11
Consider a country that is initially in a medium run equilibrium position and in which
the expected inflation rate is the constant 𝜋̅. For simplicity, assume that 𝜋̅ equals
zero, so that 𝜋 𝑒 = 0. Aside from this assumption, the economy is described by a
standard IS-LM-PC model, with a central bank that chooses the interest rate.
a. Represent the initial medium run equilibrium position of the economy, to be

denoted by 1 in the graph, assuming that it takes place for a positive value of
the natural real rate of interest (that is, 𝑟𝑛1 > 0). Suppose now that a new law
leads to an increase in the minimum wage that firms must pay their workers. In
the graph, denote by 1′ the new short run equilibrium. Compared to 1, how
have production, consumption and investment changed? Why? Explain in de-
tail. [Hint: assume that the position of the IS curve is not affected by the change
in consideration].
90
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b. Suppose that, once the economy has reached the short-run equilibrium described
in the answer to the previous point, the central bank decides to bring income to
its natural level by implementing an open market operation. Explain if, to
achieve its goal, the central bank should purchase or sell bonds, and show in the
figure the new policy rate consistent with the new medium run equilibrium, de-
noting it by 𝑟𝑛2 . Finally, discuss how the central bank should act in order not just
to bring output to its natural level, but also the general price level to the value it
was taking on in the initial medium run equilibrium.
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91
Question 12
Consider country Macro, described by an IS-LM-PC model and in which individuals

expect inflation to be constant at 2%. While Macro was, till two years ago, in a
medium run equilibrium with a real interest rate (𝑟) equal to 3%, the past couple of
years have witnessed a marked reduction in 𝑟, which has fallen to 1% both in last
year and in the current one. In addition, this year’s inflation rate has remained con-
stant at the same value it took on one year ago.
a. To understand the cause of the fall in the real interest rate, the government of
the country consults two economists, Harry and Ginny. According to Harry, the
fact that the inflation rate has remained constant allows one to conclude that the
economy must have been hit by an adverse demand shock, one to which the
central bank has reacted by bringing 𝑟 to the new, lower medium run equilib-
rium level. The reduction in the real rate therefore reflects, without any doubt, a
decrease in its natural level, 𝑟𝑛 . Ginny instead thinks that, to be able to conclude
that the economy has been experiencing a fall in 𝑟𝑛 , rather than a decision of the
central bank to bring the real rate below an unchanged natural level, further in-
formation is needed. In particular, one needs to know whether, over the past two
years, the inflation rate has remained constant at 2%, or at a level greater than
2%. Represent in the graph below the medium run equilibrium prevailing in
Macro two years ago (𝑟𝑛 = 3%), denoting it by ‘1’. In the same graph, denote
by ‘2’ the equilibrium, associated with a real rate of 1%, that would prevail if
the fall in 𝑟 is due to a decrease in the natural, medium run, real rate, and by ‘3’
that which would instead prevail if the decrease of the real rate to 1% is the
outcome of the decision of the central bank to bring 𝑟 below an unchanged nat-
ural level. Which of the two economists is right? Why? Explain.
92
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b. Say you are now told that, in Macro, rather than an inflation rate constant at 2%,
individuals always expect an inflation rate equal to that observed in the previous
period, so that 𝜋 𝑒 = 𝜋−1. Which of the two economists is right, in this case?
Why? Explain.
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93
Question 13
A country in which expected inflation for the current year equals the inflation rate
prevailing in the previous year, 𝜋 𝑒 = 𝜋−1, and in which 𝑖 ≥ 0, is initially in a me-
dium run equilibrium, with 𝑌 = 𝑌𝑛 , 𝑟𝑛 = 0 and 𝜋 𝑒 = 𝜋−1 = 0.
a. Assuming that the central bank chooses the interest rate, represent in the two-
panel IS-LM-PC diagram the initial medium run equilibrium, denoting it by
1. Having explained which value the nominal interest rate, 𝑖, will necessarily
take on in this initial equilibrium, suppose that the government launches an am-
bitious program of liberalizations, leading to an increase in the degree of com-
petition in the country’s goods markets. In the two panels of the graph below,
denote by 2 the new short run equilibrium that the economy will reach. In the
move from 1 to 2, how will have income changed? And what about the rate of
inflation? Why? Explain. [Hint: when answering, assume that the position of
the IS curve is not affected by the change described above].
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94
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b. If policy-makers do not intervene, how will the real interest rate and income
change next period? Why? Show in the graph, denoting by 3 the new short run
equilibrium that, absent any policy intervention, the economy would attain. To
make sure that, rather than from 1 to 2, from 2 to 3, etc., the economy goes
immediately from the initial medium run equilibrium 1 to the new medium run
equilibrium that you will denote by 4 in the graph, the implementation of the
liberalization program should be combined with a fiscal policy intervention, or
with a monetary policy one? And, once the kind of economic policy most ap-
propriate to go directly from the equilibrium 1 to the equilibrium 4 has been
detected, the proposed policy should be a restrictive or an expansionary
one? Show in the graph the effects of the policy intervention you suggest, and
comment.
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95
Question 14
Consider a country where both investment (which, as usual, is also a function of 𝑌)

and consumption depend on the borrowing rate 𝑟 + 𝑥. In particular, suppose that the
consumption function is 𝐶 = 𝑐0 + 𝑐1 (𝑌 − 𝑇̅) − ℎ2 (𝑟 + 𝑥), where the parameter
ℎ2 (> 0) is the sensitivity of consumption to the real borrowing rate, and that 𝜋 𝑒 =
𝜋−1. The rest of the economy is described by an IS-LM-PC based on the usual hy-
potheses − among them, the exogeneity of net taxes and of government purchases
of goods and services (𝑇 = 𝑇̅ e 𝐺 = 𝐺̅ ), and the assumption the central bank con-
ducts its monetary policy by choosing the real policy rate, 𝑟.
a. Having explained if, in the (𝑌, 𝑟) space, the slope of the IS curve is in this case
negative, zero or positive, assume that the economy is initially in a medium-run
equilibrium, with 𝑌 = 𝑌𝑛 , 𝑟 = 𝑟𝑛 and 𝜋 − 𝜋−1 = 0. Show in the graph, and
discuss, the short-run effects of a permanent increase in the financial markets
participants’ degree of risk aversion, assuming that the central bank keeps the
policy rate constant at the initial level, 𝑟𝑛 . In the move from the initial to the new
short-run equilibrium, how will consumption and investment change? Explain.
96
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in the answer to the previous point, the government decides to return output to
the natural level by changing 𝐺̅ . To achieve its goal, should the government raise
or lower 𝐺̅ ? Compare the levels of investment, consumption, private saving,
public saving and national saving in the new medium-run equilibrium that will
be reached after the government’s intervention to the levels of the same varia-
bles in the initial one (that is, the medium-run equilibrium prevailing before the
increases in the degree of risk aversion and in 𝐺̅ ). Explain. [Hint: write down
the (private) saving function for this economy].
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97
Question 15
In country XYZ, the production function is 𝑌 = 𝐴 · 𝑁, where 𝐴 is a positive con-

stant. In addition, when price expectations are correct (𝑃𝑒 = 𝑃), the price-setting
and the wage-setting relations are, respectively, 𝑃 = (1 + 𝑚) · (𝑊/𝐴) and 𝑊 = 𝑃 ·
𝐹(𝑢, 𝑧), where the variables have the usual meaning.
a. Provide an economic interpretation of the costant 𝐴 and, in the graph below,

show how a decrease in 𝐴 will change the equilibrium values of the real wage
and of the natural rate of unemployment.
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98
b. Assuming 𝜋 𝑒 = 𝜋−1 and that the economy was initially in a medium-run equi-
librium, show the effects of the same change in 𝐴 discussed above in an IS-LM-
PC diagram. In particular, show the new short-run equilibrium and describe the
adjustment process toward the new medium-run equilibrium to which the econ-
omy will eventually converge. Compare the levels of consumption and invest-
ment in this latter equilibrium with the levels of the same variables in the initial
medium-run equilibrium, providing an explanation for any observed change in
their values.
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99
Question 16
Country Eta, a closed economy with flexible prices and where 𝜋 𝑒 = 𝜋−1 , is initially
in a medium-run equilibrium.
a. To reduce a budget deficit deemed too high, the government of Eta decides to
raise taxes. At the same time, the central bank decides to resort to an open mar-
ket operation, aimed at preventing the fiscal policy just mentioned from chang-
ing the inflation rate, π. In an IS-LM-PC diagram, denote the initial medium-
run equilibrium by ‘1’ and represent the new medium-run equilibrium to which
Eta will converge after the implementation of the policy-mix described above.
In particular, describe the type of open market operation (purchase; sale) that
the central bank should implement to reach its objective.
100
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b. Compare the composition of aggregate demand prevailing in the initial and in

the final medium-run equilibria. How must the change in consumption and the
change in investment taking place as the economy goes from the first to the
second of such equilibria be related to one another?
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101
Question 17
Consider a country where investment is entirely exogenous (𝐼 = 𝐼 )̅ . In addition, con-

sumption depends not just on disposable income, but also on the real interest rate
and on financial and housing wealth, as implied by the consumption function 𝐶 =
𝑐0 + 𝑐1 (𝑌 − 𝑇̅) − ℎ2 𝑟 + 𝑎𝑊𝐹𝐻
̅̅̅̅̅̅̅. In this function, the parameter ℎ2 > 0 is the sen-
sitivity of consumption to the real interest rate, and 𝑎 – with 0 < 𝑎 < 𝑐1 < 1 – is the
sensitivity of consumption to the financial and housing wealth 𝑊𝐹𝐻 (assumed to be
exogenous, so that 𝑊𝐹𝐻 = ̅̅̅̅̅̅̅
𝑊𝐹𝐻 ). Finally, assume that 𝜋 𝑒 = 𝜋−1 . The rest of the
economy is described by an IS-LM-PC model based on the usual assumptions. In
particular, net taxes and government purchases of goods and services are exogenous
(𝑇 = 𝑇̅ and 𝐺 = 𝐺̅ ), and the central bank chooses the (real) policy interest rate, 𝑟.
that the economy was initially in a medium-run equilibrium with 𝑌 = 𝑌𝑛 , 𝑟 =
𝑟𝑛 and 𝜋 − 𝜋−1 = 0. Assuming that the central bank keeps the interest rate at
the initial level, 𝑟𝑛 , discuss how income, consumption and investment will
change in the new short-run equilibrium that the economy will reach if the indi-
viduals’ financial and housing wealth and net taxes fall at the same time and by
the same amount (𝛥𝑊𝐹𝐻 ̅̅̅̅̅̅̅ = 𝛥𝑇̅ < 0).
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102
b. Discuss how the central bank could bring the economy from the short-run equi-
librium just described to a medium-run equilibrium where the inflation rate
takes on the same value as in the initial medium-run equilibrium (that is, in the
equilibrium prevailing before the changes in ̅̅̅̅̅̅̅
𝑊𝐹𝐻 and 𝑇̅ described above).
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103
Chapter 4 - Expectations, financial markets,
and economic policies
Question 1
We are at time 𝑡. In country Tau, only one-year and two-year bonds exist. The time-
𝑡 price of two year bonds issued in that time period is €𝑃2𝑡 = €94. In addition,
𝑒
𝑖1𝑡+1 − the yield that market participants expect on one-year bonds that, issued at
𝑡 + 1, will mature at 𝑡 + 2 − is 4%.
a. Using the quantitative information provided above, compute the yield on the
one-year bonds issued at 𝑡, 𝑖1𝑡 .
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106
Expectations, financial markets, and economic policies
b. Suppose now that you do not share the market’s expectations about future
𝑒′ 𝑒
short-term rates. In particular, you expect 𝑖1𝑡+1 = 5%, rather than 𝑖1𝑡+1 =
4%. If you are interested in how much you will have two years from today,
should you buy two-year bonds or a sequence of one-year bonds? Or maybe
you should be indifferent between the two alternatives? Explain.
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107
Question 2
a. Alpha and Beta − two countries where only one, two and three-year bonds exist
– differ just for the expectations held by market participants about the monetary
policy that, in each of the two nations, will be implemented in the future. The
graph below shows the yield curve prevailing in the two countries in the current
period, time 𝑡 [N.B.: the yield curve prevailing in Alpha (the bold, continuous
line in the graph) and that observed in Beta (the dashed, bold line) overlap for
maturities up to two years; afterwards, Beta’s yield curve declines faster than
Alpha’s]. Which differences in individuals’ expectations about the future mon-
etary policy that will be implemented in each of the two countries can explain
the observed differences in the two yield curves?
Yield
to
maturity
7%
Alpha
6%
Beta
5%
1 2 3 Maturity
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108
b. Using the data provided in the graph, compute the current and future expected
one-year rates 𝑖1𝑡 , 𝑖1𝑒 𝑡+1 and 𝑖1𝑒 𝑡+2 prevailing today (time 𝑡) in each of the two
countries.
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109
Question 3
a. In country Zeta, only one-year and two-year bonds exist. Investors, who do care
about risk, ask for a risk premium 𝑥 to hold the two-year bond (which is risky,
as they do not know the price at which they will be able to sell it in a year). Use
the arbitrage equation to derive the (approximate) relation that will hold in this
case among the yield to maturity of a two-year bond (𝑖2𝑡 ), the current (𝑖1𝑡 ) and
𝑒
future expected (𝑖1,𝑡+1 ) yields on one-year bonds, and the risk premium (𝑥).
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110
b. Suppose that, in the current period (time 𝑡), Zeta’s yield curve is the one in the
figure below. Write on the axes the name of the variables measured along each
of them, and use your answer to the previous point of this question to compute
the numerical value that the risk premium 𝑥 takes on in this economy, knowing
that investors expect the future yield on one-year bonds to be the same as the
𝑒
current one (𝑖1𝑡 = 𝑖1,𝑡+1 ).
4%
1%
1 2
1
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111
Question 4
Alpha and Beta are two closed economies where only one-year and two-year bonds
exist. Investors, who do care about risk, ask for a risk premium 𝑥 to hold the two-
year bond. Suppose that the risk premium is smaller in Alpha than in Beta, 𝑥𝐴𝑙𝑝ℎ𝑎 <
𝑥𝐵𝑒𝑡𝑎 , and that the yield curves prevailing in the two countries are those represented
in the figure below. Using the implications that, for the slope of the yield curve,
follow from the approximated relation between yield to maturity of a two-year bond
𝑒
(𝑖2𝑡 ), the current (𝑖1𝑡 ) and future expected (𝑖1,𝑡+1 ) yields on one-year bonds, and the
risk premium (𝑥), explain if from the information on the two economies provided
above one can conclude that, in both countries, 𝑖1𝑡 is necessarily smaller than 𝑖1𝑒 𝑡+1.
If so, in which of the two countries is the yield on one-year bonds expected to rise
the most? If not, why? Explain.
Yield
to Beta
maturity
Alpha
1 2 Maturity
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112
Question 5
Consider Gamma, a country where stock prices have recently soared. To deflate what
it thinks is a stock market bubble, Gamma’s central bank decides to intervene to
return stock prices to a level closer to fundamentals. To achieve this goal, should the
central bank implement an expansionary or a restrictive monetary policy? Why? Mo-
tivate your answer by making reference to the formula for stock prices, showing the
determinants of the value of these financial assets [NB: when answering, assume
that, in each time period, the economy is described by a static IS-LM model, with
consumption and investment that depend on contemporaneous variables only].
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113
Question 6
a. We are at time t. Write down the expression defining the price (in nominal terms)
of a stock that has already paid the current dividend, and define carefully all the
variables entering it. From which principle/condition is this expression derived?
[Hint: you are not expected to derive the expression for the nominal stock price
formally; just describe in detail the considerations on which its derivation is
based].
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114
b. Explain if, and why, you agree, or do not agree, with the following state-
ments [Hint: when answering, assume that, in each time period, the econ-
omy is described by a standard, static IS-LM model, with consumption and
investment that depend on contemporaneous variables only]:
b.1 the prices of stocks at time 𝑡, €𝑄𝑡 , will unambiguously go up if indi-

viduals start expecting an increase in autonomous consumption at
time 𝑡 + 2;
b.2 if, at time 𝑡, individuals learn that from 𝑡 + 1 onwards fiscal policy
will become permanently more expansionary, and monetary policy
permanently more restrictive, then time 𝑡 stock prices, €𝑄𝑡 , will un-
ambiguously fall.
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115
Question 7
True or False?
a. If, because of new information that has become available, at time 𝑡 people
begin to expect a future decrease in the autonomous component of invest-
ment, 𝐼 ,̅ then time 𝑡 stock prices €𝑄𝑡 will certainly rise. [NB: when answer-
ing, assume that, in each time period, the economy is described by a static
IS-LM model, with consumption and investment that depend on contempo-
raneous variables only].
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116
b. If investment does not depend on the interest rate, the announcement (unex-
pected by individuals) that, from time 𝑡 onwards, monetary policy will be-
come permanently more expansionary does not lead to any change in stock
prices at time 𝑡 [NB: when answering, assume as before that, in each time
period, the economy is described by the same static IS-LM model considered
in the previous point of this question].
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117
* Question 8
[Intertemporal consumption choices – The microfoundations of the 'theory of
the very farsighted consumer']
There are only two time periods, 𝑡 (the “present”) and 𝑡 + 1 (the “future”). Make the
following assumptions on the individuals populating the economy:
 their preferences are described by the utility function 𝑈(𝐶𝑡 , 𝐶𝑡+1 ), increas-
ing and concave in its two arguments – present consumption, 𝐶𝑡 , and future
consumption, 𝐶𝑡+1 ;
 they have access to a credit market, where they can borrow and lend at the
real interest rate 𝑟;
 they earn a disposable (labor) income equal to (𝑌𝑡 − 𝑇𝑡 ) in the first period,
𝑒 𝑒 )
and expect to earn one equal to (𝑌𝑡+1 − 𝑇𝑡+1 in the second period.
a. Suppose that, at time 𝑡, the typical individual’s financial wealth (stocks, bonds,
etc.) and housing wealth (apartments, commercial buildings, etc.) are both zero.
Write down the individual’s budget constraints for each of the two periods, com-
bine them into a single intertemporal budget constraint and represent in the
(𝐶𝑡 , 𝐶𝑡+1 ) plane the problem the individual has to solve in order to maximize his
utility subject to such constraint. Where is the optimal “present consumption/fu-
ture consumption” program located? What determines whether, in the first pe-
riod, the individual will be a borrower, a lender, or rather consume exactly his
disposable income?
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119
b. Assuming that both 𝐶𝑡 and 𝐶𝑡+1 are “normal goods”, explain how the optimal
choice of present consumption will be affected by the following changes:
 a transitory increase in current disposable income [𝛥(𝑌𝑡 − 𝑇𝑡 ) > 0 and
𝑒 𝑒 )
𝛥(𝑌𝑡+1 − 𝑇𝑡+1 = 0]
 an increase in future expected disposable income [𝛥(𝑌𝑡 − 𝑇𝑡 ) = 0 and
𝑒 𝑒 )
𝛥(𝑌𝑡+1 − 𝑇𝑡+1 > 0] ;
 𝑒
a permanent increase in disposable income [𝛥(𝑌𝑡 − 𝑇𝑡 ) = 𝛥(𝑌𝑡+1 𝑒 )
− 𝑇𝑡+1 > 0].
What can you conclude about the consumption function implied by the analysis
of the individual’s intertemporal consumption choices?
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120
c. How does the consumption function you have just derived change if, at time 𝑡,
individuals have a positive − rather than zero, as assumed so far − nonhuman
wealth (𝑊𝐹𝐻), defined as the sum of financial and housing wealth?
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121
Question 9
There are only two periods, period 𝑡 (“the present”) and period 𝑡 + 1 (“the future”).
In the attempt to boost current economic activity, the government of country Delta
cuts by 100 the taxes each individual will have to pay in the current period (time 𝑡).
At the same time, the government however announces that future taxes will be in-
creased by the same amount. In other words, denoting per-capita net taxes by 𝑇, the
fiscal policy intervention just described can be summarized as follows: ∆𝑇𝑡 = −100,
𝑒
∆𝑇𝑡+1 = ∆𝑇𝑡+1 = +100.
a. Suppose that all individuals are identical and that, at the beginning of time 𝑡,
their non-human wealth is zero. Moreover, assume that 𝑟 = 0, where 𝑟 is the
real interest rate. Using the analysis of the intertemporal consumption choices,
evaluate ∆𝐶𝑡 and ∆𝐶𝑡+1 − that is, the changes in current and future consumption
levels of the typical inhabitant of country Delta caused by the intertemporal re-
allocation of taxes implemented by the government. Will the government be
successful in its attempt to increase consumption, and hence aggregate demand
and equilibrium production, at time 𝑡? If yes, indicate the fraction of the tax cut
by which time 𝑡 consumption of the typical individual will rise. If no, why? In
motivating your answer, make explicit reference to the way in which savings by
the typical individual will change at time 𝑡.
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b. Assume now that some individuals are subject to ‘liquidity constraints’. Typi-
cally, an individual who is facing a binding liquidity constraint consumes less
than he would like to, given the present value of his disposable income. This
may be due to imperfections in the financial markets, as those leading to situa-
tions in which some individuals simply have no means of getting credit, so that
their consumption in each period cannot exceed their current disposable income.
Does the existence of such constraints induce you to change your answer to the
previous point? Why? Explain.
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123
Question 10
True or False?
a. Suppose that today (time 𝑡) there is a fall in house prices. The consumption func-
tion based on the analysis of the intertemporal consumption decisions implies
that time 𝑡 consumption will rise – since houses are now less expensive than
before, individuals will need to save less to purchase one, and this will allow
them to consume more.
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124
b. Today (time 𝑡), stock prices fall. The consumption function based on the analysis
of the intertemporal consumption decisions implies that, at time 𝑡, households
will cut their consumption expenditures.
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125
Question 11
a. In country Macrolandia there are only one-year and two-year bonds. The
current and the expected future inflation rates are both zero, so that the
real and the nominal interest rates are equal. In period 𝑡 + 1 (“the future”),
a standard IS-LM model describes the functioning of the economy. In
particular, in the year 𝑡 + 1 consumption depends only on disposable in-
come at 𝑡 + 1, and investment on the interest rate and output at 𝑡 + 1 only.
Turning now to the current period (𝑡, “the present”), consumption is in-
creasing in both current and expected future disposable income, 𝐶𝑡 =
𝐶(𝑌𝑡 − 𝑇̅𝑡 , 𝑌𝑡+1
𝑒
− 𝑇̅𝑡+1
𝑒
), investment depends positively on current and
expected future income levels, and negatively on the current and expected
future levels of short-term interest rates, the demand for money has the
usual functional form, and 𝐺 and 𝑇 are exogenous as usual. Starting from
an initial equilibrium, at time 𝑡 the central bank of Macrolandia, that
chooses the interest rate, announces that it will raise the policy rate by two
percentage points both at time 𝑡 and at time 𝑡 + 1. If in Macrolandia, at
time 𝑡 the yield curve is initially horizontal, and assuming that the an-
nouncement is unexpected and believed by the individuals in the econ-
omy, which of the following three figures (where the new curve is labelled
“after”), describes the effect of the announcement on Macrolandia’s yield
curve? At time 𝑡, will the yield to maturity on two-year bonds change? If
so, by how much? If not, why?
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126
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b. Discuss how the permanent monetary contraction described in the previ-

ous point of this question will affect the various components of aggregate
demand at time 𝑡 – that is, how it will affect 𝐶𝑡 , 𝐼𝑡 and 𝐺𝑡 . Explain in
detail.
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127
Question 12
a. In country Delta, there are only one-year and two-year bonds. The current and
the expected future inflation rates are both zero, so that the real and the nominal
interest rates are equal. In period 𝑡 + 1 (“the future”), a standard IS-LM model
describes the functioning of the economy. In particular, in the year 𝑡 + 1 con-
sumption depends only on disposable income at 𝑡 + 1, and investment on the
interest rate and output at 𝑡 + 1 only. Turning now to the current period (𝑡, “the
present”), consumption is increasing in both current and expected future dispos-
able income, 𝐶𝑡 = 𝐶(𝑌𝑡 − 𝑇̅𝑡 , 𝑌𝑡+1𝑒
− 𝑇̅𝑡+1
𝑒
), investment depend positively on
current and expected future income levels, and negatively on the current and
expected future levels of short-term interest rates, the demand for money has the
usual functional form, and 𝐺 and 𝑇 are exogenous as usual. Starting from an
initial equilibrium, at time 𝑡 the government of Delta announces an increase of
its purchases of goods and services at time 𝑡 + 1, ∆𝐺̅𝑡+1 > 0. At the same time,
the central bank announces that it will adjust the policy rate so as to prevent any
change in equilibrium income that, at time 𝑡 and/or at time 𝑡 + 1, could be caused
by the fiscal policy just described. Explain how these announcements, which are
unexpected and credible, affect the time 𝑡 yield to maturity on the two-year
bonds circulating in Delta, 𝑖2𝑡 .
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128
b. Assume for simplicity that, in Delta, at time 𝑡 the yield curve is initially horizon-
tal. Explain how the position and the slope of this curve change after the an-
nouncement studied above. Represent both curves, the one “before” and the one
“after” the announcement, in the graph below. Clarify whether it is possible to
determine the position and the slope of the new yield curve unambiguously.
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129
Question 13
a. In country Beta, there are only one-year and two-year bonds. The current and
interest rates are equal. In period 𝑡 + 1 (“the future”), an IS-LM model describes
the functioning of the economy. In particular, in the year 𝑡 + 1 consumption de-
pends only on disposable income at 𝑡 + 1, and investment on the borrowing rate
(the sum of the interest rate and the risk premium 𝑥𝑡+1 ) and an output at 𝑡 + 1
only. Turning now to the current period (𝑡, “the present”), consumption is in-
creasing in both current and expected future disposable income, 𝐶𝑡 = 𝐶(𝑌𝑡 −
𝑇̅𝑡 , 𝑌𝑡+1
𝑒
− 𝑇̅𝑡+1
𝑒
), investment depends positively on current and expected future
income levels, and negatively on the current and expected future borrowing
rates, the central bank chooses in each period the interest rate, and 𝐺 and 𝑇 are
exogenous as usual. Starting from an initial equilibrium position in both periods,
at time 𝑡 individuals start expecting a decrease in the risk premium for time 𝑡 +
1, 𝛥𝑥𝑡+1 < 0. At the same time, the central bank announces that it will adjust
the policy rate so as to prevent any change in equilibrium income that, at time 𝑡
(and at time 𝑡 only), could be caused by the change in 𝑥𝑡+1 just described. Ex-
plain how these changes and announcements, which are unexpected and credi-
ble, affect the time 𝑡 yield to maturity on the two-year bonds circulating in Beta,
𝑖2𝑡 .
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130
b. Assume for simplicity that, in Beta, at time 𝑡 the yield curve is initially horizon-
tal. Explain how the position and the slope of this curve change after the change
and the announcement studied above. Represent both curves, the one “before”
and the one “after”, in the graph below. Clarify whether it is possible to deter-
mine the position and the slope of the new yield curve unambiguously.
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131
Question 14
In country Gamma, current and future expected inflation rates coincide and are equal
to zero, so that the real and the nominal interest rates are equal. In period 𝑡 + 1 (“the
future”), consumption depends only on disposable income at 𝑡 + 1, and investment
̅ + 𝑑1 𝑌𝑡+1 − 𝑑2 𝑖𝑡+1 , where symbols have the usual meaning. Turning
is 𝐼𝑡+1 = 𝐼𝑡+1
now to the current period (𝑡, “the present”), consumption is increasing in both current
and expected future disposable income, 𝐶𝑡 = 𝐶(𝑌𝑡 − 𝑇̅𝑡 , 𝑌𝑡+1 𝑒
− 𝑇̅𝑡+1
𝑒
), while invest-
ment is increasing in current and expected future income levels, and decreasing in
the current and expected future levels of short-term interest rates. Finally, 𝐺 and 𝑇
are exogenous in both periods.
a. At time 𝑡, individuals revise downwards their expectation about the value that
the autonomous component of investment will take on in the future. More spe-
̅ will drop to 𝐼 ′̅ 𝑡+1 , with 𝐼 ′̅ 𝑡+1 < 𝐼𝑡+1
cifically, they start expecting that 𝐼𝑡+1 ̅ .
At the same time, the central bank announces that, in the future, it will imple-
ment a monetary policy aimed at preventing any change in time 𝑡 + 1 equilib-
rium output that could be caused by the expected drop in autonomous invest-
ment in that period. To achieve its goal, what kind of monetary policy (expan-
sionary? restrictive?) should the central bank implement? Describe, and repre-
sent in the graph below, the effects of the two announcements on Gamma’s cur-
rent (that is to say, time 𝑡) income and interest rate equilibrium levels.
132
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b. Suppose that only one-year bonds and two-year bonds exist and that, before the
announcements described above, at time 𝑡 the yield curve was flat. What will
be the effects of the two announcements on the position and the slope of the
yield curve of Gamma?
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133
Question 15
a. In country Alpha, there are only one-year and two-year bonds. The current and
describes the functioning of the economy. In particular, in year 𝑡 + 1 consump-
tion depends only on disposable income at 𝑡 + 1, and investment on the interest
rate and output at 𝑡 + 1 only. Turning now to the current period (𝑡, “the pre-
sent”), consumption is increasing in both current and expected future disposable
income levels, 𝐶𝑡 = 𝐶(𝑌𝑡 − 𝑇̅𝑡 , 𝑌𝑡+1𝑒
− 𝑇̅𝑡+1
𝑒
), investment is exogenous, 𝐼𝑡 = 𝐼,̅
and the same is true about 𝐺 and 𝑇. Rather than the interest rate, Alpha's central
bank chooses a value for the nominal money supply 𝑀 and, given this level at
which 𝑀 is set, lets the interest rate free to take on any value is consistent with
the macroeconomic equilibrium. It follows that, in the (𝑌, 𝑖) plane, the LM curve
of Alpha is the curve discussed in Question 2 − and, for the case of an economy
in a liquidity trap, in Question 9 − of Chapter 2. Finally, in the initial equilibrium,
time 𝑡 + 1 income and interest rates levels are both positive, while at time 𝑡 the
economy is in a liquidity trap. Suppose now that, at time 𝑡, the central bank an-
nounces that it will decrease nominal money supply at 𝑡 + 1. Explain how this
announcement, which is unexpected and credible, affects the time 𝑡 yield to ma-
turity on the two-year bonds circulating in Alpha, 𝑖2𝑡 .
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134
b. Draw the yield curve prevailing at time 𝑡 before the central bank’s announce-
ment, and explain how this latter will affect the yield curve of Alpha. In partic-
ular, draw the new yield curve in the same graph, and explain if it is possible to
determine without ambiguity how its slope and position will compare to those
of the original curve.
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135
Question 16
In country ABC, there are only one-year and two-year bonds. The current and the
future expected inflation rates are both zero, so that the real and the nominal interest
rates are equal. In period 𝑡 + 1 (“the future”), a standard IS-LM model describes the
functioning of the economy. In particular, in year 𝑡 + 1 consumption depends only
on disposable income at 𝑡 + 1, and investment on the interest rate and output at 𝑡 +
1 only. Turning now to the current period (𝑡, “the present”), consumption is increas-
ing in both current and expected future disposable income, 𝐶𝑡 = 𝐶(𝑌𝑡 − 𝑇̅𝑡 , 𝑌𝑡+1 𝑒
−
𝑇̅𝑡+1 ), investment depends positively on current and expected future income levels,
𝑒
and negatively on the current and expected future levels of short-term interest rates,
the demand for money has the usual functional form, and 𝐺 and 𝑇 are exogenous as
usual.
a. Starting from an initial equilibrium, at time 𝑡 the government of ABC announces

an equal increase in net taxes in both periods, ∆𝑇̅𝑡 = ∆𝑇̅𝑡+1 > 0. At the same
time, the central bank announces that it will adjust the policy rate so as to prevent
any change in equilibrium income that, at time 𝑡 + 1 - and at time 𝑡 + 1 only -
could be caused by the fiscal policy just described.
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136
b. Do you think that the permanent increase in net taxes described before will lead
to a change in the time 𝑡 yield to maturity on the two-year bonds circulating in
ABC, 𝑖2𝑡 ? If no, why? If yes, in which direction will 𝑖2𝑡 change, and by how
much? Finally, assuming for simplicity that, in ABC, at time 𝑡 the yield curve
was initially horizontal, explain how the position and the slope of that curve will
change after the fiscal policy announcement studied above.
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137
Chapter 5 - The open economy
Question 1
a. Country Iota’s Statistical Office announces that, between year 𝑡 and year 𝑡 + 1,
gross investment has increased by €100bn, while public saving has fallen by
€50bn.
a.1 Knowing that Iota is a closed economy, by how much has private saving
changed between the same two years?
a.2 How would your answer change, were Iota an economy open to trade in
goods, services and financial assets with the rest of the world?
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140
The open economy
b. Explain, briefly but rigorously, what is meant by J-curve [in your answer,
make explicit reference to the so-called ‘Marshall-Lerner condition’].
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141
Question 2
Consider a country that is open to trade in goods and services with the rest of the
world, where the exchange rate and prices are fixed and in which only the goods
market exists. In the initial equilibrium, the country has a trade surplus.
a. Show in the graph the effects of an exogenous increase in investment on equi-

librium income and on the trade balance. Explain.
142
The open economy
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b. Does the increase in investment change the level of output for which trade is
balanced? Why, or why not?
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143
Question 3
Eta is an economy open to international trade in goods and services, and in which
financial markets do not exist. Assume that prices are constant both in Eta and in the
rest of the world.
Eta is initially in goods market equilibrium, with 𝐺̅ = 60, 𝑇̅ = 10, 𝑆 = 70, 𝐼 =
20, where 𝐺 is government spending on goods and services, 𝑇 net taxes, 𝑆 private
saving, and 𝐼 investment.
a. Using the information provided above, represent the initial equilibrium of Eta
in the two-panel diagram below, denoting it by ‘1’ [Hint: you do not need to
compute the equilibrium level of income; just show clearly where the initial
equilibrium position is located in each of the two panels below, and explain
why].
144
The open economy
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b. Suppose now that Eta’s policy-makers wish to raise equilibrium income, leav-
ing net exports unchanged. Having discussed why resorting to fiscal policy
only, or to an exchange rate policy only, does not allow the government to
achieve both its objectives, discuss the combination of the two policies which
would allow the country to reach its two goals. In the two panels of the graph,
denote by ‘2’ the new equilibrium that will be reached following the policy-mix
you are suggesting, and explain.
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145
Question 4
a. Consider a country that is open to trade in goods and services with the rest of the
world, where prices are fixed and in which only the goods market exists. Ini-
tially, the country is in goods market equilibrium with a trade surplus. Draw in
the two-panel diagram below the initial equilibrium position, and show how it
changes following a reduction in the domestic price level, 𝑃 [Hint: assume that,
after this reduction, 𝑃 remains forever constant at its new, lower level, so that
the economy is still described by a model with fixed prices]. In particular, explain
if and why income and net exports will change in the new equilibrium.
146
The open economy
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b. How would your answer to the previous point of this question change, if the
quantities of goods and services exported and imported by the country did not
depend on the real exchange rate, but only on foreign and domestic income lev-
els, respectively? Explain.
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147
Question 5
Felicia is an open economy where no financial markets exist, the Marshall-Lerner

condition is met, and whose initial equilibrium is the pair (1,1’) in the figure below.
Explain which policy mix would allow Felicia to reach a new equilibrium with an
unchanged level of income and positive net exports. When answering, verbally de-
scribe how the policy mix you propose affects the position in the plane of each of
the three curves represented in the graph.
45°
𝐷𝐷
𝑍𝑍
1
𝑌̂ 𝑌
NX
1′
𝑌̂ 𝑌
NX
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148
The open economy
Question 6
Consider Alpha, a country that is open to trade in goods and services with the rest of
the world, where prices are fixed and in which only the goods market exists. In Al-
pha, the Marshall-Lerner condition doesn’t hold – more precisely, net exports depend
positively on the real exchange rate. Initially, the country is in goods market equilib-
rium, and trade is balanced.
Having discussed which of the following three Figures provides a correct represen-
tation of the initial equilibrium in Alpha, describe the effects of a real appreciation.
In particular, discuss if and how the various curves represented in the graph you have
chosen will be affected, and explain the effects of the appreciation of the exchange
rate on the equilibrium values of income, consumption, investment and net exports.
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149
Question 7
world, where prices are fixed and in which only the goods market exists. Initially,
the country is in goods market equilibrium, and trade is balanced.
a. Draw in the two-panel diagram below the initial equilibrium position and show
how it changes following a reduction in foreign output, 𝑌 ∗ . In particular, explain
how and why net exports will have changed in the new equilibrium.
150
The open economy
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b. Suppose the government wants to return to a situation of balanced trade, keeping

however domestic output at the new level reached after the decrease in 𝑌 ∗ . In
order to achieve these objectives, economist Paul advocates the use of fiscal
policy, while economist Edie thinks that one should necessarily resort to some
combination of fiscal and exchange rate policies. Do you agree with Paul (in
this case, explain if the appropriate fiscal policy is an expansionary or a contrac-
tionary one), or with Edie (if this is the case, describe the specific combination
of fiscal policy and exchange rate policy you deem appropriate)? [Hint: just
provide the economic intuition behind your answer; you are not requested to
carry out any graphical analysis when answering this point.]
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151
Question 8
tially, the country is in goods market equilibrium, and trade is balanced.
Draw in the two graphs below the initial equilibrium position, and show how
this equilibrium changes following an increase in 𝐸, the nominal exchange rate
[Hint: assume that E will remain forever at the new, higher level, and that do-
mestic and foreign prices do not change]. Finally, explain if and why, in the new
equilibrium, income and net exports will have changed.
152
The open economy
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b. Consider now a different economy, where also financial markets exist and under
a flexible exchange rate regime. Show in the graph below, and discuss, how an
increase in domestic money supply 𝑀 will affect the domestic interest rate 𝑖, the
country’s level of income and the exchange rate of its currency, assuming that
investment is exogenous, 𝐼 = 𝐼 ,̅ and therefore not a function of 𝑖.
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153
Question 9
a. The euro-dollar exchange rate (number of dollars needed to purchase one euro)
is expected to be 1.30 next year (i.e., 𝐸 𝑒 = 1.30), and the one-year interest rates
are 3% in Europe and 1% in the Unites States. Assuming that the (uncovered)
interest parity condition holds, compute the current euro-dollar exchange rate,
𝐸. Do financial markets participants expect the euro to appreciate or to depreci-
ate in one year’s time?
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154
The open economy
b. Write down the approximated version of the interest parity condition, and check
how good an approximation it is by repeating the computations you carried out
when answering the previous point of this question. Finally, suggest two possible
extensions that would likely increase the degree of realism of the interest parity
condition in its simplest form (be it approximated or not) considered in this ques-
tion.
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155
Question 10
The one-year interest rate in Japan is 1%, and the nominal exchange rate between
the yen and the euro (number of yen needed to purchase one euro) is 140. Finally,
assume that financial markets participants expect the euro to appreciate by
5% against the yen in the following year.
a. For a European investor, what is the expected return from holding one-year Jap-
anese assets?
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156
The open economy
b. Suppose that financial investors care only about the expected rate of return, and
therefore want to hold only the assets with the highest expected yield. Assuming
that, in Europe, the one-year interest rate is 2%, would a European investor pur-
chase European assets or Japanese assets? In this example, does the (uncovered)
interest parity condition hold?
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157
Question 11
Consider an economy freely trading goods, services and financial assets with the rest
of the world, in a flexible exchange rate regime. Domestic and foreign prices are
constant, and equal to one (𝑃 = 𝑃∗ = 1).
a. Using the pair of graphs “open economy IS-LM – interest parity condition”,
show the initial equilibrium of the country, denoting it by ‘1’ (hint: assume that
the economy is described by a standard open economy IS-LM model, with a
central bank that chooses the interest rate). Suppose now that the government
raises its purchases of goods and services and that, to keep equilibrium income
constant, the central bank varies the interest rate by implementing an open mar-
ket operation. To achieve its aim, should the central bank buy or sell bonds? In
the figure, denote by 2 the new equilibrium that will prevail after the increase in
𝐺 and the central bank intervention. In the move from 1 to 2, how will the in-
terest rate, the exchange rate, investment and net exports change? Explain.
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158
The open economy
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b. Suppose now that the country is in a fixed, rather than in a flexible, exchange
rate regime. Can a central bank wishing to keep the exchange rate fixed also
intervene to keep income at the initial level (the one prevailing at equilibrium 1,
before the increase in 𝐺), as it did in the flexible exchange rate case considered
before? Why, or why not? In the figure, denote by 1′ the equilibrium that will
be reached in this case (increase in 𝐺, and a central bank that behaves in a way
consistent with the constancy of the exchange rate). Finally, explain how the
interest rate, consumption, investment and next exports will have changed in the
move from 1 to 1′.
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159
Question 12
Consider Alpha, an open economy with a flexible exchange rate and in which in-
vestment is a function of 𝑌 and of the borrowing rate 𝑟 + 𝑥. Aside from this, the
country is described by a standard “open economy IS-LM – interest parity condition”
model with constant domestic and foreign prices, so that 𝑖 = 𝑟.
a. Assuming that the central bank chooses the interest rate, represent the initial
equilibrium of the economy in an “open economy IS-LM – interest parity
condition” diagram, denoting it by ‘1’, and by 𝑖1 , 𝑌1 and 𝐸1 the associated
values of the interest rate, output and exchange rate. Suppose now that the
risk premium on which the borrowing rate depends, 𝑥, increases. In the
graph, denote by ‘2’ the new equilibrium that will be reached. In the move
from the initial equilibrium ‘1’ to the new one ‘2’, how will production, con-
sumption, investment, the exchange rate, net exports and the country’s
money supply and money demand change? Explain.
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160
The open economy
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b. How would your answer to the previous point change, should Alpha’s cen-
tral bank decide to intervene in order to prevent the rise in 𝑥 from affecting
production, and therefore in order to keep 𝑌 at the same level prevailing in
the initial equilibrium (‘1’)? In the graph, denote by ‘3’ the equilibrium that
would be reached in this case and explain if and why, in the move from ‘1’
to ‘3’, consumption, investment, the exchange rate, net exports and the coun-
try’s money supply and money demand will change.
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161
Question 13
Consider an open economy under a flexible exchange rate regime, described by a

standard “open economy IS-LM – interest parity condition” model. Domestic and
foreign prices are constant - for simplicity, both equal to 1 (𝑃 = 𝑃∗ = 1) - and the
country’s central bank chooses the interest rate, initially setting it at the same level
as the foreign one, so that in the initial equilibrium (point ‘1’ in the figures below)
𝑖1 = 𝑖 ∗, 𝑌 = 𝑌1 and 𝐸 = 𝐸1 .
a. Taking these assumptions into account, and having explained which value the
expected future exchange rate must necessarily take on in this economy, sup-
pose that the foreign interest rate, 𝑖 ∗ , goes up (in the figures, it becomes
𝑖 ∗ ′ > 𝑖 ∗ ), while the domestic interest rate chosen by the central bank, foreign
output 𝑌 ∗ and all the remaining exogenous variables - 𝐸 𝑒 included - remain
constant. Assuming that the country’s government decides to change taxes to
prevent domestic output 𝑌 from varying, which of the two graphs below cor-
rectly depicts the new equilibrium (point ‘2’ in the figures) that will be reached
following the exogenous increase in 𝑖 ∗ and the associated fiscal policy interven-
tion just described? To achieve its aim, should the government raise or cut
taxes? Finally, carefully explain how the exchange rate, the money supply, con-
sumption, investment and net exports will change as the economy moves from
the initial equilibrium position (‘1’) to the final one (point ‘2’).
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162
The open economy
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b. Suppose now that, in the economy studied before, investment is entirely exoge-
nous, rather than a function of 𝑖 and 𝑌, as in the standard case just considered.
How will the conclusion you have reached about the effects of the increase in
the foreign interest rate and the simultaneous fiscal policy intervention aimed at
keeping 𝑌 constant change in this case?
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163
Question 14
Consider an open economy under a fixed exchange rate regime. Domestic and for-
eign prices are constant and, for simplicity, both equal to 1 (𝑃 = 𝑃 ∗ = 1). In the pair
of graphs “open economy IS-LM – interest parity condition”, show the initial equi-
librium, denoting it by ‘1’, and by 𝑖1 , 𝑌1 and 𝐸1 the associated values of the interest
rate, output and the exchange rate. Market participants initially expect that the ex-
change rate will be kept fixed at the current level 𝐸1 also in the future, so that 𝐸 𝑒 =
𝐸1 and 𝑖1 = 𝑖 ∗ , where 𝑖 ∗ is, as usual, the foreign interest rate.
a. Suppose that foreign income, 𝑌 ∗ , falls. In the two graphs, denote by ‘2’ the new
equilibrium that will be reached following this change. In the move from ‘1 to
‘2’, in which direction must the central bank change the domestic money supply,
to make sure that the exchange rate remains constant at 𝐸1 ? Why? Explain.
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164
The open economy
b. Assume now that, once the economy has reached the equilibrium ‘2’ discussed
above, in order to bring back domestic output to the value 𝑌1 it was taking on
before the fall in foreign income, the central bank decides to change the parity
(that is, the value at which the exchange rate is kept fixed) from 𝐸1 to 𝐸3 . The
new parity is credible, in the sense that individuals expect it to be maintained in
the future, so that the new future expected exchange rate becomes 𝐸 𝑒 ′ = 𝐸3 . In
the same two graphs used to answer the previous point, represent the new equi-
librium that will be reached in this case, denoting it by ‘3’. To achieve its aim,
the central bank will have to devalue or revalue the exchange rate? Why? Com-
pared to the values they were taking on in the initial equilibrium ‘1’, investment,
consumption and net exports will be higher, lower or unchanged in the final
equilibrium ‘3’?
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165
Question 15
of the world. Furthermore, assume that domestic and foreign prices are constant, and
equal to one (𝑃 = 𝑃∗ = 1).
show the initial equilibrium of the country, assuming a flexible exchange
rate regime and, as usual, that the domestic central bank chooses the interest
rate, keeping it constant at the level it deems appropriate given the state of
the economy. In the graph, denote by ‘1’ the initial equilibrium, by 𝑖̅1 , 𝑌1 ed
𝐸1 the associated values of the interest rate, income and the exchange rate,
and assume that, in this initial equilibrium, 𝐸 𝑒 = 𝐸1 and 𝑖̅1 = 𝑖 ∗ (where, as
usual, 𝑖 ∗ is the foreign interest rate). Consider now an increase in 𝐸 𝑒 , which
now becomes 𝐸 𝑒 ′ > 𝐸 𝑒 = 𝐸1 . In other words, investors now expect the
domestic currency to be ‘stronger’ than they initially thought. Show in the
graph, and explain, how the economy’s income, interest rate, exchange rate,
and money supply will be affected by this change.
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166
The open economy
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b. Suppose that the government intends to return domestic output to the level
prevailing before the increase in 𝐸 𝑒 by changing net taxes, 𝑇̅. To achieve its
aim, should the government raise or lower net taxes? Compare the compo-
sition of aggregate demand in the new equilibrium that will be attained after
the fiscal policy intervention to that prevailing in the initial equilibrium (that
is, the equilibrium in which the economy was before the increase in 𝐸 𝑒 and
the change in 𝑇̅). Explain.
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167
Question 16
a. The world economy consists of just two countries, Alpha and Beta. International
capital mobility is perfect, and the exchange rate between the currencies of the
two countries is kept fixed at the level 𝐸̅ . Alpha has just entered a recession. To
revive its economy, would you recommend Alpha the use of monetary policy or
of fiscal policy? Explain your answer and illustrate graphically, using the pair of
graphs “open economy IS-LM-interest parity condition”.
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168
The open economy
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b. Discuss the effects of the policy intervention you have just suggested on
the trade balance of Alpha and on that of Beta, always assuming a fixed ex-
change rate.
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169
Question 17
Consider an economy that trades goods, services and financial assets with the rest of
the world, under a fixed exchange rate regime. Domestic and foreign prices are con-
stant and, for simplicity, both equal to 1 (𝑃 = 𝑃∗ = 1). In the pair of graphs “open
economy IS-LM – interest parity condition”, show the initial equilibrium, denoting
by 𝑖0 , 𝑌0 and 𝐸0 the values of the interest rate, output and exchange rate in that equi-
librium. Market participants expect that the exchange rate will be kept fixed at the
current level 𝐸0 also in the future, so that 𝐸 𝑒 = 𝐸0 .
a. Suppose that there is a fall in the foreign interest rate, 𝑖 ∗ , while foreign output
𝑌 ∗ and all the other exogenous variables remain constant. Assuming that the
country’s central bank keeps fixing the exchange rate at 𝐸0 , show in the graph,
and explain carefully, the effects of this exogenous decrease in 𝑖 ∗ on equilibrium
output, interest rate, money supply and net exports of the country, denoting by
‘1’ the new equilibrium that will be reached.
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170
The open economy
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b. How would your answer have changed if, when 𝑖 ∗ falls, foreign output 𝑌 ∗ had
also gone up, rather than remaining constant? In the same graph used before,
denote by ‘2’ the equilibrium that the economy would have reached in this case
(lower 𝑖 ∗ and higher 𝑌 ∗ ) and compare it to the equilibrium (‘1’) where the
economy settles when to vary is just the foreign interest rate. Finally, explain in
which of the two cases the intervention of the central bank (consisting in a
change in the money supply aimed at keeping the exchange rate constant) will
have to be quantitatively larger.
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171
Question 18
rate, output and the exchange rate. Market participants expect that the exchange rate
will be kept fixed at the current level 𝐸0 also in the future, so that 𝐸 𝑒 = 𝐸0 .
a. Suppose the central bank announces a devaluation of the currency − that is, it
announces that, effective immediately, the value at which the exchange rate is
kept fixed is lowered to 𝐸1 < 𝐸0 . In addition, assume that individuals, who did
not expect this announcement, revise accordingly the value of the exchange rate
they expect to prevail in the future, so that now 𝐸 𝑒 falls to 𝐸 𝑒 ′ = 𝐸1 . Analyze
in the graph, and explain, the effects of the devaluation on domestic output, in-
terest rate and money supply, denoting by ‘1’ the new equilibrium that the econ-
omy will reach.
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172
The open economy
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b. Suppose that, before the devaluation, both the domestic country and the rest of
the world were in a medium-run equilibrium, with income at its natural level
and zero inflation. In addition, assume that the inflation rate is determined
according to the following Phillips curve:
𝜋 = (𝛼/𝐿)(𝑌 − 𝑌𝑛 )
Once price adjustment − as implied by the previous equation − is taken into
account, do you think that a devaluation can permanently affect the level of
income of a country? Why, or why not? Discuss [Hint: no formal analysis is
required; just describe the likely dynamic adjustment of the economy following
a devaluation].
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173
Question 19
rate, output and the exchange rate. Initially, market participants expect that the ex-
𝐸0 .
a. Suppose that, in the initial equilibrium, income is below its natural level. Given
that, as discussed in the answer to the previous question, a decision to devalue
leads a higher equilibrium output in a country under a fixed exchange rate re-
gime, individuals start expecting an impeding devaluation. It follows that the
future expected exchange rate decreases from 𝐸 𝑒 = 𝐸0 to 𝐸 𝑒′ = 𝐸1 , with 𝐸1 <
𝐸0 . Analyze in the graph the effects of this downward revision in the expecta-
tions on the exchange rate that will prevail in the future on the levels of domestic
income and interest rate, assuming that the central bank intends to keep the ex-
change rate fixed at 𝐸0 .
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174
The open economy
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b. Which type of economic policy (monetary or fiscal; exansionary or

contractionary) could prevent the expectations of an impending devaluation
studied before from changing equilibrium output? Explain.
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175
Question 20
True or False?
a. An expansionary monetary policy rises equilibrium income under flexible ex-

change rates, but does not affect income under fixed exchange rates.
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176
The open economy
b. If financial investors only care about the expected rate of return, and therefore
want to hold only the assets with the highest expected rate of return, then from
the interest parity condition it follows that, under fixed exchange rates, the do-
mestic interest rate can only be equal to the foreign interest rate, 𝑖 = 𝑖 ∗.
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177
Question 21
a. Psi is an open economy with a flexible exchange rate. Illustrate graphically, and
explain, the effects of a decrease in the reserve ratio, θ, on output, the exchange
rate, and the trade balance of Psi. When answering, assume that – starting from
an initial interest rate that you will denote by 𝑖̅0 in the figure − the central bank
will not intervene to keep 𝑖 equal to 𝑖̅0 , but that it will allow the interest rate to
take on the new equilibrium value – to be denoted by 𝑖̅1 in the graph − that will
prevail after the fall in θ. Once 𝑖 has become equal to 𝑖̅1, the central bank will
however keep it at this new level from then on.
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178
The open economy
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b. Suppose now that the government of Psi implements a fiscal policy aimed at
bringing equilibrium output back to the level it was taking on before the decrease
in θ. What happens to the trade balance in this case? Explain.
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179
Question 22
Consider an open economy under a flexible exchange rate regime. Domestic and
foreign prices are constant and for simplicity both equal to 1 (𝑃 = 𝑃∗ = 1), con-
sumption depends positively on disposable income, investment is entirely exogenous
(𝐼 = 𝐼 )̅ , net exports depend positively on foreign income, negatively on domestic
income, and positively on the real exchange rate, so that the Marshall-Lerner condi-
tion is not met. Finally, 𝐺 and 𝑇 are exogenous, and the country’s central bank
chooses the domestic interest rate.
a. Will the IS curve of the “open economy IS-LM – interest parity con-
dition” model that describes this economy will have a negative, zero
or positive slope? Why? Explain.
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180
The open economy
b. Suppose that the government of this economy raises 𝐺̅ . To prevent this fiscal
policy intervention from affecting the equilibrium level of income, the central
bank intervenes by changing the policy rate. To make sure that equilibrium in-
come will remain constant, should the central bank increase or decrease the pol-
icy rate? Following these fiscal and monetary policy interventions, which of the
three curves (the IS, the LM, and that representing the interest parity condition)
will shift in the plane where they are drawn, and in which direction? Finally,
discuss how the exchange rate, money supply, money demand, consumption,
investment, government purchases of goods and services, and net exports will
have changed in the new equilibrium that the economy will reach.
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181
Question 23
Gamma is an economy that trades goods, services and financial assets with the rest
of the world, under a flexible exchange rate regime. In Gamma, changes in the au-
tonomous components of the demand for domestic goods are the main cause of the
observed fluctuations in real GDP. Starting from an initial equilibrium like point ‘0’
in the graph, sometimes the level of autonomous demand is high, leading to an 𝐼𝑆
curve such as 𝐼𝑆1 in the figure; sometimes it is however low, so that the 𝐼𝑆 curve
shifts to the left in the graph (𝐼𝑆2 ). Economists Jack and Jill are asked which mone-
tary policy rule − the one assumed in the 'standard' version of the IS-LM model, in
which the central bank chooses a value for the interest rate, or the alternative one, in
which the central bank chooses the nominal money supply − would, in their opinion,
help minimize the variability of output around its initial level, 𝑌0 , caused by such
demand fluctuations. Jack thinks that the best option is for the central bank to choose
the interest rate, and keep it at the chosen value; on the contrary, Jill suggests that
the central bank should choose a level for the money supply, and then let the interest
rate to take on any value that, given this choice of 𝑀, is consistent with the macroe-
conomic equilibrium.
a. In the pair of graphs “open economy IS-LM – interest parity condition’ below,
show the equilibrium levels of output that, under flexible exchange rates, will
prevail when the central bank chooses the interest rate and, following the fluc-
tuations in demand just discussed, the IS curve shifts to the right (𝐼𝑆1 ) or to the
left (𝐼𝑆2 ). In the figure, make sure to denote the corresponding equilibrium lev-
els of output by 𝑌1 and 𝑌2 , respectively.
𝐼𝑆1
𝑖 𝐼𝑆0 𝑖
𝐼𝑆2
0
●
𝑌0 𝑌 𝐸
182
The open economy
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b. In the same graph, denote by 𝑌1′ and 𝑌2′ the equilibrium levels of production that,
following the same changes in the autonomous components of aggregate de-
mand and the same shifts in the 𝐼𝑆 curve discussed before, would prevail should
the central bank choose the nominal money supply. On the basis of your answers
to this and to the previous point, do you agree with Jack or with Jill? Provide
the intuition for the lower output variability if the central banks behaves in the
way suggested by the economist whose view you share.
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183
Question 24
a. We are at time 𝑡. Use the non-approximated form of the interest parity condition
to write the current period exchange rate, 𝐸𝑡 , as a function of the current and
future expected interest rates for each year over the next 𝑛 years, as well as of
𝑒
the expected exchange rate for time 𝑡 + 𝑛 + 1, 𝐸𝑡+𝑛+1 .
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184
The open economy
b. Explain how each of the following announcements – which, made at time 𝑡, are
unexpected, and believed, by financial markets participants – affects the time 𝑡
exchange rate, 𝐸𝑡 [Hint: assume that, in each period, the functioning of the eco-
nomic system is described by a static IS-LM model, with consumption and in-
vestment depending on contemporaneous variables only]:
b.1 a permanently more expansionary monetary policy abroad, implemented

from time 𝑡 + 2 onwards;
b.2 a permanently more expansionary fiscal policy, and a permanently more

restrictive monetary policy, at home, from time 𝑡 + 1 onwards;
b.3 the emergence of expectations of a progressive, lasting worsening of

the country's current account balance.
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185
Chapter 6 - Government debt and economic
growth
* Question 1
[A graphical analysis of the evolution of the debt-to-GDP ratio]
Write down the government budget constraint as an equation that, for given values
of the real interest rate (𝑟), of the growth rate of the economy (𝑔) and of the primary
deficit-to-GDP ratio (𝑑), relates the debt-to-GDP ratio (𝐵⁄𝑌) at time 𝑡 to the value
of the same ratio at time 𝑡 − 1. Use that equation to graphically analyze the evolution
of the ratio 𝐵⁄𝑌 in the following four cases, providing the intuition underlying your
conclusions:
a. 𝑟 < 𝑔 and 𝑑 > 0.
𝐵𝑡 45°
𝑌𝑡
0 𝐵𝑡−1
𝑏𝑡−1
𝑌𝑡−1
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188
Government debt and economic growth
b. 𝑟 > 𝑔 and 𝑑 > 0.
𝐵𝑡 45°
𝑌𝑡
0 𝐵𝑡−1
𝑏𝑡−1
𝑌𝑡−1
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189
c. 𝑟 > 𝑔 and 𝑑 < 0.
𝐵𝑡 45°
𝑌𝑡
0 𝐵𝑡−1
𝑏𝑡−1
𝑌𝑡−1
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190
d. 𝑟 < 𝑔 and 𝑑 < 0.
𝐵𝑡 45°
𝑌𝑡
0 𝐵𝑡−1
𝑏𝑡−1
𝑌𝑡−1
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191
Question 2
a. Consider a country that, in period 𝑡 = 1, inherits from the previous period, 𝑡 =

0, a debt-to-GDP ratio of 100%: 𝑏0 ≡ 𝐵0 ⁄𝑌0 = 1. Moreover, the real interest
rate and the rate of economic growth are constant and equal to 3% and to 5%,
respectively (𝑟 = 0.03, 𝑔 = 0.05). Finally, the ratio of the primary deficit to
GDP is 4%, assumed to be constant over time. Write down the equation that
gives the dynamics of the debt ratio 𝑏 (≡ 𝐵⁄𝑌) and use it to calculate the value
of the debt-to-GDP ratio at times 𝑡 = 1 and 𝑡 = 2, and the steady state level of
𝑏, 𝑏̅. Will the debt ratio diverge over time, or converge to its steady state value?
Why, or why not?
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192
b. Suppose now that the government intends to stabilize 𝑏 at the value observed at
𝑡 = 0. In other words, the government wants 𝑏 to continue to take on the value
1 both in period 𝑡 = 1 and in all subsequent periods. To achieve this goal, the
Government is considering the possibility of generating a permanent change in
the ratio of the primary deficit to GDP. Compute the value that this ratio should
take on to stabilize 𝑏 at the value 1 forever, and explain whether it implies that
the Government should implement a restrictive or an expansionary fiscal policy.
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193
Question 3
At time 𝑡, a country inherits from the previous period a stock of government debt
0
greater than zero, corresponding to the debt-to-GDP ratio 𝑏𝑡−1 in the graph below.
Assuming that the real interest rate is smaller than the rate of growth of the economy,
and that the government runs a primary surplus,
a. show in the graph the steady state debt-to-GDP ratio in this economy and explain if,
absent any intervention, the debt-to-GDP ratio of the country will converge or not
to this stationary level;
𝐵𝑡 45°
𝑌𝑡
0 𝐵𝑡−1
𝑏𝑡−1
𝑌𝑡−1
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194
b. show in the graph the change in the ratio between the primary balance and GDP
0
needed to stabilize the debt-to-GDP ratio at the value 𝑏𝑡−1 from time 𝑡 onwards.
Explain.
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195
Question 4
a. Consider the following graph:
debt/GDP line
In the figure, the bold straight line,
𝐵𝑡
45° that gives the time 𝑡 debt/GDP ra-
𝑌𝑡 tio as a function of the same ratio
in the previous period, is parallel
to the 45° line going through the
origin.
In this economy, what is the rela-
𝐵𝑡−1 tive size of the growth rate of real
0
𝑏𝑡−1 GDP and of the real interest rate?
𝑌𝑡−1 Is the government running a pri-
mary deficit or a primary surplus?
Explain.
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196
0
b. Assuming that the debt-to-GDP ratio at time 𝑡 − 1 was 𝑏𝑡−1 , show in the graph
the values that this ratio will take on at times 𝑡 and 𝑡 + 1. Will the debt-to-GDP
ratio converge to a steady state value 𝑏̅? If not, why? If yes, show in the figure
this steady state value and explain whether it is stable (that is, if 𝑏 will converge
to it independently of the value of the debt-to-GDP ratio inherited from the past,
0
𝑏𝑡−1 ) or unstable (in which case, 𝑏 will take on the steady state value if and only
0
if 𝑏𝑡−1 = 𝑏̅).
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197
Question 5

0, a debt-to-GDP ratio of 60%: 𝑏0 ≡ 𝐵0 ⁄𝑌0 = 0.6. In addition, the real interest
respectively (𝑟 = 0.06, 𝑔 = 0). Finally, the ratio of the primary deficit to GDP
is 3%. Write down the relation that describes the dynamics of the debt ratio (the
government budget constraint), and use it to compute the debt-to-GDP ratio 𝑏
for times 𝑡 = 1 and 𝑡 = 2. Will this ratio converge over time to a steady state
value 𝑏̅ > 0? Why, or why not? Represent this specific case in the graph that
one uses to study the evolution of the debt ratio over time.
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198
b. Suppose now that, rather than a deficit, the same country runs a primary surplus
of 6% of GDP. How would your answer to the previous point of this question
change? Compute the debt ratio at times 𝑡 = 1 and 𝑡 = 2, and its steady state
value, 𝑏̅. Will the debt ratio converge to 𝑏̅? Explain, using the graph below to
motivate your conclusions.
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199
Question 6
The current time period is 𝑡. For country XYZ, the dynamics of the debt/GDP ratio
0
can be determined on the basis of the figure below, where 𝑏𝑡−1 is the debt/GDP ratio
inherited from the last period. Having explained if, in this country, the economy’s
growth rate is larger or smaller than the real interest rate, and if the primary budget
is in surplus or in deficit, suggest two ways in which policy-makers could stabilize
0
at 𝑏𝑡−1 the debt-to-GDP ratio prevailing at time 𝑡 (that is, two ways in which they
0
could make sure that the debt/GDP ratio will amount to 𝑏𝑡−1 also at time 𝑡). Explain.
Debt/GDP line
𝐵𝑡
𝑌𝑡
45°
0
𝑏𝑡−1 𝐵𝑡−1
𝑌𝑡−1
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200
Question 7
By making explicit reference to the government budget constraint – and, should you
find it helpful, also to the diagram employed to perform a graphical analysis of the
evolution of the debt-to-GDP ratio over time −, explain if and why you agree, or do
not agree, with the following statement:
“In a country where 𝑟 > 𝑔 and that inherits from the previous period a stock of
government debt 𝐵𝑡−1 > 0, the debt-to-GDP ratio will keep growing over time,
and this irrespective of the value – by assumption, constant – that 𝑑, the ratio of
the primary deficit to GDP, takes on”.
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201
* Question 8
a. Consider a country with a zero primary deficit-to-GDP ratio (𝑑 = 0), and in

which the real interest rate and the rate of growth of the economy are constant
and equal to 𝑟 = 𝑟̅ and 𝑔 = 𝑔̅ , respectively, with 𝑟̅ < 𝑔̅ and 1 + 𝑟̅ − 𝑔̅ > 0.
Write down the equation that gives the dynamics of the debt-to-GDP ratio for
this economy (the government budget constraint) and derive the steady state
value of that ratio. Assuming that at time 𝑡 the economy inherits from the past a
0
debt-to-GDP ratio equal to 𝑏𝑡−1 > 0, explain if, and why, the economy will ever
converge to that steady state. Use the graph below to motivate your answer.
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202
b. Suppose now that the interest rate at which the government can borrow is no
longer equal to 𝑟̅ , but rather to 𝑟̅ + 𝑣𝑏𝑡−1 , where 𝑣 is a positive parameter. In
other words, the real interest rate is no longer constant, but increasing in the debt-
to-GDP ratio (𝑏) prevailing in the last period. The growth rate of the economy
is however stiIl constant and, as before, 𝑟̅ < 𝑔̅ and 1 + 𝑟̅ − 𝑔̅ > 0. Repeat the
analysis carried out in order to answer the previous point of this question. In
particular, derive the expression of the steady state debt-to-GDP ratio, explain if
and why 𝑏 will converge to a steady state, and represent graphically.
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203
Question 9
a. Consider the Solow growth model without technological progress. The produc-
3 1
tion function is 𝑌 = 𝐾 ⁄4 𝑁 ⁄4 and the rate of depreciation, 𝛿, is equal to 0.1.
Calculate the propensity to save 𝑠 for which the steady state level of capital per
worker is 100. Represent graphically this steady state.
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204
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b. Assuming that the economy is initially in the steady state just described, explain
and represent graphically what happens to capital per worker, output per worker
and the growth rate of the economy following a reduction in the marginal pro-
pensity to consume.
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205
Question 10
1 1
tion function is 𝑌 = 𝐾 ⁄2 𝑁 ⁄2 and the rate of depreciation is 𝛿 = 0.05. Calculate
the propensity to save 𝑠 for which the steady state level of capital per worker is
200. Represent graphically this steady state.
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206
b. Assuming that the economy is initially in the steady state just described, explain,
and show in the graph, what happens to capital per worker, output per worker
and the growth rate of the economy following an increase in the rate of depreci-
ation, 𝛿.
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207
Question 11
The government of a closed economy, whose budget was previously balanced, starts
running a budget deficit equal to the percentage 𝜌 of the country’s GDP, with 0 <
𝜌 < 𝑠, where 𝑠 is the private saving rate.
a. Assuming that there is no technological progress and that both the private saving
rate and the population of the country are constant, show in the graph below the
impact of the emergence of a budget deficit (that is, of the increase in 𝜌 from
zero to a positive value) on output per worker and capital per worker in the
Solow growth model. Explain.
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208
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b. Will the budget deficit permanently affect the growth rate of the economy? Ex-
plain.
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209
Question 12
True or False?
a. “From the Solow model without technological progress it follows that, as the
saving rate s increases from its minimum value (0) to its maximum value (1),
steady-state capital per worker and output per worker first increase and then de-
crease”.
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210
b. Using the Solow model without technological progress and assuming a constant
population (𝑔𝐴 = 𝑔𝑁 = 0), explain if and why you agree, or do not agree, with
the following statements:
b.1 an increase in the saving rate 𝑠 will always raise steady state output per
worker;
b.2 an increase in the saving rate 𝑠 will always raise steady state consumption
per worker.
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211
Question 13
a. Using the Solow model with technological progress, and assuming the economy
was initially in a steady state equilibrium, study in the graph below the effects
of a decrease in the saving rate on capital and output per effective worker, briefly
explaining the reasons for the observed changes in these variables.
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212
b. How would capital and output per effective worker change following an increase
in the rate of technological progress?
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213
Question 14
Consider the Solow model, assuming positive rates of technological progress and
population growth, so that 𝑔𝐴 > 0 and 𝑔𝑁 > 0.
a. Assuming the usual aggregate production function, and denoting by 𝑠 the saving
rate and by δ the depreciation rate, represent in the graph below the steady state,
or state of balanced growth, of the economy. Clearly indicate the levels of output
per effective worker, investment per effective worker and consumption per ef-
fective worker in this steady state.
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214
b. Explain if and why you agree, or do not agree, with the following statements:
b.1 an increase in the saving rate leads to a new balanced growth path
characterized by a higher level of output per worker, but an un-
changed growth rate of 𝑌⁄𝑁;
b.2 the Solow model implies that, if the growth rate of population 𝑔𝑁 in-
creases, the economy will reach a new steady state where the
growth rate of aggregate output 𝑌 is unchanged, and the growth
rate output per worker 𝑌⁄𝑁 is lower.
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215
Part II
Solutions
Chapter 1 - The goods and financial markets
Question 1
In the economy there are only two firms, firm A and firm B. Their operations in a
given year can be summarized as follows (all figures are in thousands of Euros):
Firm A
Costs Revenues
Wages Sales to B
170 300
Purchases from B Sales to consumers

50 400
Indirect taxes
30
Firm B
Costs Revenues
Wages Sales to A
230 50
Purchases from A Sales to consumers

300 500
Indirect taxes Exports

20 100
Compute the economy’s Gross Domestic Product (GDP) using all the definitions of
this variable that it is possible to employ in this case.
220
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a. GDP is the value of the final goods and services produced in the economy:
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Value of final goods and services produced by firm A = 400 (sales to con-
sumers);
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Value of final goods and services produced by firm B = 500 (sales to con-
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sumers) + 100 (exports, which are always a final use of the goods produced
in a country – why?) = 600
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GDP = 400 + 600 = 1000.
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1. An alternative, and fully equivalent, way of computing GDP is as the sum of
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the value added (V.A.) by all the firms in the economy:.
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V.A. A = (300+ 400) – 50 = 650;
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V.A. B = (50 + 500+100) – 300 = 350;
GDP = 650 + 350 = 1000.
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2. Finally, in this economy, GDP = Incomes + Indirect taxes, where incomes
are in this case the sum of profits (revenues – costs) and wages.
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Firm A’s profits = (300 + 400) – (170 + 50 + 30) = 450;
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Firm B’s profits = (50 + 500 + 100) – (230 + 300 + 20) =100;
Wages paid by A = 170;
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Wages paid by B = 230.
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In addition, indirect taxes = 30 + 20 = 50.
It follows that GDP = 450 +100 + 170 + 230 + 50 = 1000.
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221
Question 2
a. What is meant by ‘GDP deflator’? How is the GDP deflator computed, and how
is it used?
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The GDP deflator for year 𝑡, 𝑃𝑡 , is computed by dividing nominal GDP by real
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GDP in year 𝑡:
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€𝑌𝑡
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𝑃𝑡 = ,
𝑌𝑡
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where €𝑌𝑡 and 𝑌𝑡 are year 𝑡 nominal GDP and real GDP, respectively.
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The GDP deflator is an index number with very wide coverage (it reflects the
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prices of all goods and services taken into account when measuring GDP – that
is, all the final goods and services produced in the economy). It takes on the value
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1 in the base year, and its changes between consecutive years are one of the
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possible measures of the rate of inflation – the change over time in the general
price level.
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222
b. Compared to the previous year (𝑡 − 1), in year 𝑡 the economy’s GDP defla-
tor has gone down by 1% and the real GDP growth rate has been equal to
−2%.
b.1 Compute the growth rate of nominal GDP for this economy in year 𝑡.
b.2 What is the rate at which the economy under consideration has been growing
in year 𝑡 ?
b.1 The definition of GDP deflator given when answering the previous point
of this question implies that year 𝑡 nominal GDP, €𝑌𝑡 , can be written as
the product between the GDP deflator and real GDP for the same year:
€𝑌𝑡 = 𝑃𝑡 · 𝑌𝑡 .
It follows that the rate of growth of nominal GDP is (approximately) equal
to the sum of the rate of change of the GDP deflator and the rate of change
of real GDP. In the economy we have been asked to consider, the growth
rate of nominal GDP in year 𝑡 therefore amounts to (−1%) + (−2%) =
−3%.
b.2 The ‘rate of growth of the economy’ is the rate of change of real GDP
between two consecutive years. It follows that, in year 𝑡, the economy has
been growing at a rate of −2%.
223
Question 3
A closed economy in which only the goods market exists is described by the follow-
ing system of equations:
𝐶 = 𝑐𝑜
𝐼 = 𝐼̅
𝐺 = 𝐺̅
𝑇 = 𝑇̅ + 𝑡𝑌
between zero and one) is the tax rate, the positive constant 𝑇̅ is the portion of net
taxes that does not depend on income, and the other symbols have the usual meaning.
the impact on equilibrium production, initially equal to 𝑌̂1, of an increase in 𝑇̅?
Why? Explain.
The correct figure is Fig.2. In fact, in a plane in which Y is measured along the
x-axis, the curve representing the aggregate demand for goods is a horizontal
line, as all its components are exogenous – in particular, independent of income.
For the same reason, a change in 𝑇̅ will not cause any change in the graph, and
therefore in equilibrium income.
224
Question 4
following system of equations,
𝐶 = 𝑐0
𝐼 = 𝐼̅
𝐺 = 𝐺̅
𝑇 = 𝑡𝑌
between zero and one) is the tax rate, and the other symbols have the usual meaning.
the impact on equilibrium production, initially equal to 𝑌̂1, of a decrease in the tax
rate? Why? Explain.
The correct figure is Fig.1. In fact, in a plane in which Y is measured along the
x-axis, the curve representing the aggregate demand for goods is a horizontal
line, as all its components are exogenous – in particular, independent of income.
For the same reason, a change in 𝑡 will not cause any change in the graph, and
therefore in equilibrium income.
225
Question 5
𝐶 = 𝑐0
𝐼 = 𝐼 ̅ + 𝑑1 𝑌
𝐺 = 𝐺̅ − 𝑔1 𝑌
𝑇 = 𝑇̅ + 𝑡𝑌

between zero and one) is the tax rate, 𝐺̅ and ̅𝑇 (both greater than zero) are the por-
tions of government spending and net taxes that do not depend on income, and the
parameters 𝑑1 and 𝑔1 , with 0 < 𝑑1 − 𝑔1 < 1, are both positive.
a. Having determined graphically in the figure below the equilibrium level of pro-
duction (𝑌̂) for this economy, derive the analytical expressions of 𝑌̂, of auton-
omous spending 𝐴 and of the multiplier implied by the model specified above.
45°
𝑍, 𝑌 𝑍′
2
𝑍
1
𝑐0 + 𝐼 ̅ + 𝐺̅
𝑌̂ 𝑌̂′ 𝑌
In this economy, the demand for goods is

𝑍 = 𝑐0 + 𝐼 ̅ + 𝐺̅ + (𝑑1 − 𝑔1 )𝑌
where 𝑐0 + 𝐼 ̅ + 𝐺̅ is autonomous spending, 𝐴. In the graph, 𝑍 is therefore a
straight line with slope (𝑑1 − 𝑔1 ), by assumption a quantity which is positive
but smaller than one.
226
Writing down the goods market equilibrium condition, and solving for Y, one gets
the following expression for equilibrium income (the value of Y corresponding to
point 1 in the figure):
𝑐0 + 𝐼 ̅ + 𝐺̅
𝑌̂ = ,
1 − (𝑑1 − 𝑔1 )
from which it follows that the multiplier is
1
.
1 − (𝑑1 − 𝑔1 )
b. Suppose that the government raises, at the same time and by the same amount,
both 𝐺̅ and 𝑇̅, so that ∆𝐺̅ = ∆𝑇̅ > 0. Show in the graph the effects of these
changes and, using the results derived when answering the previous point of this
question, derive the analytical expressions of the changes in equilibrium produc-
tion, private saving, government saving and national saving caused by the in-
creases in 𝐺̅ and in 𝑇̅. In your answer, make sure to discuss in each case why
reaching a definite conclusion about the direction in which those variables will
change is possible, or not possible.
When ∆𝐺̅ = ∆𝑇̅ > 0, the aggregate demand curve in the figure shifts upwards in
a parallel fashion by ∆𝐺̅ , and the new equilibrium becomes point 2. From the ex-
pression for 𝑌̂ just derived, it follows that equilibrium income goes up by
1
∆𝑌̂ = ∆𝐺̅ (> 0).
1 − (𝑑1 − 𝑔1 )
The change in private saving will be
(𝑑1 − 𝑔1 ) − 𝑡
∆𝑆̂𝑝𝑟𝑖𝑣 = ∆(𝑌̂ − 𝑇̅ − 𝑡𝑌̂) = (1 − 𝑡)∆𝑌̂ − ∆𝐺̅ = ∆𝐺̅ ,
1 − (𝑑1 − 𝑔1 )
a quantity whose sign is uncertain, without further information on the relative
sizes of the parameters 𝑡, 𝑑1 and 𝑔1 , while government saving will rise for sure
by
𝑡 + 𝑔1
∆𝑆̂𝑔𝑜𝑣 = ∆𝑇̅ + 𝑡∆𝑌̂ − ∆𝐺̅ + 𝑔1 ∆𝑌̂ = ∆𝐺̅ (> 0).
1 − (𝑑1 − 𝑔1 )
Finally, and although without more information it is not possible to determine
the direction in which private saving will change, it is easy to conclude that na-
tional saving will go up, since
𝑑1
∆𝑆̂𝑛𝑎𝑡 = ∆𝐼 = ∆𝐺̅ (> 0).
1 − (𝑑1 − 𝑔1 )
227
Question 6
The goods market of a nation is described by the following equations:

𝐶 = 𝑐0 + 𝑐1 (𝑌 − 𝑇)
𝑇 = 𝑇̅ + 𝑡𝑌
𝐼 = 𝐼̅
𝐺 = 𝐺̅
𝑌 = 𝐶 + 𝐼 + 𝐺,
where the parameter 𝑡 is greater than zero (so that net taxes are increasing in the level
of income), but smaller than one.
a. Derive the expression for the equilibrium level of income and that of the
multiplier for this economy.
Using the first four equations into the last one, the goods market equilibrium
condition, and solving for 𝑌, one gets the following expression for the equilibrium
level of income:
1
𝑌̂ =  [𝑐 − 𝑐1 𝑇̅ + 𝐼 ̅ + 𝐺̅ ] ,
1 − 𝑐1 (1 − 𝑡) 0
where the term in square brackets is autonomous spending, and the multiplier is
the ratio
1
.
1 − 𝑐1 (1 − 𝑡)
228
b. Two economists, Mary and Paul, debate on the effects of an increase in the
autonomous component of government spending 𝐺̅ on the government defi-
cit, 𝐷𝑒𝑓 = 𝐺̅ − 𝑇. According to Mary, since an increase in 𝐺̅ leads to a
higher income, and net taxes are increasing in 𝑌, raising 𝐺̅ has an uncertain
effect on the deficit. For sufficiently high values of 𝑡, the increase in tax
revenues could be so large that the government deficit could end up falling.
Economist Paul, on the other hand, believes that an increase in 𝐺̅ would still
increase the deficit, for any 𝑡 < 1. Derive the expression for the change in
the deficit, 𝛥𝐷𝑒𝑓, when 𝐺̅ varies by 𝛥𝐺̅ > 0. Which of the two economists
is right?
In the initial equilibrium,

𝐷𝑒𝑓 = 𝐺̅ − 𝑇 = 𝐺̅ − 𝑇̅ − 𝑡𝑌̂ ⇒ 𝛥𝐷𝑒𝑓 = 𝛥𝐺̅ − 𝑡𝛥𝑌̂.
From the expression for equilibrium income derived before, it follows that, fol-
lowing a change in 𝐺̅ , 𝑌̂ will vary by:
1
𝛥𝑌̂ =  𝛥𝐺̅ .
1 − 𝑐1 (1 − 𝑡)
Plugging this expression for 𝛥𝑌̂ into 𝛥𝐷𝑒𝑓 = 𝛥𝐺̅ − 𝑡𝛥𝑌̂ and collecting terms,
one gets:
(1 − 𝑡)(1 − 𝑐1 )
𝛥𝐷𝑒𝑓 = [ ]  𝛥𝐺̅ .
1 − 𝑐1 (1 − 𝑡)
The term in square brackets is positive for any 𝑡 < 1, and an increase in 𝐺̅ will
therefore raise the deficit. Paul is right. [However, it is true that the larger is 𝑡,
the smaller will be the worsening of the deficit.]
229
Question 7
True or False?
Explain whether the following statement is true or false. Motivate your answer in a
brief but rigorous way, by making explicit reference to the relevant theory. Lack of
“In a country where only the goods market exists, and in which 𝐺 = 𝐺̅ , 𝑇 = 𝑇̅, 𝐶 =
𝑐0 + 𝑐1 (𝑌 − 𝑇̅) and 𝐼 = 𝐼 ̅ + 𝑑1 𝑌, where 𝑑1 is a positive constant and the other sym-
bols have the usual meaning, the decrease in public (government) saving caused by
a tax cut necessarily leads to higher equilibrium national saving (the sum of private
and public saving)”.
True. Since the tax cut raises equilibrium income, it will also lead to higher in-
vestment, since in this economy 𝐼 depends positively on 𝑌. As, in equilibrium,
investment must be equal to national saving, this latter must have risen, too.
230
Question 8
Consider a country consisting of the goods market only, where 𝐶 = 𝑐0 , 𝐺 = 𝐺̅ − 𝑔𝑌,

𝑇 = 𝑇̅, and 𝐼 = 𝐼 ,̅ with 𝑔 a positive constant and the remaining symbols having the
usual meaning. Write the expression of the multiplier for this economy, and then
assume that government purchases of goods and services and net taxes are raised by
the same amount and at the same time, so that ∆𝐺̅ = ∆𝑇̅ > 0. By making explicit
reference to the goods markets equilibrium condition written as an equality between
national saving and investment, explain if, and why, it is possible to say something
about the direction in which private saving will have changed in the new equilibrium
[N.B.: you are not expected to derive the analytical expression for the change in
private saving, but just to explain whether it is possible to conclude that, in the new
equilibrium, it will have gone up, gone down, or remained constant].
The multiplier – the constant that, in the expression for equilibrium income, mul-
tiplies autonomous spending (in this economy given by the sum of autonomous
consumption, investment and the autonomous component of governemnt pur-
chases of goods and services) – is equal to 1/(1 + 𝑔), a positive quantity. If
∆𝐺̅ = ∆𝑇̅ > 0, income will be higher in the new equilibrium (the increase in net
taxes has no impact on the demand for goods, since this latter does not depend
on 𝑇̅, while that in 𝐺̅ of course raises it). In the new equilibrium, national saving
will have to remain unchanged, just like investment (which is entirely exogenous).
Since public saving increases (being ∆𝐺̅ = ∆𝑇̅, it will change only because of the
fall in G due to the increase in income), for national saving to remain constant
private saving must have gone down by the same amount by which public saving
has gone up.
231
Question 9
𝐶 = 𝑐0
𝐼 = 𝐼̅
𝐺 = 𝐺̅ − 𝑔𝑌
𝑇 = 𝑇̅ + 𝑡𝑌
between zero and one) is the tax rate, 𝑔 (> 0) is the sensitivity to income of govern-
ment spending on goods and services, and the other symbols have the usual meaning.
a. Write down the analytical expressions of autonomous spending, equilibrium in-

come, and the multiplier for this economy.
In this economy, autonomous spending is 𝐴 = 𝑐𝑜 + 𝐼 ̅ + 𝐺̅ , while equilibrium

income is, as usual, the value of 𝑌 that solves the goods market equilibrium
condition,
𝑌 = 𝐴 − 𝑔𝑌,
that is,
1
𝑌̂ = ∙ 𝐴,
1+𝑔
where the multiplier is the ratio 1⁄(1 + 𝑔).
232
b. Suppose that the autonomous components of government purchases of goods

and services and of net taxes are cut at the same time and by the same amount,
so that ∆𝐺̅ = ∆𝑇̅ < 0. Determine the effect of this change on the government
deficit, 𝐷𝑒𝑓 = 𝐺 − 𝑇, prevailing when the goods market is in equilibrium.
Make sure to explain if, and why, the sign of the change in government deficit
will, or will not, depend on the fact that, in this economy, the parameter 𝑡 is
larger or smaller than the parameter 𝑔.
When ∆𝐺̅ = ∆𝑇̅ < 0, in equilibrium the government deficit will change by
̂ = ∆𝐺̅ − 𝑔∆𝑌̂ − ∆𝑇̅ − 𝑡∆𝑌̂ = −(𝑔 + 𝑡)∆𝑌̂.
∆𝐷𝑒𝑓
Plugging in this equation the expression for the change in equilibrium income
when ∆𝐺̅ = ∆𝑇̅ < 0, that is, ∆𝑌̂ = [1⁄(1 + 𝑔)] ∙ ∆𝐺̅ , yields
𝑔+𝑡
̂ =−
∆𝐷𝑒𝑓 ∙ ∆𝐺̅ .
1+𝑔
Since ∆𝐺̅ < 0, the government deficit will unambiguously rise, and this
independently of the relative size of the two parameters 𝑡 and 𝑔. The intuition
is as follows: if 𝐺 and 𝑇 did not depend on 𝑌 (in other words, if 𝑔 = 𝑡 = 0),
cutting 𝐺̅ and 𝑇̅ by the same amount would not change the government deficit;
however, since ∆𝐺̅ < 0 decreases equilibrium income, and given that when
income goes down government outlays rise (remember that 𝑔 > 0), and
government revenues (net taxes) fall (since 𝑡 > 0), in this economy ∆𝐺̅ = ∆𝑇̅ <
0 will unambigously increase the government deficit, and this independently of 𝑡
being greater, rather than smaller, than 𝑔.
233
Question 10
The goods market of a country is described by the following model:
𝐶 = 𝑐0 + 𝑐1 (𝑌 − 𝑇)
𝑇 = 𝑇̅ + 𝑡𝑌
𝐼 = 𝐼 ̅ + 𝑑1 𝑌
𝐺 = 𝐺̅
𝑌 = 𝐶 + 𝐼 + 𝐺,
where the parameter 𝑡 (the tax rate) is positive, but smaller than one, 𝑑1 (> 0) is the
sensitivity of investment to income, 𝑐1 + 𝑑1 < 1, and the other symbols have the
usual meaning.
a. Derive the expressions of equilibrium income and of the multiplier for this econ-
omy.
Equilibrium income, 𝑌̂, is the value of Y that solves the goods market equilibrium
condition (the last equation of the model above). Using the first four equations
in the fifth one, and solving, one gets
𝑐0 − 𝑐1 𝑇̅ + 𝐼 ̅ + 𝐺̅
𝑌̂ = .
1 − 𝑐1 − 𝑑1 + 𝑡𝑐1
It follows that the multiplier is the ratio
1
.
1 − 𝑐1 − 𝑑1 + 𝑡𝑐1
234
b. Suppose that autonomous consumption and the autonomous component of net

taxes rise at the same time and by the same amount, so that 𝛥𝑐0 = 𝛥𝑇̅ > 0. By
how much will equilibrium income and national saving (the sum of private and
public saving) change? Derive the expressions for the changes in those two var-
iables, and explain if and why they will rise, fall or remain unchanged.
From the expression for 𝑌̂ just derived, it follows that

𝛥𝑐0 − 𝑐1 𝛥𝑇̅ (1 − 𝑐1 )𝛥𝑐0
𝛥𝑌̂ = = > 0.
1 − 𝑐1 − 𝑑1 + 𝑡𝑐1 1 − 𝑐1 − 𝑑1 + 𝑡𝑐1
Equilibrium income goes up. In fact, the increase in autonomous consumption
raises the demand for goods by 𝛥𝑐0 ; the increase in taxes lowers disposable
income, and therefore consumption, but this latter falls just by −𝑐1 𝛥𝑇̅ =
−𝑐1 𝛥𝑐0 . The overall impact on autonomous demand of the two changes is
therefore 𝛥𝑐0 − 𝑐1 𝛥𝑐0 = (1 − 𝑐1 )𝛥𝑐0 , a positive quantity, since 0 < 𝑐1 < 1
and 𝛥𝑐0 > 0. It follows that equilibrium production goes up. As for national
saving, it will go up, too. In fact, in equilibrium it must be equal to investment,
and investment rises by
𝑑1 (1 − 𝑐1 )𝛥𝑐0
𝛥𝐼̂ = 𝑑1 𝛥𝑌̂ = > 0.
1 − 𝑐1 − 𝑑1 + 𝑡𝑐1
The right-hand side of the above equation therefore also represents the
equilibrium change in national saving that you were asked to derive.
235
Question 11
Country Macro, where only the good market exists and prices are constant, is
described by the following model:
̅̅̅̅̅̅̅
𝐶 = 𝑐0 + 𝑐1 (𝑌 − 𝑇) + 𝑎 𝑊𝐹𝐻
𝑇 = 𝑇̅
𝐼 = 𝐼 ̅ + 𝑑1 𝑌
𝐺 = 𝐺̅
𝑌 = 𝐶 + 𝐼 + 𝐺.
In the equations above, 0 < 𝑐1 < 1, 𝑑1 > 0, 0 < 𝑐1 + 𝑑1 < 1, the parameter 𝑎 (>
0) is the sensitivity of consumption to the financial and housing wealth 𝑊𝐹𝐻
(assumed to be exogenous, so that 𝑊𝐹𝐻 = ̅̅̅̅̅̅̅
𝑊𝐹𝐻 ), and the other symbols have the
usual meaning.
a. Derive the expressions of equilibrium income and that of the multiplier for this
economy.
Equilibrium income, 𝑌̂, is the value of Y that solves the goods market equilibrium
condition (the last equation of the model above). Using the first four equations
in the fifth one, and solving, one gets
𝑐0 − 𝑐1 𝑇̅ + 𝐼 ̅ + 𝐺̅ + 𝑎 ̅̅̅̅̅̅̅
𝑊𝐹𝐻
𝑌̂ = .
1 − (𝑐1 + 𝑑1 )
It follows that the multiplier is, as usual,

1
.
1 − (𝑐1 + 𝑑1 )
236
b. Suppose that individuals experience an increase in their financial and housing

̅̅̅̅̅̅̅ > 0. Write down the expression of the change in equi-
wealth, so that 𝛥𝑊𝐹𝐻
librium private saving caused by this change. In particular, explain if, and why,
private saving will rise, fall, or remain constant.
Private saving is the portion of their disposable income individuals decide not to
consume, 𝑆 = (𝑌 − 𝑇) − 𝐶. Using in this expression the consumption function
for Macro (first equation of the model above), it follows that, in equilibrium, pri-
vate saving is 𝑆̂ = −𝑐0 + (1 − 𝑐1 )(𝑌̂ − 𝑇̅) − 𝑎 ̅̅̅̅̅̅̅
𝑊𝐹𝐻 . If individuals’ financial
and housing wealth rises by 𝛥𝑊𝐹𝐻 ̅̅̅̅̅̅̅ > 0, equilibrium income will rise by the mul-
̅̅̅̅̅̅̅. It follows that, in equilibrium, private saving will change
tiplier times 𝑎𝛥𝑊𝐹𝐻
by
̅̅̅̅̅̅̅
𝑎𝛥𝑊𝐹𝐻
𝛥𝑆̂ = (1 − 𝑐1 )𝛥𝑌̂ − 𝑎𝛥𝑊𝐹𝐻
̅̅̅̅̅̅̅ = (1 − 𝑐1 ) · ̅̅̅̅̅̅̅
− 𝑎𝛥𝑊𝐹𝐻
1 − (𝑐1 + 𝑑1 )
𝑑1
= ̅̅̅̅̅̅̅ > 0.
· 𝑎 𝛥𝑊𝐹𝐻
1 − (𝑐1 + 𝑑1 )
Private saving will be higher. For a given disposable income, the increase in
𝑊𝐹𝐻 leads individuals to save less, and consume more. However, this increase
in consumption raises equilibrium income, and therefore saving. Although these
two forces push saving in opposite directions, to prevail must necessarily be the
second one, and private saving will go up, as made clear by the equation above.
An alternative, and fully equivalent, way to arrive to the same conclusion is to
recall that, in goods market equilibrium, investment and national saving must be
equal. Since the rise in wealth leads to more consumption and a higher income,
in the new equilibrium investment (which depends positively on Y) will be higher.
It follows that, in the new equilibrium, national saving must be higher, too. Since
government saving is unchanged, the increase in national saving can only follow
from an increase in private saving.
237
Question 12
The economy of a country consisting of the goods market only is described by the
following equations:
𝐶 = 𝑐1 (𝑌 − 𝑇)
𝑇 = 𝑇̅ + 𝑡𝐶
𝐼 = 𝐼̅
𝐺 = 𝐺̅ ,
where the parameters 𝑐1 and 𝑡 are positive but smaller than one. In this country,
autonomous consumption 𝑐0 is therefore equal to zero, government purchases of
goods and services and investment are entirely exogenous, and net taxes depend on
consumption – as they include not just an exogenous component (𝑇̅), but also a por-
tion that is increasing in consumption (𝑡𝐶).
a. Plugging the expression for net taxes given by the second equation into the first
one, and solving for 𝐶, derive the expression that the consumption function
takes on in this economy. Next, using the definition of (private) saving and the
consumption function you have just derived, write down the (private) saving
function. In this economy, is private saving still increasing in income, 𝑌, as it
is in the standard case? Why, or why not? Explain.
Plugging the expression for net taxes given by the second equation into the first
one, yields:
...........................................................................................................................
𝐶 = 𝑐1 𝑌 − 𝑐1 𝑇̅ − 𝑐1 𝑡𝐶.
...........................................................................................................................
Solving for 𝐶, the consumption function for this economy can be written as
...........................................................................................................................
𝑐1
𝐶= (𝑌 − 𝑇̅).
......................................................................................................................................
1 + 𝑐1 𝑡
.........................
Using this expression for 𝐶 and 𝑇 = 𝑇̅ + 𝑡𝐶 in the definition of private saving,
𝑆 = (𝑌 − 𝑇) − 𝐶, one gets:
1 − 𝑐1
𝑆=( ) (𝑌 − 𝑇̅),
1 + 𝑐1 𝑡
a quantity that depends positively on 𝑌, since 𝑐1 , the marginal propensity to con-
sume out of disposable income, is less than one. As usual, also in this economy
private saving is therefore increasing in the level of income.
238
b. Using the results derived when answering the previous point, write down the
expression of the government deficit (𝐷𝑒𝑓) for this economy. Is the country’s
government deficit increasing or decreasing in the level of income, 𝑌? Why?
Provide the economic intuition for your answer.
..................
From the results above, it follows that, in this economy,
𝑡𝑐1
𝐷𝑒𝑓 = 𝐺 − 𝑇 = 𝐺̅ − 𝑇̅ − (𝑌 − 𝑇̅).
1 + 𝑐1 𝑡
The government deficit is therefore smaller the larger is the economy’s income.
This is so because an increase in 𝑌 does not change the government’s purchases
of goods and services, which are entirely exogenous; by raising consumption, it
however leads to an increase in net taxes (see the second equation of the model
describing this economy), and therefore in government revenues.
239
Question 13
a. The goods market of country Zeta is described by the following equations:

𝐶 = 𝑐0 + 𝑐1 (𝑌 − 𝑇)
𝑇 = 𝑇̅
𝐼 = 𝐼 ̅ + 𝑑1 𝑌
𝐺 = 𝐺̅
𝑌 = 𝐶 + 𝐼 + 𝐺,
where 0 < 𝑐1 < 1, 𝑑1 > 0 and 𝑐1 + 𝑑1 < 1. Economist Cher thinks that, in
this economy, one could simultaneously change 𝐺̅ and 𝑇̅ so as to decrease the
government deficit 𝐷𝑒𝑓 = 𝐺̅ − 𝑇̅ without changing at the same time the equilib-
rium level of income. Economist Sonny holds a different opinion: in Zeta, cut-
ting the government deficit will always lead to a fall in equilibrium income.
Which of the two economists is right? Why? [Hint: (i) write the expression for
equilibrium income, 𝑌̂; (ii) use it to find out how the change in 𝐺̅ , 𝛥𝐺̅ , and the
change in net taxes, 𝛥𝑇̅, must be related to one another for equilibrium income
to remain constant (𝛥𝑌̂ = 0); (iii) verify whether it is possible that, for the val-
ues of 𝛥𝐺̅ and 𝛥𝑇̅ so determined, the change in the deficit 𝛥𝐷𝑒𝑓 is going to be
negative and, if so, under what circumstances this could be the case. Explain].
...........................................................................................................................
The equilibrium level of income is the value of Y that solves the goods market
equilibrium condition (the last equation of the model above), that is
...........................................................................................................................
𝑐0 − 𝑐1 𝑇̅ + 𝐼 ̅ + 𝐺̅
...........................................................................................................................
𝑌̂ = .
1 − 𝑐1 − 𝑑1
...........................................................................................................................
Following a simultaneous change in 𝐺̅ and 𝑇̅, in order to have 𝛥𝑌̂ = 0 it must be
...........................................................................................................................
the case that 𝛥𝐺̅ = 𝑐1 𝛥𝑇̅. Using this result in 𝛥𝐷𝑒𝑓 = 𝛥𝐺̅ − 𝛥𝑇̅, the change in
...........................................................................................................................
the government deficit can be written as 𝛥𝐷𝑒𝑓 = 𝑐1 𝛥𝑇̅ − 𝛥𝑇̅ = (𝑐1 − 1)𝛥𝑇̅,
which is less than zero if 𝛥𝑇̅ > 0 (remember that 0 < 𝑐1 < 1). It is easy to see
...........................................................................................................................
that raising net taxes by 𝛥𝑇̅ and 𝐺̅ by 𝛥𝐺̅ = 𝑐1 𝛥𝑇̅ (< 𝛥𝑇̅) leads to a lower def-
...........................................................................................................................
icit. The reason why income does not change is that the decision to increase net
taxes by 𝛥𝑇̅ leads to an equal fall in disposable income and, for a given 𝑌, lowers
...........................................................................................................................
consumption by 𝑐1 𝛥𝑇̅; however, this drop in consumption is offset by the in-
crease in 𝐺̅ by 𝑐1 𝛥𝑇̅. Since aggregate demand does not change, equilibrium in-
come will not change either. Cher is right.
240
b. Consider now a different country, one in which there is only a goods market de-
scribed by the same set of equations specified above. Write down the goods market
equilibrium condition as an equality between national (private plus public) saving
and investment, and assume that the country’s government decides to raise net taxes,
𝑇̅. In the new equilibrium, national and private saving will be larger or smaller than
before? [Hint: you are NOT being asked to compute the expressions for the change
in private and national saving, but just to provide the economic intuition that helps
determine the direction in which they will change].
..........................................................................................................................
In goods market equilibrium, national saving (the sum of private saving and gov-
...........................................................................................................................
ernment saving) must equal investment, 𝑆 + (𝑇 − 𝐺) = 𝐼. The increase in net
...........................................................................................................................
taxes lowers equilibrium income by
...........................................................................................................................
−𝑐1 𝛥𝑇̅
𝛥𝑌̂ =
...........................................................................................................................
1 − 𝑐1 − 𝑑1
...........................................................................................................................
and thus leads to lower investment, since this latter variable is increasing in 𝑌.
It follows that national saving will have to fall by the same amount I has gone
...........................................................................................................................
down. Since public saving is greater than before (due to the increase in 𝑇̅), this
...........................................................................................................................
requires a lower private saving. Private saving will fall because of the decrease
in disposable income caused by the decrease in 𝑌̂ and the increase in 𝑇̅.
...........................................................................................................................
241
* Question 14
[Equilibrium in the money market and equilibrium in the market for the
monetary base]
a. Define what is meant by “monetary base”, also known as “central bank money”,
𝐻. Assuming that individuals hold money both in the form of currency and in
that of checkable deposits, show in the graph an equilibrium position in the mar-
ket for the monetary base and discuss how the interest rate prevailing in such an
equilibrium changes following a decrease in 𝐻, an increase in 𝑐 (the fraction of
their money individuals want to hold as currency) and a rise in 𝜃 (the reserve
ratio).
2
1
𝑖̅
0
𝐻𝑑 𝐻𝑑 ′
𝐻’ 𝐻 𝐻 𝑠 , 𝐻𝑑
...........................................................................................................................
...........................................................................................................................
The monetary base amounts to the central bank's overall liabilities − the sum of
...........................................................................................................................
bank reserves (𝑅) and currency (𝐶𝑈). The supply of monetary base, that in the
...........................................................................................................................
figure we assume to be initially given by 𝐻, is just the total amount of currency and
...........................................................................................................................
reserves outstanding at a given point in time, 𝐻 = 𝐶𝑈 + 𝑅. Since it has full control
...........................................................................................................................
over its liabilities, the supply of monetary base is under the control of the central
...........................................................................................................................
bank (for instance, through open market operations). It follows that, in a diagram
...........................................................................................................................
where the interest rate is measured on the vertical axis, it will be represented by a
...........................................................................................................................
vertical line at 𝐻 − the value of the monetary base chosen by the central bank. The
demand for monetary base, 𝐻 𝑑 , is the sum of the individuals' demand for currency,
𝐶𝑈 𝑑 = 𝑐𝑀𝑑 , and of the banks' demand for reserves, 𝑅 𝑑 = 𝜃(1 − 𝑐)𝑀𝑑 [the frac-
tion 𝜃 of individuals' demand for deposits]. Since 𝐻 𝑑 = 𝐶𝑈 𝑑 + 𝑅 𝑑 = [𝑐 +
𝜃(1 − 𝑐)]𝑀𝑑 , and given that 𝑀𝑑 is decreasing in the interest rate, the demand for
monetary base is a negatively sloped curve in the diagram above.
242
A fall in 𝐻, due for instance to the fact that the central bank has decided to sell
bonds in the open market, shifts the supply curve to the left. The equilibrium po-
sition goes from point ′0′ to point ′1′, where the interest rate is higher (the sale
of bonds lowers their price, thus rising their yield). Finally, an increase in 𝑐
and/or 𝜃 shifts the demand curve to the right, and the equilibrium from point ′0′
to a point such as ′2′ in the figure. In this case, the interest rate goes up for the
reasons that will be discussed answering the next question.
b. Using the diagram below, show how the same changes just considered (decrease
in 𝐻; rise in 𝑐 or 𝜃) will affect the money market equilibrium. Based on the
results of your analysis, what can you conclude about the relationship between
the value of the interest rate for which the market for the monetary base is in
equilibrium, and the value of the interest rate for which the money market is in
equilibrium?
𝐻
𝑐 + 𝜃(1 − 𝑐)
𝑖
𝑖̅ 0
↓ 𝐻, ↑ 𝑐, ↑ 𝜃 𝑀𝑑
𝑀’ 𝑀 𝑀 𝑠 , 𝑀𝑑
Let's start by writing down the equilibrium condition in the market for the mon-
etary base,
𝐻 = 𝐻𝑑
= [𝑐 + 𝜃(1 − 𝑐)]𝑀𝑑 .
Dividing both sides by the term in squared brackets, the previous equation be-
comes:
243
𝐻
= 𝑀𝑑 .
𝑐 + 𝜃(1 − 𝑐)
On the right-hand side, we now have the demand for money. The term on the left-
hand side is − as you might have guessed, being the equation above an equilib-
rium condition − the supply of money. When people hold both currency and
checkable deposits, one can in fact write 𝑀 as the ratio on the left-hand side of
the equilibrium condition above.1
It follows that, whenever the market for the monetary base is in equilibrium, the
money market, too, will be in equilibrium. One can therefore analyze the deter-
mination of the interest rate with reference to either market, reaching identical
conclusions for the equilibrium value of this variable.
If, for instance, 𝐻 falls, maybe because the central bank has decided to sell bonds
in1 the open market, the left-hand side of the above equation – the supply of money
– declines, leading to the same increase in 𝑖 we concluded will take place when
answering to point a. of this question.
The same will be true following an increase in 𝑐 and/or in 𝜃 – these changes, too,
will lower the supply of money, thus leading to the same increase in the equilib-
rium interest rate that, by looking at the market for the monetary base, we con-
cluded will take place.
1
By definition, the supply of money is the sum of currency and deposits,
𝑀 = 𝐶𝑈 + 𝐷,
while the monetary base is the sum of currency and reserves,
𝐻 = 𝐶𝑈 + 𝑅.
Taking the ratio of the two previous equations, one gets:
𝑀 𝐶𝑈 + 𝐷 𝑐𝑀 + (1 − 𝑐)𝑀 1
= = =
𝐻 𝐶𝑈 + 𝑅 𝑐𝑀 + 𝜃(1 − 𝑐)𝑀 𝑐 + 𝜃(1 − 𝑐)
𝑑 𝑑
where we have used the fact that, in equilibrium, 𝐶𝑈 = 𝐶𝑈 𝑑 = 𝑐𝑀 , 𝐷 = 𝐷𝑑 = (1 − 𝑐)𝑀 ,
𝑑
𝑅 = 𝑅𝑑 = 𝜃(1 − 𝑐)𝑀 , and 𝑀 = 𝑀𝑑 .
Finally, multiplying both sides of the previous equation by 𝐻 yields
𝐻
𝑀= .
𝑐 + 𝜃(1 − 𝑐)
244
Lastly, let's try to understand why increases in 𝑐 and/or in 𝜃 end up lowering the
money supply, thus raising the equilibrium value of the interest rate. The reason
is that, whenever banks increase (decrease) the loans they extend to their cus-
tomers, the money supply goes up (down). In fact, bank loans give rise to new
deposits (I get a mortgage from my bank to buy a house; the seller of the house
will deposit with her bank at least part of the price I paid), to further loans (the
bank where the seller of the house has deposited the sum I have paid will lend
out most of it), to new deposits, etc., in a process that leads to a multiple expan-
sion of bank deposits and of the money supply − which, remember, is the sum of
currency and bank deposits outstanding at a given point in time.
If 𝑐 goes up, individuals will deposit a smaller fraction of their money; experi-
encing a decrease in deposits, banks will be able to lend out less, deposits will
further shrink, and the money supply will fall. If, on the other hand, to rise is 𝜃,
the reserve ratio, banks will lend out a smaller fraction of any given amount of
deposits received by their customers. In either case, 𝑀 falls and the equilibrium
value of the interest rate rises.
245
* Question 15
[Endogenous money supply]
a. Write down the money market equilibrium condition. Assuming that money de-
mand, 𝑀𝑑 , is increasing in the general price level 𝑃 and in real income 𝑌, and
decreasing in the interest rate 𝑖, represent in the graph below a position of equi-
librium in the money market, denoting by 𝑖̅ the value that the interest rate takes
on in that equilibrium.
𝑖̅ 1
0
𝑀𝑑 𝑀𝑑 ′
𝑀 𝑀′ 𝑀 𝑠 , 𝑀𝑑
The money market equilibrium condition is

𝑀 𝑠 = 𝑀𝑑
where the term on the left-hand side is the nominal money supply (that in the figure
we assume to be initially equal to 𝑀), and that on the right-hand side the nominal
...........................................................................................................................
demand for money, increasing in 𝑃 and 𝑌, and decreasing in 𝑖,
...........................................................................................................................
𝑀𝑑 = 𝑀𝑑 (𝑃, 𝑌, 𝑖) (∗)
...........................................................................................................................
+ + −
Since €𝑌 = 𝑃𝑌, a functional form for the demand for money slightly more specific
...........................................................................................................................
than the one above is
...........................................................................................................................
𝑀𝑑 = €𝑌 ∙ 𝐿(𝑖) (∗∗)
−
...........................................................................................................................
Alternatively, one could posit
...........................................................................................................................
𝑀𝑑 = 𝑃 ∙ 𝐿(𝑌, 𝑖) (∗∗∗)
...........................................................................................................................
+ −
The functional forms (∗∗) and (∗∗∗) are both consistent with what equation (∗)
assumes about the way in which money demand should respond to changes
246
in its determinants; for this reason, they both lead to conclusions that are, at least
qualitatively, identical about the way in which an equilibrium in the money mar-
ket is reached, and on how this equilibrium is affected by shocks. For this reason,
and the fact that this choice greatly simplifies the analysis of the analytical ver-
sion of the model that will be introduced in the next Chapter, very often we shall
assume that the demand for money takes on the functional form (∗∗∗), rather
than the one given by equation (∗∗); sometimes, we shall also write the function
𝐿 (with 𝐿 = 𝑀𝑑 ⁄𝑃 = real money demand) as 𝐿(𝑌, 𝑖) = 𝑓1 𝑌 − 𝑓2 𝑖, so that
𝑀𝑑 = 𝑃(𝑓1 𝑌 − 𝑓2 𝑖).
In the above equation, 𝑓1 and 𝑓2 are positive parameters having the interpreta-
tion of sensitivity of the demand for money to the level of income and to the in-
terest rate, respectively.
No matter the functional form − (∗∗) or (∗∗∗) – assumed for the demand for
money, this latter will be a negatively sloped curve in a diagram where the inter-
est rate is measured on the vertical axis; in the same diagram, money supply will
be a line vertical at the value 𝑀 chosen by the central bank. In the figure, the
initial equilibrium is at point ′0′, with 𝑖 = 𝑖̅.
b. Suppose that the central bank aims at keeping the interest rate constant at the
level 𝑖 = 𝑖̅ and that, starting from an initial equilibrium like the one you have
just described, there is a rise in 𝑌, or in 𝑃. What should the central bank do, to
prevent such a change from leading to an equilibrium interest rate different from
𝑖̅? Explain.
Rises in 𝑌 or in 𝑃 – changes causing an increase in nominal income – shift the money

demand curve to the right, to a position such as 𝑀𝑑′ in the figure. Absent any
central bank intervention, the interest rate would increase. To keep 𝑖 equal to 𝑖̅,
the central bank will have to raise the money supply to 𝑀′, so as to make the new
equilibrium (initially point ′0′) point ′1′. More generally, if the central bank tar-
gets a specific value for the interest rate, the supply of money becomes endoge-
nous − the central bank will have to set 𝑀 at whatever level is consistent with
𝑖 = 𝑖̅, given the values that the other variables on which money demand depends
are taking on. If, for instance, the money demand function is 𝑀𝑑 = 𝑃(𝑓1 𝑌 − 𝑓2 𝑖),
the central bank will have to set 𝑀 = 𝑃(𝑓1 𝑌 − 𝑓2 𝑖̅), a choice that implies that, in
money market equilibrium, 𝑖 = 𝑖̅ always (to convince yourself that this will in-
deed be the case, just plug this expression for M in the money market equilibrium
condition, 𝑀 = 𝑀𝑑 ).
247
Question 16
True or false?
a. “Consider a simultaneous rise in the reserve ratio, θ, and in the fraction of

their money individuals want to hold in the form of currency, 𝑐. Since, for a
given monetary base 𝐻, they push money supply in opposite directions, the
two changes will have an ambiguous impact on 𝑀”.
False. Both changes tend to lower money supply. In fact, an increase in c de-
creases bank deposits, while an increase in θ leads bank to lend out a smaller
fraction of the deposits received from their customers. It follows that, in the case
we are asked to analyze, bank will end up lending a smaller fraction of a smaller
volume of deposits. Bank loans will fall, thus leading to a further decrease in
deposits, loans, deposits… and therefore in money supply.
248
b. “A new law banning cash transactions above €500 induces individuals to

reduce the fraction of the money they hold as currency (that is, the parameter
𝑐), and to increase that held in the form of bank deposits. It follows that one
effect of the new law will be a fall in money supply, 𝑀”.
False. Other things the same, the rise in bank deposits caused by the fall in c will
allow banks to expand their loans, thus leading to new deposits, further loans,
new deposits, etc., in a process that will lead to an expansion of the money supply
 which is the sum of the currency and the bank deposits outstanding.
249
Question 17
True or False?
“An increase in the price of bonds in the bond market makes bonds more attractive
and induces individuals to hold a smaller share of their financial wealth in the form
of money – the demand for money falls”.
False. If the price of bonds increases, their yield, the interest rate, will go down.
Other things the same, this fall in the interest foregone by holding money rather
than bonds will induce individuals to hold a larger fraction of their financial
wealth in the form of money. It follows that money demand will rise.
250
Question 18
In country Alpha, the central bank chooses, and wants to keep constant at the chosen
level, the interest rate, while in country Beta the central bank chooses the money
supply 𝑀 (and, once again, keeps it constant at the level it has chosen). The figure
below depicts the money market equilibrium in the two countries. As you can see,
in this initial equilibrium position money supply is the same in both, and the same is
true about the money demand curve and the equilibrium interest rate. Explain if you
agree, or do not agree, with the following statement: “If, in both countries, income
𝑌 falls by the same amount, the central bank of Alpha will have to decrease the
money supply to keep the interest rate constant, while in Beta – whose central bank
wants to prevent the money supply from changing – the interest rate will fall”.
1
𝑀𝑑
𝑀 𝑀, 𝑀𝑑
The statement is correct. The fall in income leads individuals to demand less
money for any given level of the interest rate, so that the 𝑀𝑑 curve shifts to the
left. It is true that, in Alpha, to keep the interest rate constant, the central bank
will have to decrease the money supply by the same amount by which money
demand has fallen, and that in Beta – whose central bank keeps the money supply
constant – the interest rate will go down.
251
Question 19
a. Define, briefly but rigorously, the following concepts:
a.1 ‘liquidity trap’;

a.2 contractionary open market operation (make sure to explain why the
intervention you are describing is ‘contractionary’).
...........................................................................................................................
a.1 Situation, typically associated with a zero (or, in any case, a very low)
interest rate, in which individuals are willing to hold more money (the most
...........................................................................................................................
‘liquid’ asset) even if the interest rate doesn’t change. When the economy
...........................................................................................................................
is in a liquidity trap, monetary policy (or, at least, conventional monetary
policy) is unable to affect the interest rate and the equilibrium position of
...........................................................................................................................
the economy.
...........................................................................................................................
a.2 Sale of bonds by the central bank in the market for these financial assets. It
...........................................................................................................................
is a ‘contractionary’ policy intervention because it ends up reducing the
supply of money (the central bank gets paid in currency or, more frequently,
...........................................................................................................................
with bank reserves; it follows that the monetary base, sum of currency and
...........................................................................................................................
reserves, decreases, and with it the money supply).
..............................................................................................
252
b. Explain why, when the economy is in a liquidity trap, an increase in money sup-
ply does not lower the interest rate.
...............................
Normally, an increase in money supply lowers the interest rate because, at the
initial income and interest rate levels, individuals have an incentive to use the
...........................................................................................................................
extra money injected in the economy to purchase bonds, assets with a rate of
...........................................................................................................................
return greater than the return on money. The ensuing increase in the demand for
bonds will raise bond prices and lower their yield, the interest rate. This latter
...........................................................................................................................
will keep dropping until it gets low enough to induce individuals to willingly hold
...........................................................................................................................
all the extra money now in the economy.
...........................................................................................................................
If, however, the economy is in a liquidity trap, with a zero (or, in any case, a very
low) interest rate, this process does not take place any longer. Individuals are
...........................................................................................................................
holding more money, but they do not try to convert this extra money into bonds,
...........................................................................................................................
as the return on bonds is now very close to that on money, and money has the
extra advantage of being the most liquid asset. In this case, even if money supply
...........................................................................................................................
increases, the demand for bonds does not change, and the interest rate therefore
...........................................................................................................................
does not fall.
253
Chapter 2 - The IS-LM model
* Question 1
[An analytical version of the IS-LM model − (I) The standard case
(endogenous money supply)]
In a closed economy, consumption, investment, government purchases of goods and

services and net taxes are described by the following equations:
𝐶 = 𝑐0 + 𝑐1 (𝑌 − 𝑇)
𝐼 = 𝐼 ̅ + 𝑑1 𝑌 − 𝑑2 𝑖
𝐺 = 𝐺̅
𝑇 = 𝑇̅
where 𝐼 ̅ is autonomous investment, the coefficients 𝑑1 and 𝑑2 , both positive, have
the interpretation of sensitivity of investment to income and to the interest rate, re-
spectively, and the other symbols have the usual meaning. Furthermore, assume that
the sum 𝑐1 + 𝑑1 (the “propensity to spend”) is positive but less than one, and that
nominal money demand (𝑀𝑑 ) depends positively on the general price level (𝑃) and
on real GDP (𝑌), and negatively on the interest rate (𝑖), as implied by the following
functional form:
𝑀𝑑 = 𝑃(𝑓1 𝑌 − 𝑓2 𝑖).
In the previous equation, that we have met already when answering Question 15 of
Chapter 1, the coefficients 𝑓1 and 𝑓2, both positive, have the interpretation of sensi-
tivity of (real) money demand 𝑀𝑑 ⁄𝑃 to income and to the interest rate, respectively.
Finally, suppose that the central bank sets the money supply so as to make sure that
the interest rate always takes on the value 𝑖 = 𝑖̅.
a. Derive the analytical expression of the IS curve for this economy, and draw the IS
in the (𝑌, 𝑖) plane. What determines the slope of the curve? And what causes par-
allel shifts of the IS curve in the plane? Explain, using the graphs below and
providing the economic intuition underlying your answers.
The IS curve is the locus of all the pairs (𝑌, 𝑖) for which the goods market is in
equilibrium − that is, for which the following equilibrium condition holds true:
...........................................................................................................................
𝑌 = 𝐶 + 𝐼 + 𝐺.
...........................................................................................................................
Plugging into the previous equation the functional forms for consumption, invest-
ment and government spending given above, yields:
...........................................................................................................................
𝑌 = 𝑐1 + 𝑐1 (𝑌 − 𝑇̅) + 𝐼 ̅ + 𝑑1 𝑌 − 𝑑2 𝑖 + 𝐺̅ .
...........................................................................................................................
Since the IS curve is drawn in a plane in which the interest rate is measured along
the vertical axis, it is convenient to solve this equation for 𝑖:
256
The IS-LM model
𝐴 1 − 𝑐1 − 𝑑1
𝑖= − ·𝑌
𝑑2 𝑑2
where A ( = 𝑐0 − 𝑐1 𝑇̅ + 𝐼 ̅ + 𝐺̅ ) is autonomous demand (or spending) – the sum
of all the components of the aggregate demand for goods and services that do
not depend on 𝑌 or 𝑖. Since 𝑑2 > 0 and 0 < 𝑐1 + 𝑑1 < 1, in the (𝑌, 𝑖) plane the
IS curve for the economy under consideration is a straight line with a positive
vertical intercept (equal to 𝐴⁄𝑑2 ) and a negative slope [− (1 − 𝑐1 − 𝑑1 )⁄𝑑2 ].
The above results have the following implications for the slope and the position
of the IS curve in the (𝑌, 𝑖) plane:
 The absolute value of the slope of the IS curve is greater (the IS is steeper)
the smaller are the propensity to spend (𝑐1 + 𝑑1 ) and the sensitivity of in-
vestment to the interest rate (𝑑2 ).
Suppose, for instance, that we are dealing with an economy where 𝑑2 is rel-
atively small, and let's try to understand why this leads to a relatively steep
IS curve (to check your understanding of the properties of this curve, make
sure that you can explain why one can reach the same conclusion if to be
relatively small are the values of 𝑐1 and/or 𝑑1 ). Let us assume that, initially,
the economy is at a point lying on the IS, and therefore in a goods market
equilibrium position. If, for some reason, the interest rate falls, investment
will rise. It follows that demand and equilibrium output will increase. For a
given decrease in 𝑖, the rise in investment, demand and output will be smaller
the less sensitive is investment to changes in the interest rate (that is, the
smaller is 𝑑2 ). But if, for any given decrease in the interest rate, the increase
in 𝑌 needed to return to a goods market equilibrium position is small, the IS
curve will be relatively steep. In the limiting case in which investment does
not depend on 𝑖 (𝑑2 = 0), changes in the interest rate will not lead to changes
in the aggregate demand for goods and services, thus leaving equilibrium
output unchanged. In this case, the IS curve is a vertical line.
 Increases (decreases) in 𝑐0 , 𝐼 ,̅ 𝐺̅ and/or decreases (increases) in 𝑇̅ cause a
parallel rightward (leftward) shift of the IS curve.
In fact, and for any given level of the interest rate prevailing in the economy,
the changes mentioned above raise (lower) the demand for goods, thus lead-
ing to an increase (decrease) in equilibrium output.
The next figures summarize the conclusions we have just reached about the slope
and the position of the IS curve in the (𝑌, 𝑖) plane.
257
𝑐1 , 𝑑1 𝑖 𝑐1 , 𝑑1
𝑖 and/or 𝑑2
and/or 𝑑2
“small” “large”
𝐼𝑆
𝐼𝑆
𝑌 𝑌
𝑖 𝑖
↑𝑐0 , ↑𝐼 ̅ , ↑𝐺̅ , ↓𝑇̅
↓𝑐0 , ↓𝐼 ̅ , ↓𝐺̅ , ↑𝑇̅ 𝐼𝑆

𝐼𝑆
𝑌 𝑌
b. Derive the analytical expression of the LM curve for this economy, and draw
the LM in the (𝑌, 𝑖) plane.
The LM curve is the locus of all the pairs (𝑌, 𝑖) for which the money market is in
equilibrium − that is, for which the following equilibrium condition holds true:
𝑀 = 𝑀𝑑 ,
where the term on the left-hand side is the money supply in nominal terms, and
that on the right-hand side nominal money demand. The same equilibrium con-
dition can be written in real terms by dividing both sides by the general price
level, 𝑃:
𝑀 ⁄𝑃 = 𝑀 𝑑 ⁄𝑃 .
Given the functional form that, by assumption, money demand takes on in this
economy, the previous equation becomes:
𝑀/𝑃 = (𝑓1 𝑌 − 𝑓2 𝑖).
To make sure that 𝑖 = 𝑖̅ always, the central bank will have to set 𝑀 =
𝑃(𝑓1 𝑌 − 𝑓2 𝑖̅), something that − as discussed in the answer to Question 15 of
Chapter 1 – guarantees that the interest rate will always be equal to 𝑖̅. Given the
way in which, in this economy, the central bank sets 𝑀, the equation of the LM
curve is 𝑖 = 𝑖̅ .
258
The IS-LM model
In the (𝑌, 𝑖) plane, the LM is therefore a horizontal line drawn at the value of the
interest rate chosen by the central bank, 𝑖̅.
𝑖̅ 𝐿𝑀
c. Derive the equilibrium values of 𝑌 and 𝑖. By how much will equilibrium

output change if autonomous demand changes by 𝛥𝐴? And by how much,
following a change 𝛥𝑖̅ in the level of the interest rate chosen by the central
bank?
The equilibrium values of 𝑌 and 𝑖 are the solutions to the system of two equations
given by the analytical expressions of the IS and the LM curves:
𝐴 1 − 𝑐1 − 𝑑1
𝑖= − ·𝑌
𝑑2 𝑑2
𝑖 = 𝑖̅ .
Given our assumption about the behavior of the central bank, in equilibrium the
interest rate will always be equal to 𝑖̅. To find the equilibrium value of output, 𝑌̂,
replace 𝑖 with 𝑖̅ in the first equation, the IS curve. Solving for 𝑌, one gets:
1 𝑑2
𝑌̂ = ·𝐴− · 𝑖̅ .
1 − 𝑐1 − 𝑑1 1 − 𝑐1 − 𝑑1
The change in equilibrium output 𝑌̂ caused by a change 𝛥𝐴 in the level of auton-
omous demand is therefore 𝛥𝑌̂ = [1⁄(1 − 𝑐1 − 𝑑1 )] · 𝛥𝐴. The constant
1⁄(1 − 𝑐1 − 𝑑1 ) is sometimes referred to as “fiscal policy multiplier”, since
changes in 𝐺̅ and/or 𝑇̅ are among the possible causes of the changes in 𝐴 whose
effects we are studying. When, like in this economy, the central bank chooses a
level for the interest rate, the fiscal policy multiplier is therefore identical to the
income, or keynesian, multiplier derived when studying the goods market in iso-
lation. Finally, when the change disturbing the equilibrium of the economy is one in
𝑖̅, 𝛥𝑌̂⁄𝛥 𝑖̅ = − 𝑑2 ⁄(1 − 𝑐1 − 𝑑1 ). Notice that this constant – the “monetary pol-
icy multiplier” – equals zero if 𝑑2 = 0, that is, if no component of aggregate
demand depends on the interest rate.
259
* Question 2
[An analytical version of the IS-LM model − (II) Exogenous money supply]
Consider an economy different from the one studied in the previous question only
for the fact that, rather than the interest rate, its central bank chooses a value for the
nominal money supply 𝑀, and then lets the interest rate take on any value that turns
out to be consistent with the macroeconomic equilibrium for that given 𝑀.
a. Denoting by 𝑀̅ the value of 𝑀 chosen by the central bank, derive the analytical
expressions of the IS and LM curves for this economy.
The analytical expression of the IS curve is identical to the one derived in the
answer to the previous question. Its slope and position in the (𝑌, 𝑖) plane will
therefore be determined by the same factors discussed before. As for the LM
curve, to derive its expression let us write down the money market equilibrium
condition,
𝑀
= (𝑓1 𝑌 − 𝑓2 𝑖)
𝑃
and set 𝑀 = 𝑀 ̅ (the constant level at which the central bank keeps the supply of
money) in this equation. Since, as usual, the LM curve will be drawn in a plane
in which the interest rate is measured on the vertical axis, it is convenient to solve
for 𝑖. This leads to the following expression of the LM curve:
1 𝑀 ̅ 𝑓1
𝑖 = − ( ) · + ( ) · 𝑌.
𝑓2 𝑃 𝑓2
b. Draw the portion of the LM curve entirely lying in the first quadrant of the (𝑌, 𝑖)
plane (that is, the portion of the curve corresponding to positive values of both
output and the interest rate).1 What determines its slope? Which are the causes
of parallel shifts of the LM curve in that plane? Explain, using the following
graphs and providing the economic intuition underlying your results.
1
The assumption that the nominal interest rate cannot take on negative values allows us to disregard
the portion of the LM curve lying in the second quadrant. We shall discuss later on the shape of the LM
curve when the nominal interest rate is zero (that is, when it is at its "zero lower bound") and − as
assumed in the present question − the central bank chooses the nominal money supply.
260
The IS-LM model
Since 𝑓1 , 𝑓2 > 0, the LM curve for this economy is, in the (𝑌, 𝑖) plane, a straight
̅ ⁄𝑃, and positive slope
line with a negative vertical intercept equal to −(1⁄𝑓2 ) 𝑀
equal to the ratio 𝑓1⁄𝑓2 . The above results have the following implications for
the slope and the position of the LM curve in the (𝑌, 𝑖) plane:
 The slope of the LM curve is greater (the LM is steeper) the more sensitive is
money demand to income (that is, the larger is 𝑓1 ), and the less sensitive it is
to the interest rate (the smaller is 𝑓2 ).
First of all, to understand why the LM curve is, in this economy, positively
sloped, let us assume that we are initially on the LM, and therefore in a
money market equilibrium position. If, for some reason, starting from this
initial position income goes up, money demand will rise. In the money mar-
ket, this change will lead to an excess demand for money over the supply of
money (recall that, in this economy, the central bank keeps money supply
constant at the chosen level 𝑀 ̅ ). To return to a money market equilibrium,
the initial increase in Y must be matched by a rise in the interest rate. This
explains the positive slope of the LM. But by how much will have the interest
rate to go up? The increase in the interest rate needed to return in equilib-
rium will be larger the greater is 𝑓1. If 𝑓1is very large (that is, money demand
very sensitive to income), for any given increase in Y money demand will go
up by a lot, the excess demand in the money market will be large, and to
eliminate it the interest rate will have to rise a lot – the LM curve will there-
fore be relatively steep. To check your understanding of the properties of the
LM curve in the case analyzed in the present question, make sure that you
can explain why, for a given 𝑓1, the slope of the LM curve is decreasing in
𝑓2, the sensitivity of money demand to the interest rate.
 Increases (decreases) in 𝑀̅ , and/or decreases (increases) in 𝑃 cause parallel
rightward (leftward) shifts of the LM curve.
For any given level of income 𝑌, the changes metioned above raise (lower)
real money supply, thus leading to a fall (rise) in the level of the interest rate
for which the money market is in equilibrium.
The next figures summarize the conclusions we have just reached about the slope
and the position of the LM curve in the (𝑌, 𝑖) plane for an economy in which the
central bank chooses the money supply.
261
𝑖 𝐿𝑀 𝑖
𝑓1 “small”,
𝑓1 “large”, 𝐿𝑀
and/or
and/or
𝑓2 “large”
𝑓2 “small”
𝑌 𝑌
𝑖 𝐿𝑀 𝑖 𝐿𝑀
̅ , ↑𝑃
↓𝑀
̅̅̅ ↓𝑃
↑𝑀,
𝑌 𝑌
c. Derive the equilibrium values of 𝑌 and 𝑖. By how much will equilibrium output
change if autonomous demand changes by 𝛥𝐴? And by how much, following a
change 𝛥𝑀 ̅ in the nominal money supply?
The equilibrium values of 𝑌 and 𝑖 are the solutions to the system of two equa-
tions given by the analytical expressions of the IS and the LM curves. For the
economy under consideration, the system is the following one:
𝐴 1 − 𝑐1 − 𝑑1
𝑖= − 𝑌
𝑑2 𝑑2
1 𝑀̅ 𝑓1
𝑖 = −( ) + ( )𝑌 .
𝑓2 𝑃 𝑓2
Equating the right-hand sides of the two equations above, solving for 𝑌 and then
plugging the result in the first or in the second one, yields the following expres-
sions for the equilibrium values of 𝑌 and 𝑖:
1 𝑑2 ̅
𝑀
𝑌̂ = ·𝐴+ · (∗)
(𝑓1 𝑑2 ⁄𝑓2 ) + (1 − 𝑐1 − 𝑑1 ) 𝑓1 𝑑2 + 𝑓2 (1 − 𝑐1 − 𝑑1 ) 𝑃
𝑓1⁄𝑓2 (1 − 𝑐1 − 𝑑1 ) ̅
𝑀
𝑖̂ = ·𝐴− · (∗∗)
(𝑓1 𝑑2 ⁄𝑓2 ) + (1 − 𝑐1 − 𝑑1 ) 𝑓1 𝑑2 + 𝑓2 (1 − 𝑐1 − 𝑑1 ) 𝑃
262
The IS-LM model
These expressions, that may look rather intimidating (however, bear in mind that
you are not supposed to memorize them, and that no exam question will ask you
to derive them) are useful because they allow one to understand why, and by how
much, policy interventions and other shocks hitting an economy in which the cen-
tral bank chooses the money supply will affect the macroeconomic equilibrium.
In particular, the question asks us to determine the change in equilibrium output
caused by a change 𝛥𝐴 in autonomous demand. From the expression for 𝑌̂ we
have just derived, it follows that
1
𝛥𝑌̂ = · 𝛥𝐴
(𝑓1 𝑑2 ⁄𝑓2 ) + (1 − 𝑐1 − 𝑑1 )
where the ratio multiplying 𝛥𝐴 on the right-hand side is the “fiscal policy mul-
tiplier” − the constant by which one has to multiply any given change 𝛥𝐴 in
autonomous spending in order to get the ensuing change in equilibrium output –
in an economy where the central bank chooses the level of 𝑀. Notice that, being
𝑓1 , 𝑓2 , 𝑑2 > 0 by assumption, this multiplier will be always lower than the fiscal
policy multiplier prevailing when the central bank chooses a value for 𝑖 and that,
answering Question 1.c of this Chapter, we have concluded is given by
1⁄(1 − 𝑐1 − 𝑑1 ). Why this is necessarily the case will become clear when an-
swering some of the next questions.
Finally, the “monetary policy multiplier” (the constant by which one has to mul-
tiply any given change in 𝛥𝑀̅ /𝑃 in the real money supply, or – which is the same,
given the assumption of constant prices − in nominal money supply in order to
1
get the corresponding change in equilibrium output, 𝛥𝑌̂) is the ratio that multi-
plies 𝑀̅ ⁄𝑃 in equation (∗) above.1
1
In Question 1 of this Chapter, where the central bank was choosing the interest rate, the monetary
policy multiplier measured the impact on 𝑌̂ of a change in the value chosen for 𝑖; in the economy studied
in the present question, where the central bank chooses 𝑀, that multiplier measures instead the impact
on 𝑌̂ of a change in 𝑀̅ , the value of 𝑀 chosen by the central bank. Also in this latter case, however, a
change in money supply affects 𝑌̂ by changing 𝑖. Using equation (∗∗) above to compute the change in
𝑀̅ needed to change 𝑖̂ by the same 𝛥𝑖̅ assumed in Question 1, one gets:
𝛥𝑀̅ 𝑓1 𝑑2 + 𝑓2 (1 − 𝑐1 − 𝑑1 )
=− · 𝛥𝑖.̅
𝑃 (1 − 𝑐1 − 𝑑1 )
̅ so determined into the relation between 𝛥𝑀
Plugging the expression for 𝛥𝑀 ̅ e 𝛥𝑌̂ implied by equation
(∗), it is straightforward to conclude that the impact on income of a monetary impulse is identical in
both cases [equal to 𝛥𝑌 ̂ ⁄𝛥 𝑖̅ = − 𝑑2 ⁄(1 − 𝑐1 − 𝑑1 )], once such an impulse is expressed in a com-
parable fashion.
263
Question 3
a. Gamma is a closed economy described by a standard IS-LM model,1 given by

the following system:
𝐴 1 − 𝑐1 − 𝑑1
𝑖= − ·𝑌
𝑑2 𝑑2
𝑖 = 𝑖̅ .
In the equations above, 𝑖̅ is the value of the interest rate chosen by the central
bank, and the other symbols have the usual meaning. As discussed in the answer
to Question 1 of this Chapter, in this model the fiscal policy multiplier is:
𝛥𝑌̂ 1
= . (∗)
𝛥𝐴 (1 − 𝑐1 − 𝑑1 )
What does the ‘fiscal policy multiplier’ measure? Knowing that, in Gamma, it
equals 2, by how much will equilibrium output change if government spending
on goods and services 𝐺̅ goes up by 200 and, at the same time, autonomous con-
sumption 𝑐0 falls by 100? Explain.
As it is straightforward to conclude from (∗), the fiscal policy multiplier

measures how much the equilibrium level of output changes following a change
...........................................................................................................................
in autonomous spending 𝐴 = 𝑐0 − 𝑐1 𝑇̅ + 𝐼 ̅ + 𝐺̅ . [Alternatively, it is the coeffi-
...........................................................................................................................
cient that multiplies autonomous spending 𝐴 in the expression of equilibrium out-
put one gets solving the analytical version of the IS-LM model]. Since in this case
...........................................................................................................................
the fiscal policy multiplier is 2, and 𝛥𝐴 = 𝛥𝑐0 + 𝛥𝐺̅ = −100 + 200 = 100, the
...........................................................................................................................
change in equilibrium output will be 𝛥𝑌 = 2 · 𝛥𝐴 = 2 · 100 = 200.
...........................................................................................................................
1
From now on, by "a standard IS-LM model" we shall mean a model like the one studied in Question
1 of this Chapter, and therefore based on the following assumptions:
 consumption function of disposable income, investment function of 𝑌 and 𝑖, nominal money
demand function of 𝑃, 𝑌 and 𝑖;
 𝐺 and 𝑇 both exogenous;
 the central bank chooses a value 𝑖 = 𝑖̅ for the interest rate, and sets nominal money supply to
whatever level is consistent with the attainment of this target value for 𝑖;
 constant prices, and therefore current and future expected inflation rates equal to zero.
264
The IS-LM model
b. Consider now two different countries, Delta and Epsilon, whose IS curves are
drawn in the graphs below. Suppose that the different slopes of the two curves
only reflect differences in the value that the parameter 𝑑2 , the sensitivity of in-
vestment to the interest rate, takes on in the two countries. All the remaining
parameters take on identical values in Delta and in Epsilon. Explain what is
meant by “monetary policy multiplier”,
𝛥𝑌̂ 𝑑2
=−
𝛥𝑖̅ (1 − 𝑐1 − 𝑑1 )
and, making explicit reference to this concept (discussed in the answer to Ques-
tion 1 of this Chapter), discuss if the central bank's decision of changing the
interest rate by the same 𝛥𝑖̅ in the two countries will change equilibrium output
more in Delta or in Epsilon.
𝐷𝐸𝐿𝑇𝐴 𝐸𝑃𝑆𝐼𝐿𝑂𝑁
𝑖 𝑖
𝐼𝑆𝐷𝑒𝑙𝑡𝑎
𝐼𝑆𝐸𝑝𝑠𝑖𝑙𝑜𝑛
𝑌 𝑌
...........................................................................................................................
...........................................................................................................................
The monetary policy multiplier is the constant by which one has to multiply any
given change in the level of interest rate chosen by the central bank in order to
...........................................................................................................................
get the corresponding change in equilibrium output. The IS curve is flatter the
...........................................................................................................................
larger is 𝑑2 , the sensitivity of investment to the interest rate. It follows from the
graphs above that 𝑑2 is larger in Delta. Since monetary policy interventions −
...........................................................................................................................
decisions of changing 𝑖̅ taken by the central bank − affect equilibrium output by
...........................................................................................................................
changing those components of aggregate demand that depend on the interest rate
(in the standard model analyzed in the present question, investment only), equi-
...........................................................................................................................
librium output will rise more in Delta, where 𝑑2 is larger and where investment
...........................................................................................................................
and aggregate demand will therefore respond more to any given change in the
interest rate. More formally, the ratio on the right-hand side of the expression of
...........................................................................................................................
the fiscal policy multiplier written above is increasing in 𝑑2 ; it follows that the
same will be true about the change in equilibrium output caused by any given 𝛥𝑖̅
decided by the central bank.
265
Question 4
a. In country Macro, described by the IS-LM model, government purchases of

goods and services, net taxes and investment are exogenous (𝐺 = 𝐺̅ , 𝑇 = 𝑇̅ and
𝐼 = 𝐼 )̅ , while the consumption function is 𝐶 = 𝑐0 + 𝑐1 (𝑌 − 𝑇̅) − ℎ2 𝑖, where the
parameter ℎ2 > 0 is the sensitivity of consumption to the interest rate. In this
economy, will the slope of the IS curve in the (𝑌, 𝑖) plane be negative, zero or
positive? Explain. [Hint: no formal derivation of the IS curve is required – just
provide the economic intuition underlying your answer]. Next, represent the
initial equilibrium of Macro in an IS-LM diagram, denote it by ‘0’ and study the
effects of a decrease in net taxes. In particular, denote by ‘1’ the new equilibrium
the economy will reach and explain the reasons for the changes in equilibrium
income, consumption and investment that will take place in the move from ‘0’
to ‘1’. As the economy goes from the first to the second equilibrium, how must
the changes in consumption and in income be related to one another?
𝑖̅2 2
LM1
𝑖̅0 1
LM0
0
ISO IS1
𝑌̂0 𝑌̂1 𝑌
266
The IS-LM model
Even though investment does not depend on i, aggregate demand is nevertheless

decreasing in the interest rate, since an increase in this latter variable lowers
consumption. The IS curve has therefore, as usual, a negative slope (if, starting
from a goods market equilibrium position, i falls, in this economy C will rise,
leading to an excess demand for goods; to return to equilibrium, the supply of
goods, Y, will have to go up). If 𝑇̅ decreases, the IS curve shifts to the right, since
the increase in disposable income caused by the tax cut raises consumption, and
with it aggregate demand, for any given level of 𝑌. The equilibrium point be-
comes 1, with a higher level of output. Being 𝐺 and 𝐼 (in this economy, both
exogenous) unchanged, consumption must have gone up. Since in this new equi-
librium supply and demand must be equal, and consumption is the only compo-
nent of aggregate demand that has changed, in the move from ‘0’ to ‘1’ 𝐶 must
have risen by the same amount by which 𝑌, the supply of goods, has gone up.
b. Suppose now that Macro’s central bank intends to bring back equilibrium in-
come to its initial level, 𝑌0 . To achieve its goal, should it raise or lower the inter-
est rate? Show in the graph the new equilibrium that will be reached following
the monetary policy intervention that you are proposing, denoting it by ‘2’. Fi-
nally, compare the composition of aggregate demand at ‘2’ with that prevailing
in the initial equilibrium ‘0’.
The central bank will have to raise the interest rate. In the new equilibrium ‘2’,
the interest rate is 𝑖̅2 (> 𝑖̅0 ), and income is back to its initial level. It follows that
aggregate demand will have to take on, at ‘2’, the same value it was taking on at
‘0’. Being both G and I exogenous, this requires consumption to be, in the final
equilibrium ‘2’, the same as in the initial equilibrium ‘0’ – the favorable impact
of the decrease in net taxes, which tends to raise 𝐶, must have been exactly offset
by the adverse impact that, in this economy, a higher interest rate has on con-
sumption.
267
Question 5
True or false?
a. “In an IS-LM model that departs from the standard case only for the fact that,
rather than the interest rate, the central bank chooses the nominal money supply,
keeping it constant at the level 𝑀 = 𝑀 ̅ , the higher the sensitivity of investment
to the interest rate, the larger the increase in equilibrium income caused by an
expansionary fiscal policy”.
False, the opposite is true.

The immediate effect of an expansionary fiscal policy is to make aggregate de-
mand and output increase. However, this increase in production and income dis-
turbs the money market equilibrium, leading to an excess demand for money and
– since the central bank keeps the nominal money supply constant – to an in-
crease in interest rate, 𝑖. In turn, this higher 𝑖 will lower investment, by an amount
which will be larger the higher the sensitivity of investment to the interest rate
(or, alternatively, the flatter the IS curve). This decrease in investment mitigates
the initial increase in income caused by the expansionary fiscal policy.
We may conclude that an expansionary fiscal policy has its maximum effect on
output when investment does not depend on the interest rate – the IS curve is
vertical.
268
The IS-LM model
b. “In a standard IS-LM model, in which the central bank chooses the interest rate
and keeps it constant at the level deemed appropriate given the state of the econ-
omy (for instance, at 𝑖 = 𝑖̅), the higher the sensitivity of investment to the interest
rate, the larger the increase in equilibrium income caused by an expansionary
fiscal policy”.
False. As it is immediate to conclude also noticing that the parameter 𝑑2 does

not enter the expression for what has been defined ‘fiscal policy multiplier’ in the
answer to point c of Question 1 of this Chapter, in this case the extent by which
equilibrium income goes up following a fiscal stimulus is independent of the in-
terest rate sensitivity of investment.
In fact, and as discussed answering the previous point, the expansionary fiscal
policy still leads to a higher aggregate demand and a higher production. For a
given money supply, this would cause an increase in the interest rate. However,
since it now wants 𝑖 to remain at the chosen level, 𝑖 = 𝑖̅, the central bank will in
this case intervene, raising the money supply by the amount needed to keep the
interest rate unchanged. And, with an unchanged 𝑖, the sensitivity of investment
to changes in the interest rate will play no role in determining the extent by which
the fiscal expansion will impact on output.
269
Question 6
a. Gamma is a closed economy initially in goods and in money markets equilib-

rium. A wave of optimism about the economic future of the country leads to an
increase in autonomous consumption, 𝑐0 . Using a standard IS-LM model,
graphically represent the effects of such a change on equilibrium income. In ad-
dition, discuss the effects on equilibrium consumption, investment, private sav-
ing and national saving, explaining the reasons for the observed changes in these
variables.
1 2
𝑖̅ 𝐿𝑀
𝐼𝑆 𝐼𝑆′
𝑌̂ ̂
𝑌′ 𝑌
An increase in the autonomous component of consumption causes a rightward

shift of IS curve. The equilibrium changes from point 1 to point 2. Income rises,
as firms will meet the extra demand they now face by producing more. Since the
central bank keeps the interest rate at 𝑖̅, in the new equilibrium investment will
be higher (due to the increase in income). The same will be true about consump-
tion, that goes up both for the increase in its autonomous component and for the
increase in equilibrium income. Given that, when the economy goes from the in-
itial equilibrium 1 to the new equilibrium 2, investment rises, the same must be
true about national saving. Being public saving unchanged, private saving will
be necessarily higher (by the same amount by which investment has gone up).
270
The IS-LM model
b. Consider now country Delta. The only difference between Gamma and Delta lies
in the policy rule followed by their central banks. While, as we already know
from the first part of this question, Gamma's central bank chooses a level for the
interest rate, Delta's central bank chooses a level for the nominal supply of
money 𝑀 and, given that level, lets the interest rate take on any value turns out
to be consistent with the macroeconomic equilibrium. Suppose now that, when
the two countries are in an initial equilibrium with identical values of 𝑌 and 𝑖,
Delta experiences the same increase in 𝑐0 discussed in the previous point of this
question. Compared with what happened in Gamma, will income change more
or less in Delta? Represent graphically, and explain.
𝑖
𝐼𝑆 𝐼𝑆′
𝐿𝑀𝐷𝑒𝑙𝑡𝑎
2𝐷
1 2𝐺
𝑖̅ 𝐿𝑀𝐺𝑎𝑚𝑚𝑎
𝑌̂ 𝑌̂𝐷′ 𝑌̂𝐺′ 𝑌
Rather than flat as in Gamma, Delta's LM curve will be positively sloped. As the
figure allows one to conclude, any given increase in 𝑐0 will raise 𝑌 less in Delta
than in Gamma. In fact, the increase in aggregate demand caused by the rise in
the autonomous component of consumption will increase output, and income, in
both countries. Remember, however, that Delta's central bank keeps 𝑀 constant.
It follows that, in that country, the increase in 𝑌, by raising money demand, will
lead to an excess demand for money and to an increase in the interest rate for
which the money market is in equilibrium. This increase in 𝑖 (that, notice, takes
place in Delta, but not in Gamma) mitigates the positive impact of the increase
in 𝑐0 on aggregate demand. But if, in Delta, the rise in aggregate demand is
smaller than that taking place in Gamma, then Delta's equilibrium output will
rise less than Gamma's.
271
Question 7
a. Consider the economy of country Epsilon, described by an IS-LM model depart-

ing from the standard case only because the (private) saving function is 𝑆 =
−𝑐0 + (1 − 𝑐1 )(𝑌 − 𝑇̅) + ℎ2 𝑖, where ℎ2 > 0 is the sensitivity of savings to the
interest rate and the other symbols have the usual meaning.
a.1 Write down the consumption function for this economy.
a.2 Assuming that all the other behavioral functions (investment, money demand,
etc.) are standard, explain if and why, following an expansionary monetary pol-
icy, when ℎ2 > 0 equilibrium income increases more or less than in the stand-
ard case (ℎ2 = 0) [Hint: no formal derivation of the IS and LM curves is re-
quired – just provide the economic intuition underlying your answer].
a.1 𝐶 = (𝑌 − 𝑇̅) − 𝑆 = 𝑐0 + 𝑐1 (𝑌 − 𝑇̅) − ℎ2 𝑖 .
a.2 When ℎ2 > 0, a monetary expansion raises 𝑌 more than in the standard case
– the decrease in the interest rate decided by the central bank boosts not
just investment, but also consumption, thus causing a larger increase in ag-
gregate demand and equilibrium income.
272
The IS-LM model
b. If, rather than a monetary expansion, to be implemented is going to be a fiscal

expansion (consisting for instance in an increase in government purchases of
goods and services, 𝐺̅ ), how will your answer to the previous point a.2 change?
In particular, compare the change in equilibrium output in Gamma (where ℎ2 >
0) with the change that would prevail in the standard case (ℎ2 = 0). Illustrate in
the graph below, and explain.
0 1
𝑖̅ 𝐿𝑀
𝐼𝑆′ℎ2>0
𝐼𝑆ℎ2>0
𝐼𝑆ℎ2=0 𝐼𝑆′ℎ2=0
𝑌̂0 𝑌̂1 𝑌
The initial equilibrium is point 0; the new one point 1.

..........................................................................................................................
When, in addition to investment, also consumption depends negatively on the in-
terest rate (that is, when ℎ2 > 0), the IS curve is less steep than in the standard
...........................................................................................................................
case (ℎ2 = 0), as shown in the figure [to check your understanding of the IS-LM
...........................................................................................................................
model, make sure you can explain why this must necessarily be true]. In any case,
no matter whether ℎ2 is positive or zero, an increase in 𝐺̅ causes the same par-
...........................................................................................................................
allel, rightward shift of the IS curve and, since the central bank keeps the interest
...........................................................................................................................
rate at the chosen level 𝑖̅ (or, equivalently, since the LM curve is horizontal),
leads to the same increase in equilibrium output. On the basis of the analytical
...........................................................................................................................
version of the IS-LM model introduced in Question 1 of this Chapter, it is also
...........................................................................................................................
possible to conclude that, in both cases, the size of the horizontal shift to the right
of the IS curve, and the amount by which equilibrium output will rise, are both
..........................................................................................................................
given by [1⁄(1 − 𝑐1 − 𝑑1 )] · 𝛥𝐺̅ , an expression that does not depend on the sen-
sitivity of aggregate demand to the interest rate.
273
Question 8
True or false?
a. “The government of an economy described by a standard IS-LM model decides

to implement an expansionary fiscal policy. To keep the interest rate at its target
value 𝑖 = 𝑖̅, the central bank will have to raise money supply by an amount that
is going to be larger the more sensitive is money demand to changes in income”.
True.
The expansionary fiscal policy will disturb the equilibrium in the goods market,
raising output by the income multiplier times the change in autonomous demand
caused by the fiscal stimulus. If, for instance, the government has decided to raise
𝐺̅ , equilibrium output will go up by 𝛥𝑌̂ = [1⁄(1 − 𝑐1 − 𝑑1 )] · 𝛥𝐺̅ . In turn, this
increase in income will disturb the money market equilibrium. Money demand,
that depends positively on 𝑌, will rise and, should the central bank keep money
supply constant, at the initial interest rate 𝑖 = 𝑖̅ there would be an excess demand
for money on the supply of money. It follows that, to prevent this disequilibrium
from pushing 𝑖 above 𝑖̅, the central bank will have to intervene. More specifically,
the central bank will have to increase money supply exactly by the amount by
which the rise in equilibrium income has raised money demand − an amount that
is larger the more sensitive money demand is to changes in income (that is, the
larger is the parameter 𝑓1 we have defined when discussing the analytical version
of the IS-LM model in Question 1 of this Chapter).
274
The IS-LM model
b. “When the economy is in a liquidity trap, with the nominal interest rate at its
‘zero lower bound’, an expansionary fiscal policy cannot influence the equilib-
rium level of output”.
False.
When the economy is in a liquidity trap, to be powerless to affect output is mon-
etary policy (or, at least, so are the “conventional” monetary policy tools dis-
cussed in this Chapter). In fact, a monetary expansion affects the demand for
goods, and therefore production, by lowering the interest rate, thus raising the
components of aggregate demand that depend on 𝑖. If, however, the interest rate
is already at its lower bound, it cannot fall any further, and the channel through
which monetary policy affects the real economy is no longer operational. In a
similar situation, the only policy able to raise equilibrium output is fiscal policy.
275
Question 9
Consider a country described by an IS-LM model departing from the standard one
only for the fact that, rather than the interest rate, the central bank chooses the nom-
inal money supply and, given the level selected for 𝑀, allows the interest rate to take
on any value is consistent with the macroeconomic equilibrium. We are therefore in
the case considered in Question 2 of this Chapter. In particular, and as it was assumed
there, real money demand is 𝐿(𝑌, 𝑖) = 𝑓1 𝑌 − 𝑓2 𝑖.
a. Suppose that the country is in a ‘liquidity trap’. Represent in the graph its
initial equilibrium, denoting it by ‘1’, and by 𝑖1 and 𝑌1 the values that the
interest rate and production take on in that equilibrium position. Assume
now that autonomous consumption 𝑐0 and net taxes 𝑇̅ fall at the same time
and by the same amount, so that 𝛥𝑐0 = 𝛥𝑇̅ < 0. Show in the graph, and
explain, how these changes affect the levels of the country’s interest rate and
output, denoting by 𝑖2 and 𝑌2 the values these variables will take on in the
new equilibrium (‘2’). In this new equilibrium position, investment will be
higher or lower? And what about national saving (the sum of private and
public saving)? Motivate your answer.
𝑖
𝐿𝑀1
𝐿𝑀3
𝐼𝑆1
𝐼𝑆2
2 1 D
𝑖1 = 𝑖2 = 0
𝑌2 𝑌1 E Y
−(1⁄𝑓2 )(𝑀⁄𝑃)
−(1⁄𝑓2 )(𝑀′⁄𝑃 )
276
The IS-LM model
If we allow for the possibility that the nominal interest rate reaches its lower
bound (that is, zero), the LM for an economy in which the central bank chooses
a value for the nominal money supply consists of two portions with different
slopes: one that, as discussed in the answer to Question 2 of this Chapter, is
positively sloped for values of the interest rate greater than zero; and a second
one that − since the nominal interest rate cannot take on negative values − co-
incides with the x-axis for 𝑖 = 0. Furthermore, increases in money supply cause
parallel, rightward shifts of the positively sloped portion of the curve, prolonging
at the same time the horizontal portion. In the figure, we are assuming that, ini-
tially, the LM is given by the broken line 0D-𝐿𝑀1 . Since we are told that the
economy is in a liquidity trap (that is, in an equilibrium with 𝑖 = 0), the initial
intersection between the IS and the LM curves must take place somewhere along
the horizontal portion of the LM, at a point like ′1′ in the figure, where output is
𝑌1 and the interest rate is 𝑖1 = 0. If autonomous consumption 𝑐0 and net taxes 𝑇̅
fall at the same time and by the same amount, so that 𝛥𝑐0 = 𝛥𝑇̅ < 0, autonomous
demand 𝐴 = 𝑐0 − 𝑐1 𝑇̅ + 𝐼 ̅ + 𝐺̅ changes by 𝛥𝐴 = 𝛥𝑐0 − 𝑐1 𝛥𝑇̅ = (1 −
𝑐1 )𝛥𝑐0 < 0. It follows that the IS curve will shift to the left, and that the equilib-
rium will become ′2′ in the graph. At point ′2′, the economy is still in a liquidity
trap, with a zero interest rate and a lower equilibrium output. Since, in the move
from ′1′ to ′2′, investment falls (because of the decrease in 𝑌, and the constancy
of 𝑖), national saving, in equilibrium equal to investment, must be lower, too.
b. Suppose now that the central bank of the country attempts to return income
to the initial level, 𝑌1 , by implementing a conventional monetary policy −
for instance, an open market operation. Show in the graph the equilibrium
that will prevail after the central bank’s intervention. Explain.
To achieve its end, the central bank could resort to an open market purchase of
...........................................................................................................................
government bonds. However, this ‘conventional’ monetary policy would result in
...........................................................................................................................
a rightward shift of the positively sloped portion of the 𝐿𝑀 curve only, and would
make the horizontal one longer. The initial LM, 0D-𝐿𝑀1 , would be replaced by
...........................................................................................................................
a new one, such as 0E-𝐿𝑀3 , with the intersection between this latter curve and
...........................................................................................................................
an unchanged 𝐼𝑆 curve still taking place at point ′2′, that will therefore remain
the equilibrium position for the economy. Since the interest rate was already at
its lower bound, there is not going to be any decrease in 𝑖, and therefore no in-
crease in 𝑌. In a liquidity trap, a conventional monetary policy is ineffective.
277
Question 10
True or false?
Define the concept of real interest rate (𝑟), and write the equation that shows how 𝑟
and nominal interest rate (𝑖) are related to one another. Use this equation to explain
if you agree, or do not agree, with the following statements:
a. “If individuals expect positive inflation, then the real interest rate will be greater
than the nominal one.”
False. While the nominal interest rate tells us how a sum that has been bor-
rowed/lent out grows over time in units of currency (Euros, for instance), the real
interest rate tells us how that sum grows in real terms – that is, how its purchas-
ing power changes over time [alternative definition: “the real interest rate is the
interest rate in terms of goods; it tells us how many goods one has to repay in the
future in exchange for borrowing the equivalent of one good today”]. The real
and the nominal interest rates are related to one another as implied by the equa-
tion 𝑟 = 𝑖 − 𝜋 𝑒 , where 𝜋 𝑒 is expected inflation. From this relation it follows that
𝑟 < 𝑖 whenever 𝜋 𝑒 > 0, so that we can conclude that the above statement is in-
correct.
278
The IS-LM model
b. “The zero lower bound for the nominal interest rate implies that the real interest rate
cannot be greater than minus the expected inflation rate, −𝜋 𝑒 ”.
False, the opposite is true. Being 𝑟 = 𝑖 − 𝜋 𝑒 , and given expected inflation, 𝑟 is

lowest when 𝑖 = 0, so that 𝑟 ≥ −𝜋 𝑒 . The real interest rate cannot be less than
minus the expected inflation rate.
279
Question 11
The economy is described by an "extended" IS-LM model − that is, by an IS-LM

model based on the following additional assumptions:
− the central bank can set the real rate 𝑟, that therefore becomes the “policy
rate” determined by monetary policy, and keep it at the chosen level, let's
call it 𝑟̅ ;
− spending decisions (in particular, investment decisions by firms) depend on
the “real borrowing rate” 𝑟 + 𝑥, sum of the (real) policy rate and the risk
premium (𝑥).
Starting from an initial equilibrium position, suppose that the risk premium 𝑥 goes
up, and government purchases 𝐺̅ down. The central bank changes the policy rate to
prevent these changes in 𝑥 and 𝐺̅ from affecting equilibrium production, that there-
fore remains unchanged. In the move from the initial equilibrium to the one that will
be reached following the changes in 𝑥, 𝐺̅ and 𝑟 described above, the “real borrowing
rate” 𝑟 + 𝑥 will have gone up, down, or will have remained unchanged? Why? Ex-
plain.
The rise in 𝑥 and the decrease in 𝐺̅ shift the IS curve to the left. To prevent
equilibrium income from falling, the central bank must cut the policy rate, 𝑟.
Since, in the new equilibrium that will be reached following these changes in
𝑥, 𝐺̅ and 𝑟, income is unchanged, aggregate demand must have remained con-
stant, too. But 𝐺̅ is lower, and consumption unchanged (like disposable income).
It follows that, for aggregate demand to remain constant, investment must have
gone up (by the same amount by which 𝐺̅ has been cut). Recall that 𝐼 depends
positively on 𝑌 (that has remained constant) and negatively on the borrowing
rate. It follows that 𝑟 + 𝑥 must have gone down by the amount needed to raise
investment by −∆𝐺̅ .
280
The IS-LM model
Question 12
Consider an economy with constant prices described by an “extended” IS-LM

model, with a central bank that chooses the interest rate. How will a decrease in the
degree of risk aversion prevailing in the country’s financial markets affect the posi-
tion in the plane and/or the slope of the curves represented in the IS-LM diagram?
Say the central bank is determined to keep income constant even in face of this
change. To achieve its aim, should it buy or sell bonds in the open market? And what
if it decides to prevent income from varying by means of a change in the reserve
ratio θ? In this case, should it try to cause an increase or a decrease in θ? Why?
Explain.
...........................................................................................................................
In the “extended” IS-LM model, investment depends on the borrowing rate, sum
of the real interest rate, 𝑟, and the risk premium, x. A decrease in the degree of
..........................................................................................................................
risk aversion lowers the risk premium and the borrowing rate for any given
...........................................................................................................................
level of the real interest rate. For any given 𝑟, it therefore leads to higher in-
vestment and aggregate demand for goods. The IS curve shifts to the right, and
equilibrium income rises. To keep it at the initial level, the central bank must
implement a contractionary monetary policy, one that – by lowering the supply
of money – leads to an increase in the interest rate. To this end, it could sell
bonds in the open market, or engineer an increase in the reserve ratio (some-
thing that, causing a contraction in commercial banks’ lending, and therefore
in bank deposits, represents an alternative way of lowering M and raising i,
thus achieving the aim of preventing income from changing).
281
Question 13
Consider a country described by an ‘extended’ IS-LM model that differs from the
one described in the previous question only for the fact that consumption takes on
the following functional form:
𝐶 = 𝑐0 + 𝑐1 (𝑌 − 𝑇̅) + 𝑎 𝑊𝐹𝐻
̅̅̅̅̅̅̅ .
In the equation above, 𝑊𝐹𝐻 is the individuals’ financial and housing wealth,
assumed to be exogenous, and the parameter 𝑎 is greater than zero.
a. In this economy, will the slope of the IS curve differ from that prevailing in
the standard case, where consumption is a function of disposable income
only (𝑎 = 0)? If so, will the IS curve be steeper or flatter than in the standard
case? If not, why? Explain. [Hint: you are not being asked to derive the
analytical expression of the IS curve and of its slope, but just to discuss
whether this slope will be different from the one prevailing in the standard
case, and to provide the economic intuition underlying your answer.]
.
In the (𝑌, 𝑟) plane in which the IS-LM model is represented, the slope of the IS
depends on the extent by which a given change in the interest rate (the variable
measured along the vertical axis) changes the aggregate demand in the economy,
and therefore the level of production for which the goods market is in equilib-
rium, given the values of the other variables on which aggregate demand depends
and not measured along the axes of the graph. If, for instance (and for given 𝑐0 ,
𝐼 ,̅ 𝐺̅ , 𝑇̅, ̅̅̅̅̅̅̅
𝑊𝐹𝐻, etc.), a one percentage point decrease in 𝑟 raises aggregate de-
mand by a lot, the increase in production needed to return to goods market equi-
librium will be large, and the IS curve therefore relatively ‘flat’. It follows that
the fact that demand also depends on the individuals’ financial and housing
wealth has nothing to do with the slope of the IS – it just affects the position of
this curve in the (𝑌, 𝑟) space. When, rather than zero, the parameter 𝑎 is positive,
an increase (a decrease) in 𝑊𝐹𝐻 raises (lowers) the demand for goods for any
given value of the real interest rate, thus causing a rightward (leftward) parallel
shift of the IS curve.
282
The IS-LM model
b. Due to a stock market crash, individuals experience a fall in their financial

and housing wealth. In addition, an increase in financial market participants’
degree of risk aversion leads to a marked rise in the risk premium 𝑥. Assum-
ing that it was initially in an equilibrium that you will denote by ‘1’ in the
graph below, show the new equilibrium to which the economy will converge
following the two changes mentioned before (fall in 𝑊𝐹𝐻 ̅̅̅̅̅̅̅; rise in 𝑥), and
denote it by ‘2’. In the move from ‘1’ to ‘2’, how will the composition of
aggregate demand change? Explain.
𝑟̅ 2 1
LM1
IS2 IS1
𝑌̂2 𝑌̂1 𝑌
Both changes will shift the IS curve to the left. In the new equilibrium (point’2’
in the figure), the interest rate will remain at the level chosen by the central bank,
while output will be lower. As for the composition of aggregate demand, in the
move from the old to the new equilibrium both investment (due to the increase in
the borrowing rate caused by the rise in 𝑥, and to the decrease in 𝑌) and con-
sumption (due to the increase in 𝑥 and to the decreases in 𝑌 and in 𝑊𝐹𝐻) will
fall. Finally, being exogenous, government purchases of goods and service will
of course remain unchanged.
283
Chapter 3 - The labor market, the IS-LM-PC
model, and inflation
Question 1
Consider an economy that is initially in medium run equilibrium, with an unemploy-

ment rate at the natural level.
a. A new law that increases unemployment benefits is passed. Show in the graph
the effects of such a change on the real wage and on the natural rate of unem-
ployment. Provide the economic intuition behind the results you get.
𝑊
𝑃
1 1 𝑃𝑆
1+𝑚 0
𝑊𝑆′
𝑊𝑆
𝑢𝑛 𝑢′𝑛 𝑢
By making the prospects of unemployment less distressing, more generous unem-

ployment benefits lead to an increase in the wage requested by workers for any
given level of the unemployment rate. The WS curve shifts upwards to the right
and 𝑢𝑛 increases to 𝑢𝑛′ . A higher rate of unemployment is now necessary in order
to make workers willing to accept the real wage that firms are willing to pay,
which remains equal to 1⁄(1 + 𝑚).
286
b. Realizing that the law just passed has an impact on employment, but still deter-
mined to provide income support for those who lose their job, the government
implements measures aiming at increasing the degree of competition in the
goods market. Assuming that such measures succeed in returning the unemploy-
ment rate to the natural level − that is, to the level prevailing before the increase
in unemployment benefits −, show the effects of this second policy intervention
in the same graph used to answer the previous point of this question.
𝑊
𝑃
1 2
𝑃𝑆′
1 + 𝑚′
1 1
𝑃𝑆
1+𝑚 0
𝑊𝑆′
𝑊𝑆
The economy is initially at point 1 in the graph, reached after the increase in
unemployment benefits. If the government succeeds in his attempt to increase the
degree of competition in the goods market, firms' market power is reduced, the
mark-up 𝑚 falls, and the PS curve shifts upwards. Since we are told that, with
this intervention, the unemployment rate is returned to the initial level, the one
prevailing before the rise in benefits, the new value of 𝑚, 𝑚′, will have to be
such that the new PS (the curve PS' in the figure) crosses the new WS (WS') for
𝑢 = 𝑢𝑛 − that is, at point 2 in the graph.
287
Question 2
a. Define briefly, but rigorously, the following concepts:
a.1 “accelerationist” (sometimes also referred to as “expectations-

augmented”) Phillips curve;
a.2 stagflation.
...........................................................................................................................
a.1 𝜋𝑡 − 𝜋𝑡−1 = − 𝛼(𝑢𝑡 − 𝑢𝑛 ) or, equivalently, 𝜋𝑡 − 𝜋𝑡−1 = (𝑚 + 𝑧) − 𝛼𝑢𝑡
...........................................................................................................................
 relationship between the unemployment rate and the change in the infla-
...........................................................................................................................
tion rate: low unemployment is associated with rising inflation, and high
unemployment leads to decreasing inflation.
a.2 Situation characterized by the coexistence of stagnation and inflation, typi-
cally associated with a negative supply shock.
288
b. Explain if and why you agree or disagree with the following statement:
“In order to increase the natural level of production 𝑌𝑛 , policy-makers can follow
two alternative strategies: (i) they can try to increase the demand for goods per-
manently, for example by opting for a permanent increase in either the money
supply or in government purchases of goods and services, or (ii) they can decide
to implement ‘supply-side’ policies, such as those leading to an increase in the
degree of competition in the goods market. The difference between the two strat-
egies above is that the first one will lead not just to an increase in 𝑌𝑛 , but also to
a permanently higher level of prices, while the second strategy will push the
economy towards an equilibrium characterized by a higher 𝑌𝑛 and a lower gen-
eral price level.”
The statement is incorrect. Monetary and fiscal policies have no effect whatso-
ever on the natural level of production (in the medium run, monetary policy only
affects the price level, while fiscal policy causes – in addition to a change in the
price level – a change in the composition of aggregate demand, but not in its
overall level). The only policies that can change the natural rate of unemploy-
ment (and therefore the natural level of production) are supply-side policies
− for example, policies that affect the degree of competition in the goods market,
or the ‘flexibility’ of the labour market.
289
Question 3
True or False?
a. “The zero lower bound for the nominal interest rate implies that the real interest
rate cannot be smaller than minus the expected inflation rate, −𝜋 𝑒 ”.
True. Being 𝑟 = 𝑖 − 𝜋 𝑒 , and given expected inflation, 𝑟 is lowest when 𝑖 = 0,

so that 𝑟 ≥ −𝜋 𝑒 . The real interest rate cannot be less than expected inflation.
290
b. If 𝜋𝑡𝑒 = 𝜋𝑡−1 , from the accelerationist Phillips curve it follows that, to bring the
unemployment rate below its natural level, policymakers must be willing to tol-
erate an increase in the inflation rate.
...........................................................................................................................
True. With 𝜋𝑡𝑒 = 𝜋𝑡−1 , the equation for the expectations-augmented Phillips
...........................................................................................................................
curve is 𝜋𝑡 − 𝜋𝑡−1 = −𝛼(𝑢𝑡 − 𝑢𝑛 ). From this expression it follows that 𝑢𝑡 <
...........................................................................................................................
𝑢𝑛 if and only if 𝜋𝑡 > 𝜋𝑡−1 − inflation must increase over time. To understand
why this must be the case, recall that 𝜋𝑡𝑒 = 𝜋𝑡−1. From 𝜋𝑡 > 𝜋𝑡−1 it then follows
...........................................................................................................................
that, for given 𝑃𝑡−1 , 𝑃𝑡 > 𝑃𝑡𝑒 − workers are underestimating the general price
...........................................................................................................................
level, and therefore are overestimating the real wage they are receiving. This
overestimation is what is needed to bring unemployment below the natural rate.
...........................................................................................................................
291
Question 4
True or False?
a. “A decrease in firms' market power leads to a fall in the inflation rate”.
True. One of the ways in which the Phillips curve can be written is:
𝜋𝑡 − 𝜋𝑡𝑒 = (𝑚 + 𝑧) − 𝛼𝑢𝑡 .
A decrease in firms' market power amounts to a reduction in the mark-up 𝑚 and
therefore, other things the same, to a fall in current inflation, 𝜋𝑡 . The reason is
that today, time 𝑡, firms with less market power will set lower prices for the goods
they produce. For given prices at time 𝑡 − 1, lower prices at 𝑡 imply a lower
inflation rate.
[One could reach the same conclusion also using the following, alternative ver-
sion of the Phillips curve:
𝜋𝑡 = 𝜋𝑡𝑒 − 𝛼(𝑢𝑡 − 𝑢𝑛 ).
The WS-PS model implies that the natural rate of unemployment depends posi-
tively on the mark-up 𝑚. A decrease in 𝑚 will therefore lower 𝑢𝑛 , and − for any
given 𝜋𝑡𝑒 and 𝑢𝑡 − from the previous equation it follows that 𝜋𝑡 will fall].
292
b. “From the Phillips curve, 𝜋𝑡 = 𝜋𝑡𝑒 − 𝛼(𝑢𝑡 − 𝑢𝑛 ), it follows that, for a given
natural rate of unemployment 𝑢𝑛 , the current inflation rate 𝜋𝑡 can fall if and
only if the current rate of unemployment 𝑢𝑡 increases”.
...........................................................................................................................
False. Current inflation can fall also if, for given 𝑢𝑡 and 𝑢𝑛 , individuals start
...........................................................................................................................
expecting a lower inflation rate − that is, if 𝜋𝑡𝑒 falls. The reason is that, since
they now expect lower inflation, workers will be willing to accept a lower nomi-
nal wage. This decrease in labor costs will enable firms to set prices at a lower
level. For given prices in the previous period, a lower current rate of inflation
will result.
293
Question 5
True or False?
a. “In country Alpha 𝜋𝑡𝑒 = 𝜋𝑡 , while in country Beta 𝜋𝑡𝑒 = 2%. It follows that, to
keep the rate of unemployment at the natural level (𝑢𝑡 = 𝑢𝑛 for each time 𝑡), the
rate of inflation must remain constant in Alpha, and increase at a rate greater
than 2% in Beta”.
To conclude that the statement is incorrect, it suffices to write the equation

𝜋𝑡 − 𝜋𝑡𝑒 = − 𝛼(𝑢𝑡 − 𝑢𝑛 )
and to notice that in Alpha – where 𝜋𝑡𝑒 = 𝜋𝑡 and in which expectations are there-
fore always correct – unemployment will always be at its natural level, inde-
pendently of the way the inflation rate evolves over time. Furthermore, to have
𝑢𝑡 = 𝑢𝑛 at each time 𝑡, in country Beta one needs 𝜋𝑡 = 2% – inflation will have
to be constant at 2%, rather than increasing over time.
294
b. “In country Gamma 𝜋𝑡𝑒 = 3%, while in country Delta 𝜋𝑡𝑒 = 𝜋𝑡−1 . It follows that,
to keep the rate of unemployment at the natural level (𝑢𝑡 = 𝑢𝑛 for each time 𝑡),
in both countries the rate of inflation must remain constant over time ”.
To conclude that the statement is true it suffices to notice that, given the relation-
ship between the deviation of the inflation rate from its expected value and the
deviation of the unemployment rate from its natural level used to answer the pre-
vious point, to have 𝑢𝑡 = 𝑢𝑛 for each time 𝑡 one needs an inflation rate always
equal to 3%, and therefore constant over time, in Gamma; furthermore, in Delta
the rate of inflation will have to be always equal to the level prevailing in the
previous period, and therefore once again constant (even if not necessarily at the
3% level as in country Gamma).
295
* Question 6
[The natural rate of interest - Monetary policy and fiscal policy in the
medium-run]
Consider an economy described by the following equations:

𝐶 = 𝐶(𝑌 − 𝑇̅)
𝐼 = 𝐼(𝑟 + 𝑥, 𝑌)
𝐺 = 𝐺̅
𝑌 =𝐶+𝐼+𝐺
𝑀𝑑 = 𝑃 ∙ 𝐿(𝑟 + 𝜋 𝑒 , 𝑌)
𝑀⁄𝑃 = 𝐿(𝑟 + 𝜋 𝑒 , 𝑌)
𝜋 − 𝜋 𝑒 = (𝛼 ⁄𝐿)(𝑌 − 𝑌𝑛 )
where 𝑀 is nominal money supply, the term 𝜋 𝑒 appearing in the Phillips curve (the
last equation) is expected inflation, and the other symbols have the usual meaning.
a. Define the concept of natural rate of interest, 𝑟𝑛 , and discuss its determinants
using a graph in which the real rate 𝑟 is measured along the vertical axis,
and goods' supply and demand along the horizontal one.
𝑟𝑛 1
𝐶+𝐼+𝐺
0
𝑌𝑛 supply of goods,
demand for goods
296
The natural rate of interest, 𝑟𝑛 , is the value of the real rate 𝑟 associated with the
natural level of output, 𝑌𝑛 − that is, with the level of output that the economy
produces when unemployment is at its natural rate, 𝑢𝑛 . More specifically, 𝑟𝑛 is
the value of the real interest rate for which the goods market is in a medium-run
equilibrium. Since, in this equilibrium, 𝑌 = 𝑌𝑛 , the natural rate is implicitly de-
fined by the following equation:
𝑌𝑛 = 𝐶(𝑌𝑛 − 𝑇̅) + 𝐼(𝑟𝑛 + 𝑥, 𝑌𝑛 ) + 𝐺̅ .
In the figure, the left-hand side (the supply of goods) is the line vertical at the
natural level of output; in fact, in the medium-run the supply of goods does not
depend on 𝑟, but rather on the factors on which the WS-PS model focuses (tech-
nology, institutional characteristics of the labour market, the degree of competi-
tion in goods and factor markets, etc.) and that jointly determine the natural rate
of unemployment. The right-hand side (the demand for goods) is, in the same
graph, a curve with a negative slope, as investment is decreasing in 𝑟. The natu-
ral rate of interest is found at the intersection of the two curves.
Since, as you will remember, in goods market equilibrium national saving equals
investment, an alternative (and fully equivalent) way of defining the natural rate
of interest is to think of 𝑟𝑛 as that value of 𝑟 for which − in medium-run equilib-
rium, and therefore when output is at its natural level − the sum of private and
public saving equals investment.
b. Explain what is meant by “neutrality of money”. Using the graph you have
drawn to answer the previous point, and assuming that individuals expect
zero inflation (𝜋 𝑒 = 0), verify that money is neutral in the model considered
in this question.
Money is neutral if, in the medium run, monetary policy can only affect the gen-
eral price level and the variables measured in nominal terms, leaving unchanged
“real” variables such as output, unemployment, consumption, investment, the
real interest rate, etc. It is important to realize that the fact that money is neutral
in the medium run does not mean that it never affects the economy, but just that
its effects are going to be transitory, bound to disappear over time.
297
To verify that, in our model, money is indeed neutral, suppose that − starting from
a medium-run equilibrium like point 1 in the figure − the central bank implements
a monetary expansion. In particular, assume that it decides to lower the policy rate
and that, to this end, it raises the money supply (for instance, through an open
market purchase of bonds).
We know from the IS-LM-PC model that, in the short run, the cut in the policy rate
will increase aggregate demand. Output will rise above its natural level, and in-
flation will become positive (that is, it will rise above its expected value, that for
simplicity we have taken to be equal to zero). Prices will therefore start rising. Let
us ask ourselves, however, not how the central bank intervention will affect the
short-run equilibrium, but rather how it will affect the economy in the medium run,
the relevant time horizon for both the previous figure and the neutrality of money
proposition. The monetary expansion will not change 𝑌𝑛 (the natural level of out-
put does not depend on 𝑀, but on those supply-side factors mentioned before), or
the level of aggregate demand prevailing in medium-run equilibrium, 𝐶(𝑌𝑛 − 𝑇̅) +
𝐼(𝑟𝑛 , 𝑌𝑛 ) + 𝐺̅ (as 𝑀 is not among the variables on which 𝐶, 𝐼 or 𝐺 depend). There-
fore, following a monetary expansion, none of the two curves in the graph above
will shift, and the natural rate of interest will not change. In the new medium-run
equilibrium, output and the real interest rate will be the same as before, and the
composition of aggregate demand will be unchanged, too. Compared to the initial
equilibrium, the only variable that will take on a different value is the price level,
which will be higher.
c. And what about fiscal policy? In the medium-run, is it neutral, too? To an-
swer, study the medium-run effects of a restrictive fiscal policy consisting
in a permanent decrease in 𝐺̅ using a graph similar to the one employed to
answer the previous point.
298
𝑟𝑛 1
𝐶 + 𝐼 + 𝐺̅
𝑟𝑛′ 2
𝐶 + 𝐼 + 𝐺̅ ′
0
demand for goods
Suppose that government spending on goods and services is cut from 𝐺̅ to the
new level 𝐺̅ ′ < 𝐺̅ . This change does not affect the supply of goods prevailing in
the medium run, since 𝑌𝑛 depends on supply-side factors that we have assumed
to be independent of 𝐺. It will however lead to a lower aggregate demand for
goods. In the figure, the curve representing the aggregate demand prevailing in
the medium run shifts down and to the left, and the medium-run equilibrium be-
comes point 2, where output is unchanged and the natural interest rate is lower.
In the move from the old to the new medium-run equilibrium, the overall level of
aggregate demand is unchanged (as it must be, being the supply of goods un-
changed); its composition is however different − 𝐺 is lower, consumption is un-
changed (because disposable income is unchanged), and investment is higher
(due to the fall in the real interest rate). Since the overall level of aggregate de-
mand has not been affected by the fiscal policy in consideration, one can also
conclude that investment must have gone up by the same amount by which 𝐺 has
been cut − the fall in the natural rate (from 𝑟𝑛 to 𝑟𝑛′ in the figure) will take care
of delivering the required rise in investment.
In conclusion, and even though it does not affect output in the medium run, fiscal
policy affects the natural interest rate and the composition of aggregate demand
over the same time horizon. It follows that, contrary to what we have concluded
about monetary policy, fiscal policy is not neutral, not even in the medium run.
299
Question 7
a. By making reference to the graph “supply of goods-demand for goods” used to

analyse the determination of the medium-run equilibrium, natural real interest
rate, 𝑟𝑛 , explain if and how 𝑟𝑛 will change if, following a change in preferences,
autonomous consumption 𝑐0 goes up. In addition, compare the composition of
aggregate demand prevailing in the new medium run equilibrium that will be
reached after this change with that prevailing before the increase in 𝑐0 .
𝑟𝑛2 2
1 (𝐶 + 𝐼 + 𝐺̅ )’
𝑟𝑛1
𝐶 + 𝐼 + 𝐺̅
0
demand for goods
An increase in 𝑐0 amounts to an increase in the quantity of goods demanded for

any given levels of income and the real interest rate. In the graph above, the
demand curve shifts to the right, while the supply curve does not change. It fol-
lows that, in the new medium run equilibrium, the real interest rate will go up by
the amount needed to make sure that the demand for goods remains unchanged,
just like the supply of goods. Finally, in this new equilibrium consumption will
be higher (disposable income is unchanged, but 𝑐0 higher), investment lower (by
the same amount by which consumption has gone up) due to the increase in the
real interest rate, and 𝐺, being exogenous, unchanged.
300
b. Using once again the graph “supply of goods-demand for goods”, explain if and
how 𝑟𝑛 will change following an increase in firms’ market power that leads to a
higher mark-up (a higher value of the parameter 𝑚 in the WS-PS model). In
addition, compare the composition of aggregate demand prevailing after this
change with that prevailing before the increase in the mark-up.
𝑟𝑛2 2
𝑟𝑛1 1
𝐶 + 𝐼 + 𝐺̅
0
𝑌𝑛 ′ 𝑌𝑛 supply of goods,
demand for goods
In the WS-PS model, an increase in the mark-up shifts the PS curve downwards
and raises the natural rate of unemployment, thus leading to a decrease in the
associated natural level of production, 𝑌𝑛 . In the graph above, the supply curve
shifts to the left, going through this new, lower 𝑌𝑛 , while the demand curve re-
mains unchanged. It follows that, in the new medium run equilibrium, the real
interest rate goes up by the amount needed to make sure that the demand for
goods falls exactly by the same amount by which the supply of goods has gone
down. Finally, in this new equilibrium consumption is lower (since income is
lower), investment lower (due to the rise in the real interest rate and the fall in
𝑌𝑛 ) and 𝐺, being exogenous, unchanged.
301
* Question 8
a. Gamma is a closed economy with flexible prices described by an IS-LM-PC

model. Represent in the graphs below the medium-run equilibrium of Gamma
under the following two alternative assumptions about the way wage setters form
their expectations about this year’s inflation:
a.1 𝜋 𝑒 = 𝜋̅, where 𝜋̅ is a constant that does not depend on last year’s inflation
rate;
a.2 𝜋 𝑒 = 𝜋−1, where 𝜋−1 is last year’s inflation rate.
𝑟 𝑟
1 1
𝑟𝑛 𝐿𝑀1 𝑟𝑛 𝐿𝑀1
𝐼𝑆1 𝐼𝑆1
0 0
𝑌𝑛 𝑌 𝑌𝑛 𝑌
𝜋 − 𝜋̅ 𝑃𝐶 𝜋 − 𝜋−1 𝑃𝐶
1′ 1′
0 0
𝑌𝑛 𝑌 𝑌𝑛 𝑌
a.1: 𝜋 𝑒 = 𝜋̅ a.2: 𝜋 𝑒 = 𝜋−1
The only difference between the two graphs is in the lower panel, where the re-
lation 𝜋 − 𝜋 𝑒 = (𝛼 ⁄𝐿)(𝑌 − 𝑌𝑛 ) is drawn. If 𝜋 𝑒 = 𝜋̅, the Phillips curve is the
“original” one, and along the vertical axis of the lower panel we measure the
difference between current inflation and the constant value of the inflation rate
that wage setters expect. In the alternative case in which 𝜋 𝑒 = 𝜋−1, the relevant
Phillips curve is the “accelerationist” one, and what is measured along the ver-
tical axis of the lower panel is now the change in the inflation rate – the difference
between current and last year’s inflation.
302
Even though, in both cases, in a medium-run equilibrium 𝜋 = 𝜋 𝑒 , 𝑌 = 𝑌𝑛 and

𝑟 = 𝑟𝑛 , the way in which expectations about inflation are formed does have im-
portant consequences. To mention just two of them:
 a central bank that, having overestimated the natural level of output,

keeps the policy rate “too low”, below the natural real interest rate, will
cause inflation to be “high”, above 𝜋̅, if 𝜋 𝑒 = 𝜋̅; inflation will not just
be high, but also rising over time if 𝜋 𝑒 = 𝜋−1 ;
 in an economy at the zero lower bound for the nominal interest rate that
has been hit by a severe demand shock, a deflation spiral is possible
when 𝜋 𝑒 = 𝜋−1, but not if 𝜋 𝑒 = 𝜋̅ (unless, of course, people change the
way they form their expectations, and expectations become de-an-
chored).
b. One sometimes reads that, since over the past few decades central banks in sev-
eral major countries and regions of the world have been successful in hitting
their chosen target for the inflation rate, inflation expectations have become “an-
chored”, so that 𝜋 𝑒 = 𝜋̅, with 𝜋̅ the target set by the central bank. Does this make
the alternative case, 𝜋 𝑒 = 𝜋−1, irrelevant?
While it is true that the ECB has been (at least on average) able to meet its infla-
tion target of close to, but below, 2% till the onset of the financial and the Euro-
pean debt crises, it failed to do so for most of the past decade. With an inflation
rate persistently below, and often far from, the ECB target, it is not reasonable
to assume that individuals will keep expecting this year’s inflation to turn out
equal − or at least close − to the ECB’s target (prices prevailing in financial
markets in recent years do confirm this “de-anchoring” of inflation expecta-
tions). More generally, the way in which individuals form their expectations can
always change. This explains why the implications of alternative expectations
formation mechanisms are worth exploring, and why the cases 𝜋 𝑒 = 𝜋−1 and
𝜋 𝑒 = 𝜋̅ are both considered in some of the next questions.
303
Question 9
Consider a country where 𝜋 𝑒 = 𝜋̅, investment is entirely exogenous (𝐼 = 𝐼 )̅ , and

consumption depends not just on disposable income, but also on the real interest rate,
as implied by the consumption function 𝐶 = 𝑐0 + 𝑐1 (𝑌 − 𝑇̅) − ℎ2 𝑟, where the pa-
rameter ℎ2 > 0 is the sensitivity of consumption to the real interest rate. The rest of
the economy is described by an IS-LM-PC model based on the usual assumptions.
In particular, net taxes and government purchases of goods and services are exoge-
nous (𝑇 = 𝑇̅ and 𝐺 = 𝐺̅ ), and the central bank chooses the (real) policy interest rate,
𝑟.
that the economy was initially in a medium run equilibrium with 𝑌 = 𝑌𝑛 , 𝑟 =
𝑟𝑛 e 𝜋 − 𝜋−1 = 0, and that, in the attempt to offset a fall in autonomous con-
sumption by 𝛥𝑐0 < 0, the government of the country cuts net taxes by an equal
amount, so that 𝛥𝑐0 = 𝛥𝑇̅ < 0. Show in the graph below the new short-run
equilibrium that will be reached following the two, contemporaneous, changes
in autonomous consumption and net taxes just described, assuming that the cen-
tral bank decides to keep the policy rate at the initial level, 𝑟𝑛 . How will the
various components of aggregate demand change, in the move from the initial
medium-run equilibrium to the new short-run one?
𝑟 𝐼𝑆1
𝐼𝑆2
2 1
𝑟𝑛 𝐿𝑀1
3
𝐿𝑀3
0
𝑌2 𝑌𝑛 𝑌
𝜋 − 𝜋̅
𝑃𝐶
1
0
𝑌𝑛 𝑌
304
Although, in this economy, a fall in 𝑟 will not affect investment, it will raise con-
sumption. It follows that, as in the standard case, goods demand depends nega-
tively on the real interest rate, so that the IS curve will still be negatively sloped
in the (𝑌, 𝑟) plane. When, starting from the initial medium-run equilibrium 1 in
the figure, autonomous consumption and net taxes change by 𝛥𝑐0 = 𝛥𝑇̅ < 0, au-
tonomous demand will change by 𝛥𝑐0 − 𝑐1 𝛥𝑇̅ = (1 − 𝑐1 )𝛥𝑐0 < 0, and the IS
curve will therefore shift to the left. Since the central bank does not change the
policy rate, the new short-run equilibrium becomes 2, where income is lower.
Given that, being exogenous, both investment and 𝐺 have remained constant,
consumption will have to be lower in this new short-run equilibrium.
b. Suppose that, once the economy has reached the short run equilibrium you have
described when answering the previous point, the central bank decides to bring
income back to the natural level by implementing an open market operation. To
achieve its aim, should it buy or sell bonds in the open market? Show in the
graph the new equilibrium that will be reached following the central bank’s in-
tervention you consider appropriate. In this new equilibrium, how will the levels
of investment, consumption, private saving, public saving and national saving
compare to the levels of the same variables in the initial medium-run equilib-
rium (that is, the equilibrium prevailing before the changes in autonomous con-
sumption and the fiscal and monetary policy interventions described above)?
To return income to the natural level, the central bank will have to lower the
policy rate. This calls for a purchase of bonds in the open market, something that
will cause a downward shift in the LM curve. In the figure, the new equilibrium
becomes point 3. In this new medium-run equilibrium, 𝑌 is the same as at point
1. It follows that aggregate demand, too, will have to be the same in the two
equilibria. And since 𝐺 and 𝐼 are unchanged, in the move from 1 to 3 consump-
tion, too, must have remained unchanged. Finally, since investment is exogenous,
and therefore constant, also national saving will have to be unchanged. It follows
that, since public savings has gone down (net taxes have been cut), private saving
must have gone up (thanks to the tax cut and the decrease in 𝑐0 , and the fall in
the real interest rate notwithstanding) by the same amount.
305
Question 10
Consider an economy described by an IS-LM-PC model with 𝜋 𝑒 = 𝜋̅. For simplic-

ity, assume the constant value of expected inflation equals zero, so that 𝜋 𝑒 = 𝜋̅ =
0. In an IS-LM-PC diagram, represent the initial medium-run equilibrium of the
economy, denoting it by 1, and assuming that the associated real interest rate is pos-
itive (that is, 𝑟𝑛1 > 0).
a. Suppose that, due to a major, permanent fall in the autonomous components of

the demand for goods, the economy ends up in a new short-run equilibrium, to
be denoted by 1′ in the figure, in which output is below its natural level; further-
more, suppose that the natural interest rate associated with this lower demand,
let's call it 𝑟𝑛2 , is not only less than 𝑟𝑛1 , but also negative (𝑟𝑛2 < 0 < 𝑟𝑛1 ). In
this economy, can a “conventional” monetary policy − as the one consisting
in the decision to lower the policy rate − return output to its natural level?
Explain.
In the figure, the IS curve shift leftwards to 𝐼𝑆2 , and output falls to 𝑌1′ < 𝑌𝑛 . To
return it to its natural level, the central bank should cut the policy rate to 𝑟𝑛2 , thus
shifting the LM curve downwards till it becomes the dashed, horizontal line
drawn for this latter value of the real rate. Since 𝑟 = 𝑖 − 𝜋 𝑒 , a central bank wish-
ing to reduce 𝑟 will usually do so by lowering the nominal interest rate, 𝑖. In this
case, however, the central bank will not be able to bring the real rate to the target
level. In fact, being 𝜋 𝑒 = 𝜋̅ = 0, in this economy 𝑟 = 𝑖. The Zero Lower Bound
− that is, the fact that the nominal interest rate cannot fall below zero − implies
that the real rate cannot take on negative values, and therefore that 𝑟𝑛2 cannot be
reached. The most the central bank can do in a similar situation is to set to zero
both 𝑖 and 𝑟, shifting downwards the LM to 𝐿𝑀0 and moving the economy to
point 2′, where output is greater than 𝑌1′ , but still below its natural level.
306
𝑟 𝐼𝑆1
𝐼𝑆2
1' 1
𝑟𝑛1 𝐿𝑀1
2′
0 𝐿𝑀0
𝑟𝑛2 2
𝑌1′ 𝑌𝑛 𝑌
𝜋 𝑃𝐶
0
𝑌𝑛 𝑌
1'
b. To return output to its natural level, which economic policies would you
suggest?
An expansionary fiscal policy of appropriate size could return the IS curve to its
initial position. Alternatively, the country's policy-makers could implement a
combination of monetary expansion (for instance, one that shifts the LM to 𝐿𝑀0
− something that, as we know, rises output somewhat) and fiscal expansion (one
that shifts the IS to the right by the amount needed to fill the residual gap between
𝑌 and 𝑌𝑛 ). Finally, one could also consider “unconventional” monetary policy
measures. For instance, let us suppose that, maybe by raising its medium-run
target for the inflation rate, the central bank manages to induce individuals to
expect that inflation will be 2%, rather than zero, in the future. Now it becomes
possible for 𝑟 to take on negative values (up to −2%, in our example); it follows
that the real rate can now be brought, or in any case moved closer to, the new
natural level 𝑟𝑛2 .
307
Question 11
Consider a country that is initially in a medium run equilibrium position and in which
the expected inflation rate is the constant 𝜋̅. For simplicity, assume that 𝜋̅ equals
zero, so that 𝜋 𝑒 = 0. Aside from this assumption, the economy is described by a
standard IS-LM-PC model, with a central bank that chooses the interest rate.
a. Represent the initial medium run equilibrium position of the economy, to be

denoted by 1 in the graph, assuming that it takes place for a positive value of
the natural real rate of interest (that is, 𝑟𝑛1 > 0). Suppose now that a new law
leads to an increase in the minimum wage that firms must pay their workers. In
the graph, denote by 1′ the new short run equilibrium. Compared to 1, how
have production, consumption and investment changed? Why? Explain in de-
tail. [Hint: assume that the position of the IS curve is not affected by the change
in consideration].
2
𝑟𝑛2 𝐿𝑀2
1
𝑟𝑛1 𝐿𝑀1
1'
𝐼𝑆1
𝑌𝑛′ 𝑌𝑛 𝑌
𝜋 𝑃𝐶'
𝑃𝐶
1'
𝑌𝑛′
0
𝑌𝑛 𝑌
An increase in the minimum wage leads to a higher wage set by wage setters for
any given unemployment rate. In the WS-PS model, it is represented by an in-
crease in 𝑧 which shifts the WS curve up and to the right, thus causing an increase
in the natural rate of unemployment and a decrease in the natural level of output.
308
In the figure, the new natural level of output is 𝑌𝑛′ (< 𝑌𝑛 ). In the IS-LM-PC dia-
gram, the PC curve shifts up and to the left. Since we are told that the position of
the IS curve is not affected by the change in consideration, if the central bank
does not vary the policy rate the new short-run equilibrium becomes point 1′,
where output, consumption and investment are unchanged, but inflation is
higher. The inflation rate rises because, due to the increase in the minimum wage
and to the ensuing rise in wages, now firms charge higher unit prices for the
goods they produce. For given prices prevailing in the previous period, a higher
general price level today implies a higher inflation rate.
in the answer to the previous point, the central bank decides to bring income to
its natural level by implementing an open market operation. Explain if, to
achieve its goal, the central bank should purchase or sell bonds, and show in the
figure the new policy rate consistent with the new medium run equilibrium, de-
noting it by 𝑟𝑛2 . Finally, discuss how the central bank should act in order not just
to bring output to its natural level, but also the general price level to the value it
was taking on in the initial medium run equilibrium.
...........................................................................................................................
To bring income to the new natural level, the central bank should raise the policy
...........................................................................................................................
rate till 𝑟𝑛2 , thus shifting the 𝐿𝑀 curve upwards to 𝐿𝑀2 . This of course requires
an open market sale of bonds. As long as the economy remains in the short-run
...........................................................................................................................
equilibrium 1′, with income above the new natural level, the inflation rate is pos-
...........................................................................................................................
itive, and the price level will therefore keep rising. If the central bank aims at
bringing back not just output to the natural level, but also the general price level
...........................................................................................................................
to the value it was taking on in the initial medium run equilibrium, it should tem-
porarily bring the policy rate above 𝑟𝑛2 , and therefore production below the nat-
ural level. Being 𝑌 < 𝑌𝑛′ , the inflation rate will be negative, and the general price
level falling. Once it is back to its initial value, the central bank should lower the
real rate to 𝑟𝑛2 , thus achieving its two goals.
309
Question 12
Consider country Macro, described by an IS-LM-PC model and in which individuals

expect inflation to be constant at 2%. While Macro was, till two years ago, in a
medium run equilibrium with a real interest rate (𝑟) equal to 3%, the past couple of
years have witnessed a marked reduction in 𝑟, which has fallen to 1% both in last
year and in the current one. In addition, this year’s inflation rate has remained con-
stant at the same value it took on one year ago.
a. To understand the cause of the fall in the real interest rate, the government of
the country consults two economists, Harry and Ginny. According to Harry, the
fact that the inflation rate has remained constant allows one to conclude that the
economy must have been hit by an adverse demand shock, one to which the
central bank has reacted by bringing 𝑟 to the new, lower medium run equilib-
rium level. The reduction in the real rate therefore reflects, without any doubt, a
decrease in its natural level, 𝑟𝑛 . Ginny instead thinks that, to be able to conclude
that the economy has been experiencing a fall in 𝑟𝑛 , rather than a decision of the
central bank to bring the real rate below an unchanged natural level, further in-
formation is needed. In particular, one needs to know whether, over the past two
years, the inflation rate has remained constant at 2%, or at a level greater than
2%. Represent in the graph below the medium run equilibrium prevailing in
Macro two years ago (𝑟𝑛 = 3%), denoting it by ‘1’. In the same graph, denote
by ‘2’ the equilibrium, associated with a real rate of 1%, that would prevail if
the fall in 𝑟 is due to a decrease in the natural, medium run, real rate, and by ‘3’
that which would instead prevail if the decrease of the real rate to 1% is the
outcome of the decision of the central bank to bring 𝑟 below an unchanged nat-
ural level. Which of the two economists is right? Why? Explain.
𝑟
𝐼𝑆1
𝐼𝑆2 1
𝑟𝑛1 = 3% 𝐿𝑀1
3
1% 𝐿𝑀2,3
2
0
𝑌𝑛 𝑌3 𝑌
𝜋 − 2% 𝑃𝐶
3
1 2
0
𝑌𝑛 𝑌3 𝑌
310
The medium run equilibrium prevailing two years ago is 1 in the two graphs.
Harry thinks that the current 1% real rate is the by-product of a leftward shift of
the IS curve, and of the central bank’s decision to allow the economy to reach
the new medium run equilibrium 2 by decreasing the policy rate till the new,
lower natural level of 1%. According to Ginny, however, one should also con-
sider the possibility that the economy is at point 3 – no demand shock has hit the
economy; rather, the central bank is insisting on keeping income above, and the
real rate below, their natural levels, both unchanged compared to two years ago.
To be able to conclude which of the two economists is right, one must look at the
lower panel of the figure. From the Phillips curve it follows that, if Harry if right,
then over the past two years inflation should have remained constant at 2%; if
Ginny is right, inflation should have been constant, but at a level greater than
2%. Since we are just told that inflation has remained constant, but not at which
level, Ginny is right – to be able to assess the cause of the low real interest rate,
more information is needed.
b. Say you are now told that, in Macro, rather than an inflation rate constant at 2%,
individuals always expect an inflation rate equal to that observed in the previous
period, so that 𝜋 𝑒 = 𝜋−1. Which of the two economists is right, in this case?
Why? Explain.
In this case, the upper panel of the figure remains unchanged; however, to be
measured along the vertical axis of the lower one is now the difference between
π and 𝜋−1, rather than that between the current inflation rate and 2%. It follows
that inflation will remain constant over time if, and only if, the economy is in a
medium run equilibrium. The constancy of the inflation rate over the past two
years allows one to conclude that, in this case, the economy must have experi-
enced a fall in the natural real rate of interest, just like suggested by Harry.
311
Question 13
A country in which expected inflation for the current year equals the inflation rate
prevailing in the previous year, 𝜋 𝑒 = 𝜋−1, and in which 𝑖 ≥ 0, is initially in a me-
dium run equilibrium, with 𝑌 = 𝑌𝑛 , 𝑟𝑛 = 0 and 𝜋 𝑒 = 𝜋−1 = 0.
a. Assuming that the central bank chooses the interest rate, represent in the two-
panel IS-LM-PC diagram the initial medium run equilibrium, denoting it by
1. Having explained which value the nominal interest rate, 𝑖, will necessarily
take on in this initial equilibrium, suppose that the government launches an am-
bitious program of liberalizations, leading to an increase in the degree of com-
petition in the country’s goods markets. In the two panels of the graph below,
denote by 2 the new short run equilibrium that the economy will reach. In the
move from 1 to 2, how will have income changed? And what about the rate of
inflation? Why? Explain. [Hint: when answering, assume that the position of
the IS curve is not affected by the change described above].
𝑟
3 𝐿𝑀3
𝑟3
1 4 𝐿𝑀1
𝑟𝑛1 = 0
2
𝑌𝑛 𝑌𝑛′ 𝑌
𝐼𝑆4
𝐼𝑆1
𝜋 − 𝜋−1 𝑃𝐶
𝑃𝐶'
𝑌𝑛 1 4
0
𝑌𝑛′ 𝑌
2
3
Being 𝑖 = 𝑟 + 𝜋 𝑒 , and since in this economy 𝑟𝑛 = 0 and 𝜋 𝑒 = 𝜋−1 = 0, in the

initial medium run equilibrium (points 1 in the two panels) the nominal interest
rate is equal to zero. In the WS-PS model, an increase in the degree of competi-
tion in the goods markets amounts to a decrease in the mark-up 𝑚. It follows that
the PS curve shifts upwards, the natural rate of unemployment falls, and the nat-
ural level of output becomes 𝑌𝑛′ > 𝑌𝑛 .
312
In the IS-LM-PC diagram, the PC curve shifts to the right, crossing the x-axis for
the new, higher natural level of production. If the central bank does not change
its choice of the real policy rate, the new short run equilibrium becomes point 2
in the two panels, where production is unchanged and the inflation rate is lower.
In particular, from zero that it was in initial the equilibrium 1, the inflation rate
becomes negative – in the current period, prices are lower than in the previous
one. In fact, given that their market power has fallen, firms will now be willing
to supply each unit of output at a price lower than that prevailing before the
launch of the liberalization program.
b. If policy-makers do not intervene, how will the real interest rate and income
change next period? Why? Show in the graph, denoting by 3 the new short run
equilibrium that, absent any policy intervention, the economy would attain. To
make sure that, rather than from 1 to 2, from 2 to 3, etc., the economy goes
immediately from the initial medium run equilibrium 1 to the new medium run
equilibrium that you will denote by 4 in the graph, the implementation of the
liberalization program should be combined with a fiscal policy intervention, or
with a monetary policy one? And, once the kind of economic policy most ap-
propriate to go directly from the equilibrium 1 to the equilibrium 4 has been
detected, the proposed policy should be a restrictive or an expansionary
one? Show in the graph the effects of the policy intervention you suggest, and
comment.
Since 𝜋 𝑒 = 𝜋−1, next period individuals will start expecting a negative inflation
rate, and this will lead to a higher 𝑟. The real interest rate, which was initially zero,
will become positive, rising for instance to the level denoted by 𝑟3 in the graph.
Notice that the central bank will be unable to keep the real rate at 𝑟𝑛1 ; in fact, to do
so it should lower the nominal interest rate by the amount needed to offset the im-
pact on 𝑟 of the decrease in expected inflation. However, we know that the nominal
interest rate is already at its lower bound (zero), and therefore cannot be lowered
any further. We may conclude that, absent policy interventions − not just by the
central bank, but also by the government −, the economy will therefore reach the
new short run equilibrium 3, with a level of output which is lower, due to the rise
in the real interest rate. Finally, to make sure that, from the initial equilibrium 1,
the economy directly goes to the new medium run equilibrium 4, the implementa-
tion of the liberalization program should be combined with an expansionary fiscal
policy, one that shifts to the right the 𝐼𝑆 curve from 𝐼𝑆1 to 𝐼𝑆4 , thus immediately
bringing output to the new natural level 𝑌𝑛′ . In the new medium run equilibrium,
the natural real rate will still be 𝑟𝑛1 , and the inflation rate constant and equal to
zero.
313
Question 14
Consider a country where both investment (which, as usual, is also a function of 𝑌)

and consumption depend on the borrowing rate 𝑟 + 𝑥. In particular, suppose that the
consumption function is 𝐶 = 𝑐0 + 𝑐1 (𝑌 − 𝑇̅) − ℎ2 (𝑟 + 𝑥), where the parameter
ℎ2 (> 0) is the sensitivity of consumption to the real borrowing rate, and that 𝜋 𝑒 =
𝜋−1. The rest of the economy is described by an IS-LM-PC based on the usual hy-
potheses − among them, the exogeneity of net taxes and of government purchases
of goods and services (𝑇 = 𝑇̅ e 𝐺 = 𝐺̅ ), and the assumption the central bank con-
ducts its monetary policy by choosing the real policy rate, 𝑟.
a. Having explained if, in the (𝑌, 𝑟) space, the slope of the IS curve is in this case
negative, zero or positive, assume that the economy is initially in a medium-run
equilibrium, with 𝑌 = 𝑌𝑛 , 𝑟 = 𝑟𝑛 and 𝜋 − 𝜋−1 = 0. Show in the graph, and
discuss, the short-run effects of a permanent increase in the financial markets
participants’ degree of risk aversion, assuming that the central bank keeps the
policy rate constant at the initial level, 𝑟𝑛 . In the move from the initial to the new
short-run equilibrium, how will consumption and investment change? Explain.
𝑟 𝐼𝑆1
𝐼𝑆2
2 1
𝑟𝑛 𝐿𝑀1
0
𝑌2 𝑌𝑛 𝑌
1
0
𝑌𝑛 𝑌
2
314
In this economy, a decrease in 𝑟 raises not just investment, but also consumption.
As in the standard case, the demand for goods will depend negatively on the real
rate, and the IS curve will therefore be negatively sloped in the (𝑌, 𝑟) plane.
When, starting from the initial medium-run equilibrium denoted by 1 in the fig-
ure, the degree of risk aversion rises, the IS shifts to the left, as the increase in
the risk premium 𝑥 leads to an increase in the borrowing rate that lowers con-
sumption and investment. Since, by assumption, the central bank does not change
the policy rate, the new short-run equilibrium becomes 2, where both consump-
tion and investment have gone down, due to the rise in 𝑥 and the ensuing fall in
𝑌.
in the answer to the previous point, the government decides to return output to
the natural level by changing 𝐺̅ . To achieve its goal, should the government raise
or lower 𝐺̅ ? Compare the levels of investment, consumption, private saving,
public saving and national saving in the new medium-run equilibrium that will
be reached after the government’s intervention to the levels of the same varia-
bles in the initial one (that is, the medium-run equilibrium prevailing before the
increases in the degree of risk aversion and in 𝐺̅ ). Explain. [Hint: write down
the (private) saving function for this economy].
To return output to its natural level, the government will have to bring the IS
curve back to its initial position. This requires an increase in 𝐺̅ . After this fiscal
policy intervention, the medium run equilibrium will be once again at point 1 in
the figure, with lower consumption and investment (𝑟 and Y are unchanged, but
the risk premium is now higher, and with it the borrowing rate). Government
saving will be lower, too (𝐺̅ has gone up, and net taxes 𝑇̅ have not changed),
while private saving 𝑆 = (𝑌 − 𝑇̅) − 𝐶 = −𝑐0 + (1 − 𝑐1 )(𝑌 − 𝑇̅) + ℎ2 (𝑟 + 𝑥)
will be higher, due to the increase in 𝑥. Since investment has gone down, the
same must be true about national saving (the amount by which private saving has
risen will be smaller than that by which public saving has fallen).
315
Question 15
In country XYZ, the production function is 𝑌 = 𝐴 · 𝑁, where 𝐴 is a positive con-

stant. In addition, when price expectations are correct (𝑃𝑒 = 𝑃), the price-setting
and the wage-setting relations are, respectively, 𝑃 = (1 + 𝑚) · (𝑊/𝐴) and 𝑊 =
𝑃 · 𝐹(𝑢, 𝑧), where the variables have the usual meaning.
a. Provide an economic interpretation of the costant 𝐴 and, in the graph below,

show how a decrease in 𝐴 will change the equilibrium values of the real wage
and of the natural rate of unemployment.
𝑊/𝑃
𝐴/(1+𝑚) 𝑃𝑆
𝐴′/(1+𝑚) 𝑃𝑆′
𝑊𝑆
The constant A is labor productivity (average and marginal productivity, equal

under the hypothesis of a linear production function). If A decreases, labor costs
per unit of output 𝑊 ⁄𝐴 (= 𝑊𝑁⁄𝐴𝑁 = 𝑊𝑁/𝑌) rise. The PS curve shifts down-
wards and the equilibrium real wage decreases, while the natural rate of unem-
ployment increases. Firms will set higher prices and will pay a lower real wage
to workers who are now less productive. Employment will decrease and unem-
ployment will increase.
316
b. Assuming 𝜋 𝑒 = 𝜋−1 and that the economy was initially in a medium-run equi-
librium, show the effects of the same change in 𝐴 discussed above in an IS-LM-
PC diagram. In particular, show the new short-run equilibrium and describe the
adjustment process toward the new medium-run equilibrium to which the econ-
omy will eventually converge. Compare the levels of consumption and invest-
ment in this latter equilibrium with the levels of the same variables in the initial
medium-run equilibrium, providing an explanation for any observed change in
their values.
2
𝑟𝑛2 𝐿𝑀2
1
𝑟𝑛1 𝐿𝑀1
1'
𝐼𝑆1
𝑌𝑛′ 𝑌𝑛 𝑌
𝜋 − 𝜋−1 𝑃𝐶'
𝑃𝐶
1'
𝑌𝑛′
0
𝑌𝑛 𝑌
In the IS-LM-PC diagram, the PC curve shifts upwards. If the central bank does
not change the policy rate, the new short-run equilibrium is point 1′, where out-
put is unchanged and inflation higher. The rise in inflation is due to the fact that,
as discussed above, the fall in A leads firms to supply each unit of output at a
higher price. Given last period’s prices, a higher current price level implies more
inflation. To prevent inflation from rising period after period, sooner or later the
central bank will have to raise the policy rate. When this latter will be set to 𝑟𝑛2 ,
the economy will once again be in a medium-run equilibrium position, with con-
stant inflation and output at its (new) natural level. Compared to the initial equi-
librium (1), in this new medium-run equilibrium (2) both consumption (due to
the fall in 𝑌) and investment (due to the fall in 𝑌 and the rise in 𝑟) will be lower.
317
Question 16
Country Eta, a closed economy with flexible prices and where 𝜋 𝑒 = 𝜋−1 , is initially
in a medium-run equilibrium.
a. To reduce a budget deficit deemed too high, the government of Eta decides to
raise taxes. At the same time, the central bank decides to resort to an open mar-
ket operation, aimed at preventing the fiscal policy just mentioned from chang-
ing the inflation rate, π. In an IS-LM-PC diagram, denote the initial medium-
run equilibrium by ‘1’ and represent the new medium-run equilibrium to which
Eta will converge after the implementation of the policy-mix described above.
In particular, describe the type of open market operation (purchase; sale) that
the central bank should implement to reach its objective.
𝑟 𝐼𝑆1
𝐼𝑆2
𝑟𝑛1 1' 1 𝐿𝑀1
𝑟𝑛2 𝐿𝑀2
2
𝑌𝑛 𝑌
0
𝑌𝑛 𝑌
1'
318
The tax hike lowers consumption and shifts the IS curve to the left. If the central
bank did not intervene, the fall in aggregate demand caused by the decrease in
consumption would lower output, and the economy would go from the initial me-
dium-run equilibrium 1 to the new short-run equilibrium 1′. Output would fall
below its natural level, and the unemployment rate rise above 𝑢𝑛 . These changes
would lower wages, and therefore prices. To prevent the ensuing fall in inflation,
the central bank will have to lower the policy rate to 𝑟𝑛2 , thus shifting the 𝐿𝑀
curve downwards to 𝐿𝑀2 . What is needed is therefore a monetary expansion, that
− since it has decided to resort to an open market operation − the central bank
will have to implement by purchasing bonds in the secondary market for these
assets. Notice that the new LM that will result from this intervention will have to
intersect the new IS curve for 𝑌 = 𝑌𝑛 − in fact, from the Phillips curve it follows
that an intersection for any level of output different from the natural one would
lead, rather than to an unchanged π, to an inflation rate rising or falling over
time, depending on whether, at the intersection point, output is greater than 𝑌𝑛 ,
or less than 𝑌𝑛 .
b. Compare the composition of aggregate demand prevailing in the initial and in

the final medium-run equilibria. How must the change in consumption and the
change in investment taking place as the economy goes from the first to the
second of such equilibria be related to one another?
...........................................................................................................................
As the supply of goods is at its natural level both at point 1 and at point 2, ag-
...........................................................................................................................
gregate demand will have to be the same in those two equilibria. In the move
...........................................................................................................................
from the first to the second one, government purchases are unchanged, consump-
tion has gone down (income has not changed, but taxes are higher), and invest-
...........................................................................................................................
ment up (due to the fall in the real interest rate). In addition, and since aggregate
demand is unchanged, one can also conclude that investment will have risen ex-
actly by the amount by which consumption has fallen.
319
Question 17
Consider a country where investment is entirely exogenous (𝐼 = 𝐼 )̅ . In addition, con-

sumption depends not just on disposable income, but also on the real interest rate
and on financial and housing wealth, as implied by the consumption function 𝐶 =
𝑐0 + 𝑐1 (𝑌 − 𝑇̅) − ℎ2 𝑟 + 𝑎𝑊𝐹𝐻
̅̅̅̅̅̅̅. In this function, the parameter ℎ2 > 0 is the sen-
sitivity of consumption to the real interest rate, and 𝑎 – with 0 < 𝑎 < 𝑐1 < 1 – is the
sensitivity of consumption to the financial and housing wealth 𝑊𝐹𝐻 (assumed to be
exogenous, so that 𝑊𝐹𝐻 = ̅̅̅̅̅̅̅
𝑊𝐹𝐻 ). Finally, assume that 𝜋 𝑒 = 𝜋−1 . The rest of the
economy is described by an IS-LM-PC model based on the usual assumptions. In
particular, net taxes and government purchases of goods and services are exogenous
(𝑇 = 𝑇̅ and 𝐺 = 𝐺̅ ), and the central bank chooses the (real) policy interest rate, 𝑟.
that the economy was initially in a medium-run equilibrium with 𝑌 = 𝑌𝑛 , 𝑟 =
𝑟𝑛 and 𝜋 − 𝜋−1 = 0. Assuming that the central bank keeps the interest rate at
the initial level, 𝑟𝑛 , discuss how income, consumption and investment will
change in the new short-run equilibrium that the economy will reach if the indi-
viduals’ financial and housing wealth and net taxes fall at the same time and by
the same amount (𝛥𝑊𝐹𝐻 ̅̅̅̅̅̅̅ = 𝛥𝑇̅ < 0).
Although, in this economy, a fall in 𝑟 will not affect investment, it will raise con-
sumption. It follows that, as in the standard case, goods demand depends nega-
tively on the real interest rate, so that the IS curve will still be negatively sloped
in the (𝑌, 𝑟) plane. When, starting from the initial medium-run equilibrium,
̅̅̅̅̅̅̅ and 𝑇̅ fall by the same amount, autonomous demand will change by
𝑊𝐹𝐻
̅̅̅̅̅̅̅ − 𝑐1 𝛥𝑇̅ = (𝑎 − 𝑐1 )𝛥𝑇̅ – a positive quantity, since 𝛥𝑇̅ < 0 and, by as-
𝑎𝛥𝑊𝐹𝐻
sumption, 𝑎 < 𝑐1 . The IS curve will therefore shift to the right. Since, at this
stage, the central bank does not change the policy rate, in the new short-run
equilibrium income is higher – in particular it will be larger than 𝑌𝑛 . Given that,
being exogenous, both investment and 𝐺 have remained constant, consumption
will have to be higher in this new short-run equilibrium, too.
320
b. Discuss how the central bank could bring the economy from the short-run equi-
librium just described to a medium-run equilibrium where the inflation rate
takes on the same value as in the initial medium-run equilibrium (that is, in the
equilibrium prevailing before the changes in ̅̅̅̅̅̅̅
𝑊𝐹𝐻 and 𝑇̅ described above).
Since in the new short-run equilibrium 𝑌 > 𝑌𝑛 , inflation is rising. If the central
bank aims at bringing the economy to a medium-run equilibrium in which not
just 𝑌 = 𝑌𝑛 once again, but also in which the inflation rate has returned to its
initial level, it will have to keep the policy rate above its new level 𝑟𝑛′ > 𝑟𝑛 , and
therefore Y below 𝑌𝑛 , at least for some time – namely, for the time needed for the
fall in inflation when Y is being kept below 𝑌𝑛 to offset the increase in π that took
place while Y was above 𝑌𝑛 .
321
Chapter 4 - Expectations, financial markets,
and economic policies
Question 1
We are at time 𝑡. In country Tau, only one-year and two-year bonds exist. The time-
𝑡 price of two year bonds issued in that time period is €𝑃2𝑡 = €94. In addition,
𝑒
𝑖1𝑡+1 − the yield that market participants expect on one-year bonds that, issued at
𝑡 + 1, will mature at 𝑡 + 2 − is 4%.
a. Using the quantitative information provided above, compute the yield on the
one-year bonds issued at 𝑡, 𝑖1𝑡 .
Plugging €𝑃2𝑡 = €94 into €𝑃2𝑡 = €100/(1 + 𝑖2𝑡 )2, and solving, one gets
1 𝑒 𝑒
𝑖2𝑡 = 3.14%. Since 𝑖2𝑡 = 2 (𝑖1𝑡 + 𝑖1𝑡+1 ) and 𝑖1𝑡+1 = 4%, it is straightforward
...........................................................................................................................
to compute 𝑖1𝑡 = 2 · 3.14% − 4% = 2.28%.
324
b. Suppose now that you do not share the market’s expectations about future
𝑒′ 𝑒
short-term rates. In particular, you expect 𝑖1𝑡+1 = 5%, rather than 𝑖1𝑡+1 =
4%. If you are interested in how much you will have two years from today,
should you buy two-year bonds or a sequence of one-year bonds? Or maybe
you should be indifferent between the two alternatives? Explain.
The purchase of two-year bonds at the price €𝑃2𝑡 = €94, one that reflects the
market participants’ average opinion about the future value of short-term rates,
delivers an average yearly return of 3.14% (remember that 𝑖2𝑡 = 3.14%). How-
ever, since your expectations about the future level of short-term rates differ from
those held by the market, by purchasing one-year bonds you will get a 2.28%
return on the first year, and one that you expect to be 5% the next one, corre-
sponding to an expected average yearly return of 3.64% (> 3.14%). You should
purchase one-year bonds.
325
Question 2
a. Alpha and Beta − two countries where only one, two and three-year bonds exist
– differ just for the expectations held by market participants about the monetary
policy that, in each of the two nations, will be implemented in the future. The
graph below shows the yield curve prevailing in the two countries in the current
period, time 𝑡 [N.B.: the yield curve prevailing in Alpha (the bold, continuous
line in the graph) and that observed in Beta (the dashed, bold line) overlap for
maturities up to two years; afterwards, Beta’s yield curve declines faster than
Alpha’s]. Which differences in individuals’ expectations about the future mon-
etary policy that will be implemented in each of the two countries can explain
the observed differences in the two yield curves?
Yield
to
maturity
7%
Alpha
6%
Beta
5%
1 2 3 Maturity
...........................................................................................................................
A flat (negatively sloped) yield curve signals expectations of constant (decreas-
ing) short-term rates. In both countries short-term rates are therefore expected
...........................................................................................................................
to remain next year at today’s level, and then to decrease two years from now.
...........................................................................................................................
This expected future decrease is larger in country Beta. Since, by assumption,
these different expectations on future interest rates only reflect differences in the
...........................................................................................................................
monetary policy that is expected to be implemented in the future, we may con-
clude that market participants think that next year the stance of monetary policy
will be the same as today’s both in Beta and in Alpha; however, they also expect
...........................................................................................................................
that, in two years, monetary policy will become more expansionary in both coun-
...........................................................................................................................
tries, and more so in Beta.
326
b. Using the data provided in the graph, compute the current and future expected
one-year rates 𝑖1𝑡 , 𝑖1𝑒 𝑡+1 and 𝑖1𝑒 𝑡+2 prevailing today (time 𝑡) in each of the two
countries.
From the graph it follows that 𝑖1𝑡 = 7%, 𝑖2𝑡 = 7% and 𝑖3𝑡 = 6% in Alpha,,
𝑒
while 𝑖1𝑡 = 7%, 𝑖2𝑡 = 7% e 𝑖3𝑡 = 5% in Beta. Since 𝑖2𝑡 = 12(𝑖1𝑡 + 𝑖1𝑡+1 ), plug-
𝑒
ging the values of 𝑖1𝑡 and 𝑖2𝑡 , and solving, in Alpha 𝑖1𝑡+1 = 7%. Furthermore,
𝑒 𝑒 𝑒
since 𝑖3𝑡 = 13(𝑖1𝑡 + 𝑖1𝑡+1 + 𝑖1𝑡+2 ), plugging the values of 𝑖3𝑡 , 𝑖1𝑡 and 𝑖1𝑡+1 , and
𝑒
solving, for Alpha one computes 𝑖1𝑡+2 = 4%.
Following the same steps, in the case of Beta it is straightforward to conclude
𝑒 𝑒
that, in that country, 𝑖1𝑡 = 7%, 𝑖1𝑡+1 = 7% and 𝑖1𝑡+2 = 1%.
327
Question 3
a. In country Zeta, only one-year and two-year bonds exist. Investors, who do care
about risk, ask for a risk premium 𝑥 to hold the two-year bond (which is risky,
as they do not know the price at which they will be able to sell it in a year). Use
the arbitrage equation to derive the (approximate) relation that will hold in this
case among the yield to maturity of a two-year bond (𝑖2𝑡 ), the current (𝑖1𝑡 ) and
𝑒
future expected (𝑖1,𝑡+1 ) yields on one-year bonds, and the risk premium (𝑥).
In this case, the arbitrage equation is

𝑒
€𝑃1,𝑡+1
1 + 𝑖1𝑡 + 𝑥 = ,
€𝑃2𝑡
where the term on the right-hand side is the expected yield on a two-year bond.
Solving for €𝑃2𝑡 , and equating the expression thus obtained for €𝑃2𝑡 to the one
that follows from the definition of the yield to maturity on the same bond, one
gets
𝑒
(1 + 𝑖2𝑡 )2 = (1 + 𝑖1𝑡 + 𝑥)(1 + 𝑖1,𝑡+1 ).
𝑒
For 𝑖2𝑡 , 𝑖1𝑡 e 𝑖1,,𝑡+1 ‘small enough’ (close to zero), the previous equation implies
that one can write
1 𝑒
𝑖2𝑡 = 2(𝑖1𝑡 + 𝑖1,𝑡+1 + 𝑥). (∗)
328
b. Suppose that, in the current period (time 𝑡), Zeta’s yield curve is the one in the
figure below. Write on the axes the name of the variables measured along each
of them, and use your answer to the previous point of this question to compute
the numerical value that the risk premium 𝑥 takes on in this economy, knowing
that investors expect the future yield on one-year bonds to be the same as the
𝑒
current one (𝑖1𝑡 = 𝑖1,𝑡+1 ).
Yield
to
maturity
4%
1%
1 2 Maturity
1
𝑒
In this economy, 𝑖2𝑡 = 4% and 𝑖1𝑡 = 𝑖1,𝑡+1 = 1%. Plugging these values into (∗
),
1
4% = 2(1% + 1% + 𝑥) .
Solving,
𝑥 = 6% .
329
Question 4
Alpha and Beta are two closed economies where only one-year and two-year bonds
exist. Investors, who do care about risk, ask for a risk premium 𝑥 to hold the two-
year bond. Suppose that the risk premium is smaller in Alpha than in Beta, 𝑥𝐴𝑙𝑝ℎ𝑎 <
𝑥𝐵𝑒𝑡𝑎 , and that the yield curves prevailing in the two countries are those represented
in the figure below. Using the implications that, for the slope of the yield curve,
follow from the approximated relation between yield to maturity of a two-year bond
𝑒
(𝑖2𝑡 ), the current (𝑖1𝑡 ) and future expected (𝑖1,𝑡+1 ) yields on one-year bonds, and the
risk premium (𝑥), explain if from the information on the two economies provided
above one can conclude that, in both countries, 𝑖1𝑡 is necessarily smaller than 𝑖1𝑒 𝑡+1.
If so, in which of the two countries is the yield on one-year bonds expected to rise
the most? If not, why? Explain.
Yield
to Beta
maturity
Alpha
1 2 Maturity
With risk averse investors, the yield on two-year bonds exceeds the average of
the current and future expected yields on one-year bonds by an amount that is
larger the greater is the risk premium, x. It follows that, with risk aversion, a
positively sloped yield curve does not necessarily signal expectations of a rise in
short term rates (for instance, when x>0 the yield curve will be positively sloped
even if investors expect future short rates to be equal to current short rates).
Similarly, the fact that Beta’s yield curve is steeper than Alpha’s could be due
only to the larger risk premium prevailing in Beta, rather than to the fact that the
yield on one-year bonds is expected to rise more in Beta than in Alpha.
330
Question 5
Consider Gamma, a country where stock prices have recently soared. To deflate what
it thinks is a stock market bubble, Gamma’s central bank decides to intervene to
return stock prices to a level closer to fundamentals. To achieve this goal, should the
central bank implement an expansionary or a restrictive monetary policy? Why? Mo-
tivate your answer by making reference to the formula for stock prices, showing the
determinants of the value of these financial assets [NB: when answering, assume
that, in each time period, the economy is described by a static IS-LM model, with
consumption and investment that depend on contemporaneous variables only].
Since the stock price at time 𝑡 can be written as:

𝑒 𝑒
€𝐷𝑡+1 €𝐷𝑡+2
€𝑄𝑡 = + 𝑒 + … ,
1 + 𝑖1𝑡 + 𝑥 (1 + 𝑖1𝑡 + 𝑥)(1 + 𝑖1𝑡+1 + 𝑥)
𝑒
where 𝑥 is the equity premium and €𝐷𝑡+𝑗 denotes expected dividends at time 𝑡 +
𝑗, Gamma’s central bank will have to announce and implement a restrictive mon-
etary policy, one that will lead to higher current and future expected short-term
interest rates and to lower future expected levels of firms’ production, revenues
and dividends. For both reasons, today’s stock prices will fall.
331
Question 6
a. We are at time t. Write down the expression defining the price (in nominal terms)
of a stock that has already paid the current dividend, and define carefully all the
variables entering it. From which principle/condition is this expression derived?
[Hint: you are not expected to derive the expression for the nominal stock price
formally; just describe in detail the considerations on which its derivation is
based].
The price (in nominal terms) of a stock that has already paid the current dividend
can be written as:
𝑒 𝑒
€𝐷𝑡+1 €𝐷𝑡+2
€𝑄𝑡 = + 𝑒 + … ,
1 + 𝑖1𝑡 + 𝑥 (1 + 𝑖1𝑡 + 𝑥)(1 + 𝑖1𝑡+1 + 𝑥)
where €𝐷 𝑒 denotes expected dividends at various future time periods, 𝑥 is the
equity premium, and the discount rates appearing at the denominator of the terms
on the right-hand side of the equation are the current and the future expected
nominal yields on one-year bonds.
The expression for the price of a stock can be derived from the arbitrage condi-
tion, which requires the expected return from holding stocks for one year to be
the same as the expected return from holding alternative assets, for instance one-
year bonds.
332
b. Explain if, and why, you agree, or do not agree, with the following statements
[NB: when answering, assume that, in each time period, the economy is de-
scribed by a standard, static IS-LM model, with consumption and investment
that depend on contemporaneous variables only]:
b.1 the prices of stocks at time 𝑡, €𝑄𝑡 , will unambiguously go up if indi-

viduals start expecting an increase in autonomous consumption at
time 𝑡 + 2;
b.2 if, at time 𝑡, individuals learn that from 𝑡 + 1 onwards fiscal policy
will become permanently more expansionary, and monetary policy
permanently more restrictive, then time 𝑡 stock prices, €𝑄𝑡 , will un-
ambiguously fall.
b.1 The statement is correct. Since the question is silent about possible changes
in the monetary policy stance, we may assume that at 𝑡 + 2 the central bank
will keep the interest rate at the level prevailing before the increase in 𝑐0 .
The only effect of the change in autonomous consumption will therefore be
an increase in income at time 𝑡 + 2, and in the dividends expected for that
period. It follows that €𝑄𝑡 will rise.
b.2 False. Without additional information on the size of the two policy interven-
tions and on the characteristics of the economy, is not possible to conclude
anything definite about the direction in which €𝑄𝑡 will change. In fact, the
monetary contraction will lead to higher future interest rates, something that
tends to lower €𝑄𝑡 (in fact, higher future expected interest rates decrease the
present value of any given flow of dividends expected in the future). However,
one must also take into account how the announced policy-mix will affect
future income levels and dividends. The monetary contraction will lower fu-
ture incomes, while the fiscal expansion will raise them. If to prevail is this
latter effect, and if the increase in future incomes (and therefore dividends)
is large enough, stock prices today could even increase; if, on the other hand,
future incomes do not increase enough, or if they fall because the adverse
impact on economic activity of the monetary contraction prevails on that of
the fiscal expansion, €𝑄𝑡 would fall.
333
Question 7
True or False?
a. If, because of new information that has become available, at time 𝑡 people
begin to expect a future decrease in the autonomous component of invest-
ment, 𝐼 ,̅ then time 𝑡 stock prices €𝑄𝑡 will certainly rise. [NB: when answer-
ing, assume that, in each time period, the economy is described by a static
IS-LM model, with consumption and investment that depend on contempo-
raneous variables only].
False. Remember that stock prices, €𝑄𝑡 , can be written as the present value of
the flow of future dividends, computed using the current and future expected
short-term interest rates as discount rates. Taking this into account, it follows
that the statement is incorrect. In fact, if 𝐼 ̅ falls, future incomes will be lower.
Individuals will therefore expect lower future dividends, and this will tend to
decrease €𝑄𝑡 . Since the question does not mention anything about future changes
in the monetary policy stance, we may assume that the central bank will keep
future interest rates at the level at which they were set before the change in 𝐼 .̅
Therefore, in the formula of the fundamental value of a stock, the only terms that
will change are the numerators of the ratios appearing on the right-hand side,
which will fall. It follows that, rather than rising, as stated in the question, stock
prices will fall, too.
334
b. If investment does not depend on the interest rate, the announcement (unex-
pected by individuals) that, from time 𝑡 onwards, monetary policy will be-
come permanently more expansionary does not lead to any change in stock
prices at time 𝑡 [NB: when answering, assume as before that, in each time
period, the economy is described by the same static IS-LM model considered
in the previous point of this question].
False. Stock prices at time 𝑡, €𝑄𝑡 , are equal to the present value of expected
future dividends. If demand for investment does not depend on the interest rate,
the IS curve is vertical in every period, and an expansionary monetary policy will
not change either current income, nor expected future income levels. Although,
for this reason, expected future dividends will remain constant, the policy we are
considering will nevertheless lead to a reduction in interest rates at time 𝑡 and in
all future periods, and therefore to a decrease in the rate at which those (con-
stant) expected future dividends are discounted. It follows that stock prices at
time 𝑡 will rise.
335
* Question 8
[Intertemporal consumption choices – The microfoundations of the 'theory of
the very farsighted consumer']
There are only two time periods, 𝑡 (the “present”) and 𝑡 + 1 (the “future”). Make the
following assumptions on the individuals populating the economy:
 their preferences are described by the utility function 𝑈(𝐶𝑡 , 𝐶𝑡+1 ), increas-
ing and concave in its two arguments – present consumption, 𝐶𝑡 , and future
consumption, 𝐶𝑡+1 ;
 they have access to a credit market, where they can borrow and lend at the
real interest rate 𝑟;
 they earn a disposable (labor) income equal to (𝑌𝑡 − 𝑇𝑡 ) in the first period,
𝑒 𝑒 )
and expect to earn one equal to (𝑌𝑡+1 − 𝑇𝑡+1 in the second period.
a. Suppose that, at time 𝑡, the typical individual’s financial wealth (stocks, bonds,
etc.) and housing wealth (apartments, commercial buildings, etc.) are both zero.
Write down the individuals budget constraints for each of the two periods, com-
bine them into a single intertemporal budget constraint and represent in the
(𝐶𝑡 , 𝐶𝑡+1 ) plane the problem the individual has to solve in order to maximize his
utility subject to such constraint. Where is the optimal “present consumption/fu-
ture consumption” program located? What determines whether, in the first pe-
riod, the individual will be a borrower, a lender, or rather consume exactly his
disposable income?
The budget constraints we are asked to write are:

(𝑌𝑡 − 𝑇𝑡 ) = 𝐶𝑡 + 𝑆
𝑒
(𝑌𝑡+1 𝑒 )
− 𝑇𝑡+1 + (1 + 𝑟)𝑆 = 𝐶𝑡+1
The first one refers to the first period, and tells us that, at time 𝑡, there are two
possible uses of the individual’s disposable income – consumption (𝐶𝑡 ), and sav-
ing (𝑆). Notice that, depending on whether in the first period the individual con-
sumes less than (𝑌𝑡 − 𝑇𝑡 ), more than (𝑌𝑡 − 𝑇𝑡 ), or exactly (𝑌𝑡 − 𝑇𝑡 ), his saving
𝑆 will be positive, negative, or equal to zero.
The second constraint states that, at 𝑡 + 1, disposable income in that period,
augmented by what the individual will receive for the fact that he was a lender at
𝑡 (that is, if 𝑆 > 0, augmented by the repayment of the sum he has lent out,
336
𝑆, plus interest 𝑟𝑆 on that lending), or reduced by the same amount, if at 𝑡 he was

1
a borrower (𝑆 < 0), is going to be entirely consumed.1
Solving the first constraint for 𝑆, plugging the result into the second one, and
rearranging terms, it is possible to combine the two previous constraints into the
following intertemporal budget constraint:
𝑒
(𝑌𝑡+1 𝑒 )
𝐶𝑡+1 − 𝑇𝑡+1
𝐶𝑡 + = (𝑌𝑡 − 𝑇𝑡 ) + .
1+𝑟 1+𝑟
The right-hand side − the present value of the individual’s disposable labor in-
come − is sometimes referred to as human wealth. Since we shall draw the above
constraint in the (𝐶𝑡 , 𝐶𝑡+1 ) plane, it is convenient to solve it for 𝐶𝑡+1:
𝑒 𝑒 )]
𝐶𝑡+1 = [(1 + 𝑟)(𝑌𝑡 − 𝑇𝑡 ) + (𝑌𝑡+1 − 𝑇𝑡+1 − (1 + 𝑟)𝐶𝑡 ,
which is the equation of the straight line in the figure, having a positive vertical in-
tercept (given by the term in squared brackets) and a negative slope −(1 + 𝑟). No-
tice that the horizontal intercept of the constraint (the value it implies for 𝐶𝑡 when
𝐶𝑡+1 = 0) is given by what we have just termed human wealth.
𝐶𝑡+1
𝐴
𝑒
(𝑌𝑡+1 𝑒 )
− 𝑇𝑡+1 •
𝐸
∗
𝐶𝑡+1 •
•𝐵
• 𝑒 𝑒 )
(𝑌𝑡+1 − 𝑇𝑡+1 𝐶𝑡
(𝑌𝑡 − 𝑇𝑡 ) 𝐶𝑡∗ (𝑌𝑡 − 𝑇𝑡 ) +
1+𝑟
1
Why, on the right-hand side of the budget constraint for time t + 1, there is no term analogous to the
term 𝑆 appearing in the constraint for time 𝑡? The reason is that t + 1 is the second, and last, period of
the model (or, if you want, of the individual’s lifetime). At t + 1, the individual would like to borrow
as much as possible, since this loan will come due only at an inexistent time t + 2, and therefore never.
But, exactly because of this, he will find no one willing to lend. In the last period, the individual will
therefore consume all the resources that, also as a result of the choices made in the first one, he has
available, nothing more and nothing less.
337
𝑒 𝑒 )]
The budget constraint goes always through the point [(𝑌𝑡 − 𝑇𝑡 ), (𝑌𝑡+1 − 𝑇𝑡+1 −
a point that, in the figure, we initially assume to be 𝐴. In fact, to consume in each
period exactly his contemporaneous disposable income is a strategy always at
the individual's reach (albeit certainly not the only, nor necessarily the optimal,
one). In the same graph, we have drawn some of the indifference curves corre-
sponding to the utility function 𝑈(𝐶𝑡 , 𝐶𝑡+1 ). As Microeconomics allows us to
conclude, the optimal choice is given by point 𝐸 in the figure, where the budget
constraint is tangent to an indifference curve, and by the associated levels of
∗
present consumption 𝐶𝑡∗ and future consumption 𝐶𝑡+1 . Notice that, given the way
we have drawn the figure, the individual will find it optimal to borrow today
∗ 𝑒 𝑒 )].
[𝐶𝑡∗ > (𝑌𝑡 − 𝑇𝑡 )], and then repay this loan tomorrow [𝐶𝑡+1 < (𝑌𝑡+1 − 𝑇𝑡+1 If,
however, for given preferences and slope of the budget constraint, the point rep-
resenting the sequence of disposable incomes had been 𝐵, rather than A, to max-
imize his utility the individual would have chosen to be a lender at time 𝑡. Simi-
larly, and this time for given disposable incomes in the two periods, the fact that
the individual will be a lender rather than a borrower also depends on the value
of 𝑟, as well as on the individual's preferences (for instance, on how steep are his
indifference curves). Having said that, it is important to realize that the fact that
the individual will choose a positive, a negative, or a zero value for 𝑆 in the first
period does not change any of the conclusions that will be reached when answer-
ing the next point of this question, or the properties of the consumption function
we are about to derive.
b. Assuming that both 𝐶𝑡 and 𝐶𝑡+1 are “normal goods”, explain how the optimal
choice of present consumption will be affected by the following changes:
 a transitory increase in current disposable income [𝛥(𝑌𝑡 − 𝑇𝑡 ) > 0 and
𝑒 𝑒 )
𝛥(𝑌𝑡+1 − 𝑇𝑡+1 = 0]
 an increase in future expected disposable income [𝛥(𝑌𝑡 − 𝑇𝑡 ) = 0 and
𝑒 𝑒 )
𝛥(𝑌𝑡+1 − 𝑇𝑡+1 > 0] ;
 𝑒
a permanent increase in disposable income [𝛥(𝑌𝑡 − 𝑇𝑡 ) = 𝛥(𝑌𝑡+1 𝑒 )
− 𝑇𝑡+1 > 0].
What can you conclude about the consumption function implied by the analysis
of the individual’s intertemporal consumption choices?
All the changes we are asked to investigate raise the individual’s human wealth
(the present value of his disposable labor incomes), causing a rightward shift in
his intertemporal budget constraint. Being 𝐶𝑡 and 𝐶𝑡+1 normal goods, this
will induce the consumer to raise both present and future consumption levels.
338
We can therefore conclude that time 𝑡 consumption depends positively on human

wealth,
𝐶𝑡 = 𝐶(ℎ𝑢𝑚𝑎𝑛 𝑤𝑒𝑎𝑙𝑡ℎ𝑡 ).
(+)
Needless to say, human wealth, and therefore current consumption, will rise
more if, rather than transitory (limited to the current period), the increase in
current disposable income is permanent (that is, expected to last indefinitely, thus
leading to an upward revision of expected future income, too). Furthermore, 𝐶𝑡
rises also if, for a given disposable income today, individuals start expecting a
higher disposable income tomorrow (in fact, today’s consumption depends on the
present value of disposable income, which rises also when, for a given current
income, future income goes up).
Finally, and even though the real interest rate enters the expression of human
wealth, in what follows we shall not include 𝑟 among the variables on which 𝐶𝑡
depends, and write current consumption as a function of current and future
expected disposabe income levels only,
𝐶𝑡 = 𝐶(𝑌𝑡 − 𝑇̅𝑡 , 𝑌𝑡+1
𝑒
− 𝑇̅𝑡+1
𝑒 ).
(+) (+)
The reason for this choice is that changes in 𝑟 affect 𝐶𝑡 through several channels,
often pushing current consumption in opposite directions (as evident from the
fact that, in the figure, changes in the real interest rate change not only the
intercept, but also the slope of the budget constraint). We shall therefore capture
the impact of changes in 𝑟 on aggregate demand through the effect these changes
have on investment, rather than through the ambiguous impact they have on
consumption.
c. How does the consumption function you have just derived change if, at time 𝑡, indi-
viduals have a positive − rather than zero, as assumed so far − nonhuman wealth
(𝑊𝐹𝐻), defined as the sum of financial and housing wealth?
In this case, the term 𝑊𝐹𝐻𝑡 must be added to the left-hand side (resources) of
the individual’s budget constraint for time 𝑡, and – as it is straightforward to
conclude – to human wealth in the expression of the horizontal intercept of the
intertemporal budget constraint. This latter intercept now equals the sum of hu-
man and nonhuman wealth, a sum also called total wealth. If total wealth rises,
because of an increase in human and/or in financial and housing wealth, the
budget constraint will shift to the right, and today’s consumption will go up. It
follows that the consumption function now becomes:
𝐶𝑡 = 𝐶(𝑡𝑜𝑡𝑎𝑙 𝑤𝑒𝑎𝑙𝑡ℎ𝑡 ).
(+)
339
Question 9
There are only two periods, period 𝑡 (“the present”) and period 𝑡 + 1 (“the future”).
In the attempt to boost current economic activity, the government of country Delta
cuts by 100 the taxes each individual will have to pay in the current period (time 𝑡).
At the same time, the government however announces that future taxes will be in-
creased by the same amount. In other words, denoting per-capita net taxes by 𝑇, the
fiscal policy intervention just described can be summarized as follows: ∆𝑇𝑡 = −100,
𝑒
∆𝑇𝑡+1 = ∆𝑇𝑡+1 = +100.
a. Suppose that all individuals are identical and that, at the beginning of time 𝑡,
their non-human wealth is zero. Moreover, assume that 𝑟 = 0, where 𝑟 is the
real interest rate. Using the analysis of the intertemporal consumption choices,
evaluate ∆𝐶𝑡 and ∆𝐶𝑡+1 − that is, the changes in current and future consumption
levels of the typical inhabitant of country Delta caused by the intertemporal re-
allocation of taxes implemented by the government. Will the government be
successful in its attempt to increase consumption, and hence aggregate demand
and equilibrium production, at time 𝑡? If yes, indicate the fraction of the tax cut
by which time 𝑡 consumption of the typical individual will rise. If no, why? In
motivating your answer, make explicit reference to the way in which savings by
the typical individual will change at time 𝑡.
Since individuals have zero non-human wealth at the beginning of period 𝑡, their
total wealth equals their human wealth, which − being 𝑟 = 0 − is just the sum
of their current and future expected disposable income levels, (𝑌𝑡 − 𝑇𝑡 ) +
𝑒
(𝑌𝑡+1 𝑒 ).
− 𝑇𝑡+1
𝑒
It follows that, since ∆𝑇𝑡 = −∆𝑇𝑡+1 , the fiscal policy under consideration will
not change the present value of disposable income. The individuals’ budget con-
straints will remain in their initial position, and their intertemporal consumption
choices will not change. But, if consumption at time 𝑡 does not change, aggregate
demand will not change either, and the policy under consideration will not affect
economic activity.
340
Notice that, at time 𝑡, the tax cut raises disposable income. Since individuals do
not change their consumption choices, this means that they will save the whole
increase in disposable income brought about by the tax cut at time 𝑡. Next period,
individuals will use these extra savings to pay the higher taxes due at time 𝑡 + 1,
and this will allow them to keep time 𝑡 + 1 consumption unchanged.
b. Assume now that some individuals are subject to ‘liquidity constraints’. Typi-
cally, an individual who is facing a binding liquidity constraint consumes less
than he would like to, given the present value of his disposable income. This
may be due to imperfections in the financial markets, as those leading to situa-
tions in which some individuals simply have no means of getting credit, so that
their consumption in each period cannot exceed their current disposable income.
Does the existence of such constraints induce you to change your answer to the
previous point? Why? Explain.
The tax cut implemented by the government raises individuals’ disposable in-
...........................................................................................................................
come at time 𝑡, thus allowing those who are facing liquidity constraints to in-
crease their consumption at 𝑡, bringing it closer to their preferred level of con-
...........................................................................................................................
sumption for that period. In this case, and even if the present value of their dis-
...........................................................................................................................
posable income does not change, time 𝑡 consumption by liquidity-constrained
individuals will rise. It follows that aggregate demand and the equilibrium level
...........................................................................................................................
of income will increase, too.
341
Question 10
True or False?
a. Suppose that today (time 𝑡) there is a fall in house prices. The consumption func-
tion based on the analysis of the intertemporal consumption decisions implies
that time 𝑡 consumption will rise – since houses are now less expensive than
before, individuals will need to save less to purchase one, and this will allow
them to consume more.
False. The analysis of the intertemporal consumption decisions implies that

consumption is increasing in individuals’ total wealth. Since total wealth is the
sum of human wealth and of financial and housing wealth, and since a fall in
house prices amounts to a decrease in individuals’ housing wealth, current
consumption will fall.
342
b. Today (time 𝑡), stock prices fall. The consumption function based on the analysis
of the intertemporal consumption decisions implies that, at time 𝑡, households
will cut their consumption expenditures.
True. A fall in stock prices reduces individuals’ financial wealth and therefore,
as it is clear from the answer to the previous point, households’ current consump-
tion expenditures. Other things the same, it follows that a drop in stock prices
leads to lower aggregate demand and equilibrium income.
343
Question 11
a. In country Macrolandia there are only one-year and two-year bonds. The
current and the expected future inflation rates are both zero, so that the
real and the nominal interest rates are equal. In period 𝑡 + 1 (“the future”),
a standard IS-LM model describes the functioning of the economy. In
particular, in the year 𝑡 + 1 consumption depends only on disposable in-
come at 𝑡 + 1, and investment on the interest rate and output at 𝑡 + 1 only.
Turning now to the current period (𝑡, “the present”), consumption is in-
creasing in both current and expected future disposable income, 𝐶𝑡 =
𝐶(𝑌𝑡 − 𝑇̅𝑡 , 𝑌𝑡+1
𝑒
− 𝑇̅𝑡+1
𝑒
), investment depends positively on current and
expected future income levels, and negatively on the current and expected
future levels of short-term interest rates, the demand for money has the
usual functional form, and 𝐺 and 𝑇 are exogenous as usual. Starting from
an initial equilibrium, at time 𝑡 the central bank of Macrolandia, that
chooses the interest rate, announces that it will raise the policy rate by two
percentage points both at time 𝑡 and at time 𝑡 + 1. If in Macrolandia, at
time 𝑡 the yield curve is initially horizontal, and assuming that the an-
nouncement is unexpected and believed by the individuals in the econ-
omy, which of the following three figures (where the new curve is labelled
“after”), describes the effect of the announcement on Macrolandia’s yield
curve? At time 𝑡, will the yield to maturity on two-year bonds change? If
so, by how much? If not, why?
344
The correct figure is Figure 2. The central bank will raise both 𝑖1𝑡 and 𝑖1𝑡+1 by
2%. Of the two points that the yield curve connects, the first one (𝑖1𝑡 ) will there-
fore go up by 2% ; the second one, 𝑖2𝑡 , will go up by the average amount by
which the current and future expected short rates will increase, which is once
again 2%. It follows that the new yield curve will remain flat, but will lie uni-
formily above the initial one, signaling expectations of a monetary tightening of
the same intensity in the two periods.
b. Discuss how the permanent monetary contraction described in the previ-

ous point of this question will affect the various components of aggregate
demand at time 𝑡 – that is, how it will affect 𝐶𝑡 , 𝐼𝑡 and 𝐺𝑡 . Explain in
detail.
At time 𝑡 + 1, the monetary contraction leads to an equilibrium with a higher

interest rate and a lower income level. At time 𝑡, individuals will want to consume
𝑒
less due to the fall in 𝑌𝑡+1 , while firm will decrease investment, because of the
lower future expected income and the higher current and future expected interest
rates. Being exogenous, 𝐺𝑡 will of course remain unchanged. The fall in aggre-
gate demand due to decreases in 𝐶𝑡 and 𝐼𝑡 just described will lower 𝑌𝑡 , a change
that will further reduce both time 𝑡 consumption and time 𝑡 investment.
345
Question 12
a. In country Delta, there are only one-year and two-year bonds. The current and
describes the functioning of the economy. In particular, in the year 𝑡 + 1 con-
sumption depends only on disposable income at 𝑡 + 1, and investment on the
interest rate and output at 𝑡 + 1 only. Turning now to the current period (𝑡, “the
present”), consumption is increasing in both current and expected future dispos-
able income, 𝐶𝑡 = 𝐶(𝑌𝑡 − 𝑇̅𝑡 , 𝑌𝑡+1𝑒
− 𝑇̅𝑡+1
𝑒
), investment depend positively on
current and expected future income levels, and negatively on the current and
expected future levels of short-term interest rates, the demand for money has the
usual functional form, and 𝐺 and 𝑇 are exogenous as usual. Starting from an
initial equilibrium, at time 𝑡 the government of Delta announces an increase of
its purchases of goods and services at time 𝑡 + 1, ∆𝐺̅𝑡+1 > 0. At the same time,
the central bank announces that it will adjust the policy rate so as to prevent any
change in equilibrium income that, at time 𝑡 and/or at time 𝑡 + 1, could be caused
by the fiscal policy just described. Explain how these announcements, which are
unexpected and credible, affect the time 𝑡 yield to maturity on the two-year
bonds circulating in Delta, 𝑖2𝑡 .
...........................................................................................................................
The increase in government purchases of goods and services that will be imple-
mented at 𝑡 + 1 will shift to the right the IS curve for that period. To keep 𝑌𝑡+1
...........................................................................................................................
constant, the central bank will have to raise the short-term interest rate, 𝑖1𝑡+1 .
...........................................................................................................................
At time 𝑡, this will lead individuals to expect a higher short-term future interest
rate. These expectations will lower time 𝑡 investment, and will therefore cause a
...........................................................................................................................
leftward shift of the IS curve for the current period. It follows that, to prevent 𝑌𝑡
from falling, the central bank will have to cut the current short-term rate, 𝑖1𝑡 .
Since 𝑖2𝑡 is (approximately) equal to the average of the current and the future
expected short term interest rates, and since these rates move in opposite direc-
tions, one cannot conclude anything definite about the way in which yield to ma-
turity on the two-year bonds at time t will change − it could rise, fall, or remain
constant.
346
b. Assume for simplicity that, in Delta, at time 𝑡 the yield curve is initially horizon-
tal. Explain how the position and the slope of this curve change after the an-
nouncement studied above. Represent both curves, the one “before” and the one
“after” the announcement, in the graph below. Clarify whether it is possible to
determine the position and the slope of the new yield curve unambiguously.
Yield
to
maturity
“before” “after”
1 2 Maturity
Since 𝑖1𝑡 falls, while the sign of the change in 𝑖2𝑡 is uncertain, the dashed seg-
ments in the figure show three new, equally plausible yield curves for the econ-
omy in consideration. In particular, and no matter the direction in which 𝑖2𝑡 will
...........................................................................................................................
change, the new curve will have a positive slope. Since we know that 𝑖1𝑡 will be
...........................................................................................................................
lower, it is easy to understand why the new yield curve will be positively sloped
if 𝑖2𝑡 will rise, or remain constant. But what if 𝑖2𝑡 ends up falling? From 𝛥𝑖2𝑡 =
...........................................................................................................................
1 𝑒 𝑒
(𝛥𝑖1𝑡 + 𝛥𝑖1,𝑡+1 ), 𝛥𝑖1𝑡 < 0 and 𝛥𝑖1,𝑡+1 > 0 it follows that 𝛥𝑖2𝑡 − 𝛥𝑖1𝑡 > 0.
...........................................................................................................................
2
The slope of the yield curve, whose sign is equal to that of the difference (𝑖2𝑡 −
𝑖1𝑡 ), will therefore rise − going from zero to a positive value − also in this case.
[To put it differently, even if it should end up falling, being the average of the
current short-term yield, which falls, and the future expected one, which rises,
𝑖2𝑡 will necessarily fall less than 𝑖1𝑡 ]. As usual, the positive slope of the new yield
curve signals expectations of short term rates increasing over time (in this case,
due to the fall in the current short rate, and the expectation of a rise in the future
one).
347
Question 13
a. In country Beta, there are only one-year and two-year bonds. The current and
interest rates are equal. In period 𝑡 + 1 (“the future”), an IS-LM model describes
the functioning of the economy. In particular, in the year 𝑡 + 1 consumption de-
pends only on disposable income at 𝑡 + 1, and investment on the borrowing rate
(the sum of the interest rate and the risk premium 𝑥𝑡+1 ) and an output at 𝑡 + 1
only. Turning now to the current period (𝑡, “the present”), consumption is in-
creasing in both current and expected future disposable income, 𝐶𝑡 = 𝐶(𝑌𝑡 −
𝑇̅𝑡 , 𝑌𝑡+1
𝑒
− 𝑇̅𝑡+1
𝑒
), investment depends positively on current and expected future
income levels, and negatively on the current and expected future borrowing
rates, the central bank chooses in each period the interest rate, and 𝐺 and 𝑇 are
exogenous as usual. Starting from an initial equilibrium position in both periods,
at time 𝑡 individuals start expecting a decrease in the risk premium for time 𝑡 +
1, 𝛥𝑥𝑡+1 < 0. At the same time, the central bank announces that it will adjust
the policy rate so as to prevent any change in equilibrium income that, at time 𝑡
(and at time 𝑡 only), could be caused by the change in 𝑥𝑡+1 just described. Ex-
plain how these changes and announcements, which are unexpected and credi-
ble, affect the time 𝑡 yield to maturity on the two-year bonds circulating in Beta,
𝑖2𝑡 .
At time 𝑡 + 1, the decrease in the risk premium lowers the borrowing rate, raises
investment and shifts to the right the IS curve for that period. It follows that in-
come rises at 𝑡 + 1. At time 𝑡, the IS curve shifts to the right both for the increase
in the future expected equilibrium income and for the decrease in the borrowing
rate for time 𝑡 + 1. To prevent this from increasing time 𝑡 equilibrium income,
the central bank will have to raise the current policy rate. Since the future ex-
pected short rate remains constant, while the current one goes up, the current
long rate 𝑖2𝑡 increases.
348
b. Assume for simplicity that, in Beta, at time 𝑡 the yield curve is initially horizon-
tal. Explain how the position and the slope of this curve change after the change
and the announcement studied above. Represent both curves, the one “before”
and the one “after”, in the graph below. Clarify whether it is possible to deter-
mine the position and the slope of the new yield curve unambiguously.
Yield
to
maturity
“after”
“before”
1 2 Maturity
Given that both the current short rate (𝑖1𝑡 ) and the current long one (𝑖2𝑡 ) go up,
1 𝑒
the new yield curve will lie above the initial one. Since 𝛥𝑖2𝑡 = (𝛥𝑖1𝑡 + 𝛥𝑖1,𝑡+1 ),
2
𝑒
and being 𝛥𝑖1,𝑡+1 = 0, the increase in the current long rate will be half that in
the short one, so that the new curve will be negatively sloped.
349
Question 14
In country Gamma, current and future expected inflation rates coincide and are equal
to zero, so that the real and the nominal interest rates are equal. In period 𝑡 + 1 (“the
future”), consumption depends only on disposable income at 𝑡 + 1, and investment
̅ + 𝑑1 𝑌𝑡+1 − 𝑑2 𝑖𝑡+1 , where symbols have the usual meaning. Turning
is 𝐼𝑡+1 = 𝐼𝑡+1
now to the current period (𝑡, “the present”), consumption is increasing in both current
and expected future disposable income, 𝐶𝑡 = 𝐶(𝑌𝑡 − 𝑇̅𝑡 , 𝑌𝑡+1 𝑒
− 𝑇̅𝑡+1
𝑒
), while invest-
ment is increasing in current and expected future income levels, and decreasing in
the current and expected future levels of short-term interest rates. Finally, 𝐺 and 𝑇
are exogenous in both periods.
a. At time 𝑡, individuals revise downwards their expectation about the value that
the autonomous component of investment will take on in the future. More spe-
̅ will drop to 𝐼 ′̅ 𝑡+1 , with 𝐼 ′̅ 𝑡+1 < 𝐼𝑡+1
cifically, they start expecting that 𝐼𝑡+1 ̅ .
At the same time, the central bank announces that, in the future, it will imple-
ment a monetary policy aimed at preventing any change in time 𝑡 + 1 equilib-
rium output that could be caused by the expected drop in autonomous invest-
ment in that period. To achieve its goal, what kind of monetary policy (expan-
sionary? restrictive?) should the central bank implement? Describe, and repre-
sent in the graph below, the effects of the two announcements on Gamma’s cur-
rent (that is to say, time 𝑡) income and interest rate equilibrium levels.
𝑖𝑡
0 1
𝐿𝑀𝑡
𝐼𝑆𝑡1
𝐼𝑆𝑡0
𝑌𝑡
350
To offset the impact of the fall in autonomous investment on time 𝑡 + 1 equilib-

rium output, the central bank will have to implement an expansionary monetary
policy in that period − for instance, a purchase of bonds in the open market, that
will lead to a drop in the interest rate at time 𝑡 + 1. In the future, the IS curve
will therefore shift to the left, and the LM curve downwards, with the two curve
crossing for the same level of output as the one prevailing before the fall invest-
ment, but for a lower interest rate. At time 𝑡, the expectation of a lower interest
rate in the future will boost investment, thus shifting the IS curve to the right. In
the new equilibrium, if the central bank keeps the current interest rate at the level
it had initially chosen, current output will be higher, and the interest rate un-
changed.
b. Suppose that only one-year bonds and two-year bonds exist and that, before the
announcements described above, at time 𝑡 the yield curve was flat. What will
be the effects of the two announcements on the position and the slope of the
yield curve of Gamma?
The current one-year yield does not change, while the future expected one falls.
1 𝑒
Since 𝑖2𝑡 = (𝑖1𝑡 + 𝑖1,𝑡+1 ), the time 𝑡 yield to maturity on two-year bonds will
2
𝑒 1
drop, too (more specifically, it will fall by 𝛥𝑖1,𝑡+1 ). The changes analyzed in
2
the previous point of this question will therefore lead to a negatively sloped yield
curve.
351
Question 15
a. In country Alpha, there are only one-year and two-year bonds. The current and
describes the functioning of the economy. In particular, in year 𝑡 + 1 consump-
tion depends only on disposable income at 𝑡 + 1, and investment on the interest
rate and output at 𝑡 + 1 only. Turning now to the current period (𝑡, “the pre-
sent”), consumption is increasing in both current and expected future disposable
income levels, 𝐶𝑡 = 𝐶(𝑌𝑡 − 𝑇̅𝑡 , 𝑌𝑡+1𝑒
− 𝑇̅𝑡+1
𝑒
), investment is exogenous, 𝐼𝑡 = 𝐼,̅
and the same is true about 𝐺 and 𝑇. Rather than the interest rate, Alpha's central
bank chooses a value for the nominal money supply 𝑀 and, given this level at
which 𝑀 is set, lets the interest rate free to take on any value is consistent with
the macroeconomic equilibrium. It follows that, in the (𝑌, 𝑖) plane, the LM curve
of Alpha is the curve discussed in Question 2 − and, for the case of an economy
in a liquidity trap, in Question 9 − of Chapter 2. Finally, in the initial equilibrium,
time 𝑡 + 1 income and interest rates levels are both positive, while at time 𝑡 the
economy is in a liquidity trap. Suppose now that, at time 𝑡, the central bank an-
nounces that it will decrease nominal money supply at 𝑡 + 1. Explain how this
announcement, which is unexpected and credible, affects the time 𝑡 yield to ma-
turity on the two-year bonds circulating in Alpha, 𝑖2𝑡 .
.........................................................................................................................
The decrease in money supply announced for 𝑡 + 1 will shift the LM for that year
to the left. This will lead to a new equilibrium in which income 𝑌𝑡+1 is lower, and
...........................................................................................................................
the short-term interest rate 𝑖1𝑡+1 higher. At time 𝑡, the fall in expected future
...........................................................................................................................
income will decrease consumption, the IS will shift to the left, and the economy
...........................................................................................................................
will converge to an equilibrium in which 𝑌𝑡 is lower and 𝑖1𝑡 unchanged (since at
time 𝑡 the economy is in a liquidity trap, the intersection between the IS and the
...........................................................................................................................
LM curves will still take place in the horizontal portion of the latter curve, even
...........................................................................................................................
after the leftward shift in the IS). Since 𝑖2𝑡 is (approximately) equal to the average
𝑒
of the current and the future expected short term interest rates, and since 𝑖1𝑡+1
...........................................................................................................................
rises and 𝑖1𝑡 does not change, the yield to maturity of the two-year bonds at time
t will definitely rise.
352
b. Draw the yield curve prevailing at time 𝑡 before the central bank’s announce-
ment, and explain how this latter will affect the yield curve of Alpha. In partic-
ular, draw the new yield curve in the same graph, and explain if it is possible to
determine without ambiguity how its slope and position will compare to those
of the original curve.
Yield
to
maturity
“after”
“before”
1 2 Maturity
𝑒
Since we know that, before the announcement, 𝑖1𝑡 = 0 and 𝑖1𝑡+1 > 0, initially
the slope of the yield curve is positive.
After the announcement, 𝑖1𝑡 remains equal to zero, while 𝑖2𝑡 rises. It follows that
the new curve will still be positively sloped, but steeper than the initial one.
353
Question 16
In country ABC, there are only one-year and two-year bonds. The current and the
future expected inflation rates are both zero, so that the real and the nominal interest
rates are equal. In period 𝑡 + 1 (“the future”), a standard IS-LM model describes the
functioning of the economy. In particular, in year 𝑡 + 1 consumption depends only
on disposable income at 𝑡 + 1, and investment on the interest rate and output at 𝑡 +
1 only. Turning now to the current period (𝑡, “the present”), consumption is increas-
ing in both current and expected future disposable income, 𝐶𝑡 = 𝐶(𝑌𝑡 − 𝑇̅𝑡 , 𝑌𝑡+1 𝑒
−
𝑇̅𝑡+1 ), investment depends positively on current and expected future income levels,
𝑒
and negatively on the current and expected future levels of short-term interest rates,
the demand for money has the usual functional form, and 𝐺 and 𝑇 are exogenous as
usual.
a. Starting from an initial equilibrium, at time 𝑡 the government of ABC announces

an equal increase in net taxes in both periods, ∆𝑇̅𝑡 = ∆𝑇̅𝑡+1 > 0. At the same
time, the central bank announces that it will adjust the policy rate so as to prevent
any change in equilibrium income that, at time 𝑡 + 1 - and at time 𝑡 + 1 only -
could be caused by the fiscal policy just described.
At time 𝑡 + 1, the increase in net taxes will shift to the left the IS curve for that
period. To keep 𝑌𝑡+1 constant, the central bank will have to lower the short-term
interest rate, 𝑖1𝑡+1 . At time 𝑡, the IS curve will tend to shift to the left due to the
increase in current and future expected net taxes (an increase that will lower
current consumption), and to the right because of the fall in the future expected
interest rate (that will boost time 𝑡 investment). Since it is uncertain which of the
two effects will prevail, and therefore if and how the IS curve for the current
period will shift, one cannot conclude anything definite about the change in time
t equilibrium income, investment and consumption levels – they could go up,
down, or remain unchanged.
354
b. Do you think that the permanent increase in net taxes described before will lead
to a change in the time 𝑡 yield to maturity on the two-year bonds circulating in
ABC, 𝑖2𝑡 ? If no, why? If yes, in which direction will 𝑖2𝑡 change, and by how
much? Finally, assuming for simplicity that, in ABC, at time 𝑡 the yield curve
was initially horizontal, explain how the position and the slope of that curve will
change after the fiscal policy announcement studied above.
𝑒
Since 𝑖1𝑡 does not change and 𝑖1,𝑡+1 goes down, 𝑖2𝑡 – approximately equal to the
average of the current and the future expected short term interest rates – will fall.
More precisely, it will go down by half of the decrease in the future expected
1 𝑒 1 𝑒
short rate [𝛥𝑖2𝑡 = (𝛥𝑖1𝑡 + 𝛥𝑖1,𝑡+1 ) = 2 𝛥𝑖1,𝑡+1 , being 𝛥𝑖1𝑡 = 0]. Finally, the
2
yield curve will now be negatively sloped – it will connect a first point that it
shares with the old one to a second point that reflects the new, lower value of 𝑖2𝑡 .
355
Chapter 5 - The open economy
Question 1
a. Country Iota’s Statistical Office announces that, between year 𝑡 and year 𝑡 + 1,
gross investment has increased by €100bn, while public saving has fallen by
€50bn.
a.1 Knowing that Iota is a closed economy, by how much has private saving
changed between the same two years?
a.2 How would your answer change, were Iota an economy open to trade in
goods, services and financial assets with the rest of the world?
a.1 In a closed economy, in goods market equilibrium national saving − the

sum of private savings and public savings − is equal to investment. If the
latter has increased by €100bn, and public savings has decreased by
€50bn, private savings will necessarily have increased by €150bn.
a.2 In an open economy, in goods market equilibrium national saving is equal

to the sum of investment and the trade balance (NX). Since we do not know
what has happened to net exports NX, in this case it is not possible to say
anything definite about the change in private savings.
358
The open economy
b. Explain, briefly but rigorously, what is meant by ‘J-curve’ [in your answer, make
explicit reference to the so-called ‘Marshall-Lerner condition’].
“J-curve”: graphical representation of the response of the trade balance to a

real depreciation (or, more generally, to a change in the real exchange rate).
When this response follows the J-curve, a depreciation initially worsens the trade
balance. This happens because, immediately after the depreciation, the quantities
exported and imported change little, while each unit of goods imported from
abroad is now more expensive in terms of domestic goods (in other words, in the
short run the Marshall-Lerner condition may not hold). The trade balance starts
improving only after some time, when the quantities of goods exported and im-
ported begin to adjust to the change in relative prices, and the Marshall-Lerner
condition will eventually hold (as it empirically does, at least from the medium
to long run, for most countries and time periods).
359
Question 2
world, where the exchange rate and prices are fixed and in which only the goods
market exists. In the initial equilibrium, the country has a trade surplus.
a. Show in the graph the effects of an exogenous increase in investment on equi-

librium income and on the trade balance. Explain.
45°
𝐷𝐷′
Z
𝑍𝑍′
1 45° 𝐷𝐷
𝐷𝐷′
𝑍𝑍
Z
0 𝑍𝑍′
1 𝐷𝐷
𝑍𝑍
0
𝑌̂0 𝑌̂1 𝑌𝑇𝐵 𝑌
NX
𝑁𝑋0 𝑌̂0 𝑌̂1 𝑌𝑇𝐵 𝑌

𝑁𝑋1
NX
𝑌
𝑁𝑋0
𝑁𝑋1
𝑌
360
The open economy
Starting from an initial equilibrium at point 0, with income 𝑌̂0 and a trade surplus
𝑁𝑋0 , an exogenous increase in investment leads to an increase in aggregate de-
mand and equilibrium output. Both the ZZ and the DD curves shift upwards by
an amount equal to the exogenous increase in investment (𝛥𝐼 ̅ > 0). Equilibrium
income becomes 𝑌̂1 in the graph. In turn, this increase in income leads to higher
imports, thus worsening the trade balance, that now becomes 𝑁𝑋1 (< 𝑁𝑋0 ). [No-
tice that, had investment increased by more than assumed in the graph, net ex-
ports could have become negative.]
Starting from an initial equilibrium at point 0, with an equilibrium income 𝑌̂0 and
a trade surplus 𝑁𝑋0 , an exogenous increase in investment leads to an increase
in aggregate demand and equilibrium output. Both the ZZ and the DD curves
b. Does the increase in investment change the level of output for which trade is
shift upwards by an amount equal to the exogenous increase in investment
balanced? Why, or why not?
(𝛥𝐼 ̅ > 0). Equilibrium income rises, and is now 𝑌̂1 in the graph. In turn, this
increase in income leads to higher imports, thus worsening the trade balance,
that now becomes 𝑁𝑋1 (< 𝑁𝑋0 ). Notice that, had investment increased by more
than assumed in the graph, net exports could have become negative.
...........................................................................................................................
𝑌𝑇𝐵 does not change, because the ZZ and the DD curves shift upwards in a par-
...........................................................................................................................
allel fashion by the same amount (𝛥𝐼 ̅ ). It follows that they will keep intersecting
for the same 𝑌𝑇𝐵 (the level of income for which foreign trade is balanced). One
...........................................................................................................................
can reach the same conclusion by noticing that the NX does not shift, since − for
...........................................................................................................................
any given 𝑌 − the change in 𝐼 ̅ does not affect net exports.
...........................................................................................................................
361
Question 3
Eta is an economy open to international trade in goods and services, and in which
financial markets do not exist. Assume that prices are constant both in Eta and in the
rest of the world.
Eta is initially in goods market equilibrium, with 𝐺̅ = 60, 𝑇̅ = 10, 𝑆 = 70, 𝐼 =
20, where 𝐺 is government spending on goods and services, 𝑇 net taxes, 𝑆 private
saving, and 𝐼 investment.
a. Using the information provided above, represent the initial equilibrium of Eta
in the two-panel diagram below, denoting it by ‘1’ [Hint: you do not need to
compute the equilibrium level of income; just show clearly where the initial
equilibrium position is located in each of the two panels below, and explain
why].
45° 𝐷𝐷′
𝑍𝑍2
Z
2
𝐷𝐷
𝑍𝑍1′
1′
𝑍𝑍1
1
𝑌1 𝑌1′ 𝑌2 𝑌
NX
1 2
0
𝑌
𝑁𝑋2
𝑁𝑋1
362
The open economy
In an open economy, the goods market equilibrium condition can be written as

follows: 𝑆 + (𝑇 − 𝐺) − 𝐼 = 𝑁𝑋. Since, in Eta, 𝑆 + (𝑇 − 𝐺) − 𝐼 = 70 + (10 −
60) − 20 = 0, in the initial equilibrium net exports are therefore equal to zero.
It follows that, in the first panel, the ZZ and the DD curves will intersect at a
point (1 in the figure) lying on the 45° line, and that equilibrium income 𝑌̂1 , will
also be the level of income for which trade is balanced.
b. Suppose now that Eta’s policy-makers wish to raise equilibrium income, leav-
ing net exports unchanged. Having discussed why resorting to fiscal policy
only, or to an exchange rate policy only, does not allow the government to
achieve both its objectives, discuss the combination of the two policies which
would allow the country to reach its two goals. In the two panels of the graph,
denote by ‘2’ the new equilibrium that will be reached following the policy-mix
you are suggesting, and explain.
An expansionary fiscal policy raises income, but worsens the country’s net ex-
ports; a real depreciation increases income, but also improves net exports. To
raise 𝑌 and keep net exports equal to zero, policy-makers will have to resort to
an appropriate mix of fiscal expansion and real depreciation. In particular, an
expansionary fiscal policy will shift up, and by the same amount, the 𝑍𝑍 and the
𝐷𝐷 curves. They will therefore keep crossing for the same level of production,
and the new equilibrium income will become 𝑌1′ in the figure. However, for this
level of output 𝑁𝑋 < 0. To prevent net exports from becoming negative, policy-
makers will have to engineer a real depreciation of appropriate size – one that
will shift the ZZ curve up, so that it will cross the new DD curve exactly on the
45° line, and that, in the lower panel, will lead to an upward shift in NX, so that
it will cross the horizontal axis for the new equilibrium output, 𝑌2 . As planned, at
point 2 𝑁𝑋 = 0 and equilibrium income is higher.
363
Question 4
tially, the country is in goods market equilibrium with a trade surplus. Draw in
the two-panel diagram below the initial equilibrium position, and show how it
changes following a reduction in the domestic price level, 𝑃 [Hint: assume that,
after this reduction, 𝑃 remains forever constant at its new, lower level, so that
the economy is still described by a model with fixed prices]. In particular, explain
if and why income and net exports will change in the new equilibrium.
45°
DD
ZZ’
1 ZZ
0
⦁ ⦁⦁ ′
⦁
𝑌̂0 𝑌̂1 𝑌𝑇𝐵 𝑌
A A’
𝑌
B B’
NX’
NX
364
The open economy
A decrease in 𝑃 leads to a fall in the real exchange rate 𝜀 = 𝐸𝑃⁄𝑃∗ (a real de-
preciation), a change that increases the price-competitiveness of domestically
produced goods. The ZZ curve shifts up, and the NX curve does the same (since,
for any given 𝑌, net exports are now higher). This increase in net exports raises
aggregate demand and equilibrium income. As the graph clearly shows, although
in the new equilibrium 𝑌 has increased, the trade surplus is larger (the impact of
the real depreciation, which tends to increase net exports, prevails on that com-
ing from the increase in 𝑌, which tends to lower them).
b. How would your answer to the previous point of this question change, if the
quantities of goods and services exported and imported by the country did not
depend on the real exchange rate, but only on foreign and domestic income lev-
els, respectively? Explain.
...........................................................................................................................
In this case, net exports are given by the following expression:
...........................................................................................................................
∗)
1
𝑁𝑋 = 𝑋(𝑌 − 𝐼𝑀(𝑌),
...........................................................................................................................
𝜀
increasing in the real exchange rate 𝜀.
In this economy, the real depreciation brought about by the fall in 𝑃 lowers net
exports, since it does not change 𝑋 or 𝐼𝑀, but only causes an increase in the
price of each unit of goods imported from abroad in terms of domestic goods. It
follows that the Marshall-Lerner condition does not hold, and a fall in 𝜀 shifts
the ZZ curve downwards, rather than upwards. In the new equilibrium, income
is lower, and the trade balance worsens.
365
Question 5
Felicia is an open economy where no financial markets exist, the Marshall-Lerner

condition is met, and whose initial equilibrium is the pair (1,1’) in the figure below.
Explain which policy mix would allow Felicia to reach a new equilibrium with an
unchanged level of income and positive net exports. When answering, verbally de-
scribe how the policy mix you propose affects the position in the plane of each of
the three curves represented in the graph.
45°
𝐷𝐷
𝑍𝑍
1
𝑌̂ 𝑌
NX
1′
𝑌̂ 𝑌
NX
...........................................................................................................................
In order to keep income unchanged and generate a trade balance surplus, one
...........................................................................................................................
has to implement a combination of fiscal tightening and exchange rate depreci-
....................................
ation. Due to the fiscal contraction, .......................................................................................
the DD and the ZZ curves will shift down-
wards by the same amount. On the other hand, and given that the Marshall-Ler-
...........................................................................................................................
ner condition is met, the exchange rate depreciation will raise net exports, so that
...........................................................................................................................
both the NX and the ZZ curves will shift upwards. It follows that an appropriate
combination of the two interventions will increase the level of income for which
...........................................................................................................................
trade is balanced, keeping at the same time constant that for which the goods
...........................................................................................................................
market is in equilibrium. [Intuition behind this result: the contractionary fiscal
policy improves net exports, but lowers equilibrium income; the exchange rate
...........................................................................................................................
depreciation has the same effect on net exports, but raises income. Through an
...........................................................................................................................
appropriate combination of fiscal tightening and exchange rate depreciation, one
can reach an equilibrium where net exports have improved, while income has
remained unchanged].
366
The open economy
Question 6
Consider Alpha, a country that is open to trade in goods and services with the rest of
the world, where prices are fixed and in which only the goods market exists. In Al-
pha, the Marshall-Lerner condition doesn’t hold – more precisely, net exports depend
positively on the real exchange rate. Initially, the country is in goods market equilib-
rium, and trade is balanced.
Having discussed which of the following three Figures provides a correct represen-
tation of the initial equilibrium in Alpha, describe the effects of a real appreciation.
In particular, discuss if and how the various curves represented in the graph you have
chosen will be affected, and explain the effects of the appreciation of the exchange
rate on the equilibrium values of income, consumption, investment and net exports.
...........................................................................................................................
The correct figure
..................... is Figure 1 – the fact that net exports depend positively on the
......................................................................................................
real exchange rate has no bearing on the slopes of curves that, like the ZZ, the
...........................................................................................................................
DD and the NX represented in the graphs, are drawn in a plane in which Y is
measured along the horizontal axis. Following the real appreciation, income,
...........................................................................................................................
consumption, investment and net exports will go up. In fact, since in Alpha an
...........................................................................................................................
increase in the real exchange rate raises, other things the same, net exports, a
real appreciation will have effects identical to those of a real depreciation in a
...........................................................................................................................
country where the Marshall-Lerner condition is met.
367
Question 7
world, where prices are fixed and in which only the goods market exists. Initially,
the country is in goods market equilibrium, and trade is balanced.
a. Draw in the two-panel diagram below the initial equilibrium position and show
how it changes following a reduction in foreign output, 𝑌 ∗ . In particular, explain
how and why net exports will have changed in the new equilibrium.
Z 45°
DD
ZZ
0 ZZ’
′
𝑌𝑇𝐵 𝑌̂1 𝑌̂0 (= 𝑌𝑇𝐵 ) 𝑌
NX
𝑌
NX
NX’
368
The open economy
..........................................................................................................................
A decrease in foreign output leads to a fall in the demand for domestically pro-
...........................................................................................................................
duced goods. The ZZ curve shifts down, and the same does the NX curve, since
net exports are now lower for any given 𝑌. This fall in net exports lowers aggre-
...........................................................................................................................
gate demand and equilibrium output. The lower panel show that, although in the
...........................................................................................................................
new equilibrium 𝑌 is lower than before, net exports will nevertheless be smaller
than in the initial equilibrium – they were initially zero, and are now negative.
...........................................................................................................................
b. Suppose the government wants to return to a situation of balanced trade, keeping

however domestic output at the new level reached after the decrease in 𝑌 ∗ . In
order to achieve these objectives, economist Paul advocates the use of fiscal
policy, while economist Edie thinks that one should necessarily resort to some
combination of fiscal and exchange rate policies. Do you agree with Paul (in
this case, explain if the appropriate fiscal policy is an expansionary or a contrac-
tionary one), or with Edie (if this is the case, describe the specific combination
of fiscal policy and exchange rate policy you deem appropriate)? [Hint: just
provide the economic intuition behind your answer; you are not requested to
carry out any graphical analysis when answering this point.]
A contractionary fiscal policy would succeed in improving the trade balance,

returning net export to zero. However, it would also lead to a further decrease in
domestic output. On the other hand, a real depreciation would improve net ex-
ports, but also raise Y. To achieve the two objectives of constant output and bal-
anced trade, one should implement an appropriate combination of contraction-
ary fiscal policy and real exchange rate depreciation. Edie is right.
369
Question 8
tially, the country is in goods market equilibrium, and trade is balanced.
Draw in the two graphs below the initial equilibrium position, and show how
this equilibrium changes following an increase in 𝐸, the nominal exchange rate
[Hint: assume that E will remain forever at the new, higher level, and that do-
mestic and foreign prices do not change]. Finally, explain if and why, in the new
equilibrium, income and net exports will have changed.
Z 45°
DD
ZZ
0 ZZ’
′
𝑌𝑇𝐵 𝑌̂1 𝑌̂0 (= 𝑌𝑇𝐵 ) 𝑌
NX
𝑌
NX
NX’
370
The open economy
..........................................................................................................................
An increase in the nominal exchange rate causes an appreciation of the real ex-
...........................................................................................................................
change rate 𝜀 ≡ 𝐸𝑃/𝑃∗, and therefore reduces the price-competitiveness of do-
mestically produced goods. The ZZ curve shifts downwards, and the same hap-
...........................................................................................................................
pens to the NX, since net exports are now lower for any given 𝑌. This fall in net
exports lowers aggregate demand and equilibrium output. As it is clear from the
lower panel of the graph above, although 𝑌 is now smaller, in the new equilib-
rium net exports will be lower – the country will now be running a trade deficit
(the adverse impact of the real appreciation, which tends to decrease net exports,
prevails on the one coming from the decrease in domestic income, which tends
to lower imports, and therefore to improve the trade balance).
b. Consider now a different economy, where also financial markets exist and under
a flexible exchange rate regime. Show in the graph below, and discuss, how an
increase in domestic money supply 𝑀 will affect the domestic interest rate 𝑖, the
country’s level of income and the exchange rate of its currency, assuming that
investment is exogenous, 𝐼 = 𝐼 ,̅ and therefore not a function of 𝑖.
𝑖 𝑖
0 𝐿𝑀0 0
𝑖̅0
1 1
𝑖̅1
𝐿𝑀1
𝐼𝑆0
𝑌̂0 𝑌̂1 𝑌 𝐸1 𝐸0 𝐸
Even though investment is exogenous, aggregate demand still depends negatively

...........................................................................................................................
on the interest rate, as a decrease in 𝑖 causes a nominal exchange rate depreci-
...........................................................................................................................
ation and an increase in net exports. It follows that the IS curve will have the
usual, negative slope in the (𝑌, 𝑖)-plane. In the figure above, the expansionary
...........................................................................................................................
monetary policy brings the equilibrium from point 0 to point 1, where the interest
...........................................................................................................................
rate is lower (due to the increase in 𝑀), the exchange rate has depreciated (since
the decrease in 𝑖 amounts to a fall in the return on domestic assets, that leads to
...........................................................................................................................
an increase in the demand for foreign assets and therefore in the demand for the
currency in which they are denominated), and domestic income is higher, thanks
to the exchange rate depreciation.
371
Question 9
a. The euro-dollar exchange rate (number of dollars needed to purchase one euro)
is expected to be 1.30 next year (i.e., 𝐸 𝑒 = 1.30), and the one-year interest rates
are 3% in Europe and 1% in the Unites States. Assuming that the (uncovered)
interest parity condition holds, compute the current euro-dollar exchange rate,
𝐸. Do financial markets participants expect the euro to appreciate or to depreci-
ate in one year’s time?
From the non-approximated version of the (uncovered) interest parity condition,

𝐸𝑡
(1 + 𝑖𝑡 ) = (1 + 𝑖𝑡∗ ) ( 𝑒 ),
𝐸𝑡+1
it follow that the current exchange rate can be written as:
(1 + 𝑖𝑡 ) 𝑒
𝐸𝑡 = 𝐸 .
(1 + 𝑖𝑡∗ ) 𝑡+1
Given the numerical values that 𝐸 𝑒 , 𝑖 and 𝑖 ∗ take on in this case, it follows that:
1.03
𝐸𝑡 = · 1.30 = 1.3265.
1.01
Being
𝑒
𝐸𝑡+1 − 𝐸𝑡 1.30 − 1.3265
= ≌ −0.02,
𝐸𝑡 1.33
the euro is expected to depreciate by about 2% between today and next year.
372
The open economy
b. Write down the approximated version of the interest parity condition, and check
how good an approximation it is by repeating the computations you carried out
when answering the previous point of this question. Finally, suggest two possible
extensions that would likely increase the degree of realism of the interest parity
condition in its simplest form (be it approximated or not) considered in this ques-
tion.
In its approximated version, the interest parity condition is:

...........................................................................................................................
𝑒
∗
𝐸𝑡+1 − 𝐸𝑡
𝑖 𝑡 = 𝑖 𝑡 − .
...........................................................................................................................
𝐸
...........................................................................................................................
From the previous equation, it follows that the current exchange rate can be writ-
ten as:
...........................................................................................................................
𝑒
𝐸𝑡+1
...........................................................................................................................
𝐸𝑡 = .
1 + 𝑖𝑡∗ − 𝑖𝑡
...........................................................................................................................
Plugging the assigned values for the domestic interest rate, the foreign interest
...........................................................................................................................
rate and the future expected exchange rate in the right-hand side, yields:
...........................................................................................................................
1.30
𝐸𝑡 = = 1.3257.
1 + 0.01 − 0.03
...........................................................................................................................
Furthermore, and as before,
...........................................................................................................................
𝑒
𝐸𝑡+1 − 𝐸𝑡 1.30 − 1.3257
...........................................................................................................................
= ≌ −0.02,
𝐸𝑡 1.33
...........................................................................................................................
One can therefore conclude that, when the values that interest rates and the ex-
...........................................................................................................................
pected appreciation term take on are, as in the case we are analyzing, small
enough (close to zero), the version of the interest parity used to answer this sec-
...........................................................................................................................
ond part of the question is a very good approximation to the non-approximated
...........................................................................................................................
one considered when answering the previous point.
...........................................................................................................................
Finally, both versions of the interest rate parity are based on the assumption that,
in making their portfolio choices, financial investors only look at the expected
returns of the available assets, and not also to the variability of those returns. In
addition, both ignore the existence of transaction costs. Since, in the real world,
financial market participants are typically risk averse, and transaction costs are
nonzero, this explains why more sophisticated versions of this condition do exist
(for instance, versions allowing for the existence of a nonzero risk premium).
373
Question 10
The one-year interest rate in Japan is 1%, and the nominal exchange rate between
the yen and the euro (number of yen needed to purchase one euro) is 140. Finally,
assume that financial markets participants expect the euro to appreciate by
5% against the yen in the following year.
a. For a European investor, what is the expected return from holding one-year Jap-
anese assets?
...........................................................................................................................
𝐸𝑡 = 140 (𝑦𝑒𝑛 𝑝𝑒𝑟 𝑒𝑢𝑟𝑜) = current exchange rate.
...........................................................................................................................
Market participants expect the euro to appreciate by 5% against the yen, or:
...........................................................................................................................
𝑒 𝑒
𝐸𝑡+1 − 𝐸𝑡 𝐸𝑡+1 − 140
...........................................................................................................................
= = 0.05.
𝐸𝑡 140
...........................................................................................................................
𝑒
Solving for 𝐸𝑡+1 ,
...........................................................................................................................
𝑒
𝐸𝑡+1 = 140(1 + 0.05) = 147.
...........................................................................................................................
To compute the expected return from holding Japanese bonds, notice that, at the
current exchange rate, with one euro a European investor can purchase 140 yen.
Using these 140 yen to buy Japanese bonds, paying an interest of 1%, next year
the European investor will receive 140(1 + 0.01) = 141.40 yen, which are ex-
𝑒
pected to be worth 141.40/𝐸𝑡+1 = 141.40/147 = 0.96 euro one year from
now.
The expected return from investing in Japanese one-year bonds is therefore neg-
ative, equal to −4% [(0.96 − 1)/1 = −0.04].
374
The open economy
b. Suppose that financial investors care only about the expected rate of return, and
therefore want to hold only the assets with the highest expected yield. Assuming
that, in Europe, the one-year interest rate is 2%, would a European investor pur-
chase European assets or Japanese assets? In this example, does the (uncovered)
interest parity condition hold?
A European investor who invests today one euro in European one-year bonds
will receive, next year, 1(1 + .02) = 1.02 euros, for a rate of return of 2%. Us-
ing the same euro to purchase one-year Japanese bonds, we already know that
the investor would receive, next year, 0.96 euros, so that the rate of return from
investing in foreign bonds is negative (−4%).
The investor is clearly better off by purchasing euro-denominated bonds. In this
example, the interest parity condition does not hold, and there are therefore ar-
bitrage opportunities between the two types of investments.
375
Question 11
of the world, in a flexible exchange rate regime. Domestic and foreign prices are
constant, and equal to one (𝑃 = 𝑃∗ = 1).
a. Using the pair of graphs ‘open economy IS-LM – interest parity condition’,
show the initial equilibrium of the country, denoting it by ‘1’ (hint: assume that
the economy is described by a standard open economy IS-LM model, with a
central bank that chooses the interest rate). Suppose now that the government
raises its purchases of goods and services and that, to keep equilibrium income
constant, the central bank varies the interest rate by implementing an open mar-
ket operation. To achieve its aim, should the central bank buy or sell bonds? In
the figure, denote by 2 the new equilibrium that will prevail after the increase in
𝐺 and the central bank intervention. In the move from 1 to 2, how will the in-
terest rate, the exchange rate, investment and net exports change? Explain.
𝑖 𝑖
2 𝐿𝑀2 2
𝑖̅2
1′ 1
𝑖̅1
1 𝐿𝑀1
𝐼𝑆2
𝐼𝑆1
𝑌̂1 𝑌 𝐸1 𝐸2 𝐸
376
The open economy
If the central bank did not intervene, the increase in 𝐺 would raise equilibrium
income. To prevent 𝑌 from changing, the central bank will have to increase the
policy rate, something that requires a sale of bonds in the open market. In the
new equilibrium (point 2 in the figure) the interest rate is higher, and this leads
to an exchange rate appreciation. Furthermore, investment is lower (because of
the increase in 𝑖), consumption is unchanged (income and net taxes have re-
mained constant), and net exports are smaller (due to the appreciation of the
exchange rate).
b. Suppose now that the country is in a fixed, rather than in a flexible, exchange
rate regime. Can a central bank wishing to keep the exchange rate fixed also
intervene to keep income at the initial level (the one prevailing at equilibrium 1,
before the increase in 𝐺), as it did in the flexible exchange rate case considered
before? Why, or why not? In the figure, denote by 1′ the equilibrium that will
be reached in this case (increase in 𝐺, and a central bank that behaves in a way
consistent with the constancy of the exchange rate). Finally, explain how the
interest rate, consumption, investment and next exports will have changed in the
move from 1 to 1′.
From the answer to the previous point we know that, to prevent income from
changing, the central bank should raise the interest rate, thus causing an appre-
ciation of the exchange rate. It is therefore straightforward to conclude that a
central bank wishing to keep the exchange rate fixed at the chosen level will have
to accept the rise in income caused by the fiscal expansion implemented by the
government. The interest rate will have to be kept unchanged, and in the figure
the new equilibrium becomes in this case point 1′, where income has gone up,
consumption and investment are higher (𝑌 is higher, and net taxes and the inter-
est rate unchanged), and net exports lower (due to the rise in 𝑌, and taking into
account the fact that the exchange rate has remained constant).
377
Question 12
Consider Alpha, an open economy with a flexible exchange rate and in which
investment is a function of 𝑌 and of the borrowing rate 𝑟 + 𝑥. Aside from this, the
country is described by a standard ‘open economy IS-LM – interest parity’ model
with constant domestic and foreign prices, so that 𝑖 = 𝑟.
a. Assuming that the central bank chooses the interest rate, represent the initial
equilibrium of the economy in an “open economy IS-LM – interest parity”
diagram, denoting it by ‘1’, and by 𝑖1 , 𝑌1 and 𝐸1 the associated values of the
interest rate, output and exchange rate. Suppose now that the risk premium on
which the borrowing rate depends, 𝑥, increases. In the graph, denote by ‘2’ the
new equilibrium that will be reached. In the move from the initial equilibrium
‘1’ to the new one ‘2’, how will production, consumption, investment, the
exchange rate, net exports and the country’s money supply and money demand
change? Explain.
𝑖 𝑖
𝐼𝑆1
𝐼𝑆2
2 1 𝐿𝑀1 1
𝑖̅1
𝑖̅3 𝐿𝑀3 3
3
𝑌̂2 𝑌̂1 𝑌 𝐸3 𝐸1 𝐸
For a given interest rate 𝑖 chosen by the central bank, an increase in the risk
premium raises the borrowing rate and lowers investment. The IS curve shifts to
the left, and the new equilibrium becomes point 2 in the figure, where production
is lower. Consumption has gone down (due to the fall in income), and the same
is true about investment (income is lower, and the borrowing rate higher).
378
The open economy
Since the central bank keeps the interest rate at the initial level, the exchange
rate remains constant and net exports improve (due to the decrease in income).
Finally, since in the new equilibrium money demand has gone down (the interest
rate is unchanged, but income is lower), money supply must be lower, too. In fact,
if the central bank did not change 𝑀, the interest rate would fall (recall that the
decrease in 𝑌 lowers money demand). To keep 𝑖 at the chosen level, the central
bank will have to decrease money supply by the same amont by which money
demand has fallen.
b. How would your answer to the previous point change, should Alpha’s central
bank decide to intervene in order to prevent the rise in 𝑥 from affecting
production, and therefore in order to keep 𝑌 at the same level prevailing in the
initial equilibrium (‘1’)? In the graph, denote by ‘3’ the equilibrium that would
be reached in this case and explain if and why, in the move from ‘1’ to ‘3’,
consumption, investment, the exchange rate, net exports and the country’s
money supply and money demand will change.
To keep production at the initial level, the central bank must lower the policy rate
till 𝑖̅3 , thus shifting downwards the 𝐿𝑀 curve to 𝐿𝑀3 . In the new equilibrium that
will be reached in this case, compared to 1 both money supply (the central bank
has lowered the policy rate) and money demand (𝑖 is lower, 𝑌 unchanged) will
be higher, the exchange rate has depreciated (due to the decrease in the domestic
interest rate), net exports have improved (thanks to the decrease in 𝐸) and con-
sumption will be unchanged. Finally, and although the rise in 𝑥 and the fall in 𝑖
tend to push it in opposite directions, investment will necessarily be lower. In
fact, in the two equilibria 1 and 3 the supply of goods is the same; this means
that aggregate demand will have to be the same, too, and that, therefore, invest-
ment will have gone down by the same amount by which net exports have gone
up.
379
Question 13
Consider an open economy under a flexible exchange rate regime, described by a

standard “open economy IS-LM – interest parity condition” model. Domestic and
foreign prices are constant - for simplicity, both equal to 1 (𝑃 = 𝑃∗ = 1) - and the
country’s central bank chooses the interest rate, initially setting it at the same level
as the foreign one, so that in the initial equilibrium (point ‘1’ in the figures below)
𝑖1 = 𝑖 ∗, 𝑌 = 𝑌1 and 𝐸 = 𝐸1 .
a. Taking these assumptions into account, and having explained which value the
expected future exchange rate must necessarily take on in this economy, sup-
pose that the foreign interest rate, 𝑖 ∗ , goes up (in the figures, it becomes
𝑖 ∗ ′ > 𝑖 ∗ ), while the domestic interest rate chosen by the central bank, foreign
output 𝑌 ∗ and all the remaining exogenous variables - 𝐸 𝑒 included - remain
constant. Assuming that the country’s government decides to change taxes to
prevent domestic output 𝑌 from varying, which of the two graphs below cor-
rectly depicts the new equilibrium (point ‘2’ in the figures) that will be reached
following the exogenous increase in 𝑖 ∗ and the associated fiscal policy interven-
tion just described? To achieve its aim, should the government raise or cut
taxes? Finally, carefully explain how the exchange rate, the money supply, con-
sumption, investment and net exports will change as the economy moves from
the initial equilibrium position (‘1’) to the final one (point ‘2’).
380
The open economy
...........................................................................................................................
From the interest parity condition it follows that, if 𝑖 = 𝑖 ∗, then 𝐸 𝑒 = 𝐸1 , where
𝐸1 is the value that the exchange rate
................................................ takes on in the initial equilibrium. In the
...........................................................................
right-hand panel of the graph, the increase in the foreign interest rate leads to a
...........................................................................................................................
lefward shift in the line representing the interest parity condition; the new line
will now go through – as it has to do by construction – the point (𝐸 = 𝐸 𝑒 =
...........................................................................................................................
𝐸1 , 𝑖 = 𝑖 ∗ ′), where 𝑖 ∗ ′ is the new level of the foreign interest rate. It follows that
...........................................................................................................................
the correct figure is Figure 1. The ensuing depreciation of the exchange rate, that
now becomes 𝐸2 , would raise net exports, thus shifting the IS to the right and
...........................................................................................................................
increasing equilibrium ouput. To prevent 𝑌 from changing, the goverment will
...........................................................................................................................
have to raise taxes by the amount needed to keep the IS in the initial position. As
mentioned before, in the new equilibrium (point 2 in the two panels) the exchange
...........................................................................................................................
rate will be lower, since the increase in the foreign interest rate leads to a higher
...........................................................................................................................
demand for foreign assets, and therefore for the currency in which they are de-
nominated; consumption will be lower (𝑌 is unchanged, but taxes are higher);
..........................................................................................................................
investment is unchanged, just like 𝑌 and the domestic interest rate; with 𝑌 and 𝑖
...........................................................................................................................
unchanged, both money demand and money supply will be unchanged; finally,
net exports will be higher, due to the exchange rate depreciation and the con-
...........................................................................................................................
stancy of 𝑌. [Even though the question does not ask for this extra step, it is im-
mediate to reach the conclusion that the above discussion implies that, in the new
equilibrium, net exports will have necessarily gone up by the same amount by
which consumption has gone down].
b. Suppose now that, in the economy studied before, investment is entirely exoge-
nous, rather than a function of 𝑖 and 𝑌, as in the standard case just considered.
How will the conclusion you have reached about the effects of the increase in
the foreign interest rate and the simultaneous fiscal policy intervention aimed at
keeping 𝑌 constant change in this case?
................................................... ........................................................................
The effects will be identical to those described when answering the previous
...........................................................................................................................
point. The exchange rate depreciation will continue to stimulate the country’s net
exports, thus shifting to the right an IS curve that will still be negatively sloped,
...........................................................................................................................
due to the fact that E depends – via interest parity condition – on the domestic
...........................................................................................................................
interest rate. To prevent 𝑌 from changing, the government will have to bring back
the IS to the left by raising net taxes. In the new equilibrium, and as before, 𝐶
...........................................................................................................................
will be smaller, NX larger, G unchanged and, of course, I unchanged.
381
Question 14
rate, output and the exchange rate. Market participants initially expect that the ex-
𝐸1 and 𝑖1 = 𝑖 ∗ , where 𝑖 ∗ is, as usual, the foreign interest rate.
a. Suppose that foreign income, 𝑌 ∗ , falls. In the two graphs, denote by ‘2’ the new
equilibrium that will be reached following this change. In the move from ‘1 to
‘2’, in which direction must the central bank change the domestic money supply,
to make sure that the exchange rate remains constant at 𝐸1 ? Why? Explain.
The fall in foreign income lowers net exports and shifts the IS curve to the left. In
the first panel, the new equilibrium ‘2’ takes place for a lower equilibrium in-
come. In the second panel, the equilibrium position ‘2’ coincides with the initial
one, ‘1’, since the exchange rate is kept fixed and individuals expect it to remain
at the current level also in the future. In the move from ‘1’ to ‘2’, to keep the
exchange rate constant the central bank will have to reduce the supply of money.
In fact, the fall in domestic income due to the decrease in 𝑌 ∗ lowers domestic
money demand. If the central bank did not decrease by the same amount the
money supply, the domestic interest rate would go down and the exchange rate
would depreciate, falling below 𝐸1 .
382
The open economy
b. Assume now that, once the economy has reached the equilibrium ‘2’ discussed
above, in order to bring back domestic output to the value 𝑌1 it was taking on
before the fall in foreign income, the central bank decides to change the parity
(that is, the value at which the exchange rate is kept fixed) from 𝐸1 to 𝐸3 . The
new parity is credible, in the sense that individuals expect it to be maintained in
the future, so that the new future expected exchange rate becomes 𝐸 𝑒 ′ = 𝐸3 . In
the same two graphs used to answer the previous point, represent the new equi-
librium that will be reached in this case, denoting it by ‘3’. To achieve its aim,
the central bank will have to devalue or revalue the exchange rate? Why? Com-
pared to the values they were taking on in the initial equilibrium ‘1’, investment,
consumption and net exports will be higher, lower or unchanged in the final
equilibrium ‘3’?
The central bank will have to devalue the exchange rate by the amount needed to
bring back the IS curve to its initial position, thus offsetting the adverse impact
of the fall in foreign income on net exports. In the left panel, the IS curve becomes
once again 𝐼𝑆1. In the right panel, the line representing the interest parity condi-
tion shifts upwards, now going through the new point (𝐸 = 𝐸 𝑒 ′ = 𝐸3 ; 𝑖 = 𝑖 ∗ ).
In both panels, the new equilibrium becomes point ‘3’, where income is the same
as in the initial equilibrium ‘1’, the domestic interest rate is still equal to the
foreign one, which has not changed, and the exchange rate is lower. In the move
from ‘1’ to ‘3’, aggregate demand is unchanged, just like the supply of goods.
Since consumption and investment are also unchanged (due to the constancy of
domestic income and interest rate) and that G is exogenous, net exports will have
to take on at ‘3’ the same value they were taking on at ‘1’.
383
Question 15
of the world. Furthermore, assume that domestic and foreign prices are constant, and
equal to one (𝑃 = 𝑃∗ = 1).
show the initial equilibrium of the country, assuming a flexible exchange
rate regime and, as usual, that the domestic central bank chooses the interest
rate, keeping it constant at the level it deems appropriate given the state of
the economy. In the graph, denote by ‘1’ the initial equilibrium, by 𝑖̅1 , 𝑌1 ed
𝐸1 the associated values of the interest rate, income and the exchange rate,
and assume that, in this initial equilibrium, 𝐸 𝑒 = 𝐸1 and 𝑖̅1 = 𝑖 ∗ (where, as
usual, 𝑖 ∗ is the foreign interest rate). Consider now an increase in 𝐸 𝑒 , which
now becomes 𝐸 𝑒 ′ > 𝐸 𝑒 = 𝐸1 . In other words, investors now expect the
domestic currency to be ‘stronger’ than they initially thought. Show in the
graph, and explain, how the economy’s income, interest rate, exchange rate,
and money supply will be affected by this change.
𝑖 𝑖
2 1 1 2
𝑖̅1 = 𝑖 ∗
𝐼𝑆2 𝐼𝑆1
𝑌̂2 𝑌̂1 𝑌 𝐸 𝑒 = 𝐸1 𝐸 𝑒 ′ 𝐸
384
The open economy
For given 𝑖̅1 and 𝑖 ∗ , the increase in 𝐸 𝑒 lowers the expected return on foreign
assets, thus raising (appreciating) the exchange rate 𝐸 consistent with the inter-
est parity condition. The exchange rate appreciation lowers, for any given 𝑌, net
exports and shifts the IS curve to the left. The new equilibrium becomes point 2,
where income is lower, 𝑖 unchanged, 𝐸 greater (equal to 𝐸 𝑒′ in the figure) and
the supply of money lower. In fact, the fall in 𝑌 lowers money demand. To keep
the domestic interest rate at the chosen level, 𝑖̅1 , the central bank will have to
lower the supply of money by the same amount by which money demand has
gone down.
b. Suppose that the government intends to return domestic output to the level
prevailing before the increase in 𝐸 𝑒 by changing net taxes, 𝑇̅. To achieve its
aim, should the government raise or lower net taxes? Compare the compo-
sition of aggregate demand in the new equilibrium that will be attained after
the fiscal policy intervention to that prevailing in the initial equilibrium (that
is, the equilibrium in which the economy was before the increase in 𝐸 𝑒 and
the change in 𝑇̅). Explain.
To return output to the initial level, the government will have to shift the 𝐼𝑆 curve
to the right, till 𝐼𝑆1. This requires a cut in net taxes. Once the economy is back to
the equilibrium corresponding to point 1, consumption will be higher than before
the increase in 𝐸 𝑒 and the cut in 𝑇̅ (income has returned to the initial level, but
net taxes are lower), investment will be unchanged (both 𝑌 and 𝑖 are unchanged),
𝐺 unchanged (it is exogenous) and net exports lower (due to the exchange rate
appreciation).
385
Question 16
a. The world economy consists of just two countries, Alpha and Beta. International
capital mobility is perfect, and the exchange rate between the currencies of the
two countries is kept fixed at the level 𝐸̅ . Alpha has just entered a recession. To
revive its economy, would you recommend Alpha the use of monetary policy or
of fiscal policy? Explain your answer and illustrate graphically, using the pair of
graphs 'open economy IS-LM'-'interest parity condition'.
𝑖 𝑖
0 1 𝐿𝑀0 𝑖∗ 0
𝑖̅0 = 𝑖∗ 1
′ ′
0 0
𝑖̅0 ′
𝐿𝑀1
𝐼𝑆0 𝐼𝑆1
𝑌 𝐸0′ 𝐸̅ 𝐸
Under a fixed exchange rate regime, monetary policy cannot be used to affect
...........................................................................................................................
the equilibrium level of income. In fact, if individuals expect the exchange rate to
remain in the future at the current level 𝐸̅ , the value at which the central bank is
...........................................................................................................................
pegging it, the interest parity condition implies that the domestic interest rate has
...........................................................................................................................
to be equal to the foreign one. In the initial equilibrium, point 0 in the graph, this
equality holds, with a domestic interest rate 𝑖̅0 (= 𝑖 ∗ ) and an exchange rate
...........................................................................................................................
equal to 𝐸̅ . If, starting from this initial equilibrium, to boost economic activity
...........................................................................................................................
the central bank decided to lower the interest rate to 𝑖̅0 ′ (for instance, by pur-
chasing bonds in the open market), the exchange rate would immediately tend to
...........................................................................................................................
depreciate, falling to the level 𝐸0′ (< 𝐸̅ ).
...........................................................................................................................
386
The open economy
...........................................................................................................................
To avoid this depreciation, the central bank must immediately intervene in the
...........................................................................................................................
foreign exchange market, buying the domestic currency and selling the foreign
...........................................................................................................................
one. This intervention, that reduces 𝑀, must continue until 𝑀 returns to its orig-
inal level, and the LM curve to its initial position. But if, to make sure that the
exchange rate remains constant, the money supply and the domestic interest rate
must be returned to their initial levels, aggregate demand and output will be un-
affected.
Under fixed exchange rates, to increase equilibrium output one can only resort
to an expansionary fiscal policy that, by shifting the IS to the right (𝐼𝑆1 ), leads
to a new equilibrium such as point 1 in the figure.
b. Discuss the effects of the policy intervention you have just suggested on
the trade balance of Alpha and on that of Beta, always assuming a fixed ex-
change rate.
Because of the expansionary fiscal policy adopted in Alpha and described in the
preceding paragraph, Alpha’s income increases, while the exchange rate re-
mains constant. The trade balance of Alpha worsens, because of the increase
in imports caused by the rise in equilibrium income. In a two-country world such
as the one we are considering, Beta's trade balance can only improve by the same
amount by which Alpha's worsens.
387
Question 17
Consider an economy that trades goods, services and financial assets with the rest of
the world, under a fixed exchange rate regime. Domestic and foreign prices are con-
stant and, for simplicity, both equal to 1 (𝑃 = 𝑃∗ = 1). In the pair of graphs “open
economy IS-LM – interest parity condition”, show the initial equilibrium, denoting
by 𝑖0 , 𝑌0 and 𝐸0 the values of the interest rate, output and exchange rate in that equi-
librium. Market participants expect that the exchange rate will be kept fixed at the
current level 𝐸0 also in the future, so that 𝐸 𝑒 = 𝐸0 .
a. Suppose that there is a fall in the foreign interest rate, 𝑖 ∗ , while foreign output
𝑌 ∗ and all the other exogenous variables remain constant. Assuming that the
country’s central bank keeps fixing the exchange rate at 𝐸0 , show in the graph,
and explain carefully, the effects of this exogenous decrease in 𝑖 ∗ on equilibrium
output, interest rate, money supply and net exports of the country, denoting by
‘1’ the new equilibrium that will be reached.
𝐼𝑆0 𝐼𝑆2
𝑖 𝑖
0 𝐿𝑀0 0
𝑖∗
1 2
𝑖 ∗’ 𝐿𝑀1 1, 2
𝑌̂0 𝑌̂1 𝑌̂2 𝑌 𝐸 𝑒 = 𝐸0 𝐸
388
The open economy
In the right panel, the fall in the foreign interest rate leads to a downward shift
in the line representing the interest parity condition; the new line will now go
through – as it has to do by construction – the point (𝐸 = 𝐸 𝑒 , 𝑖 = 𝑖 ∗ ′), where 𝑖 ∗ ′
is the new level of the foreign interest rate. Absent any intervention by the do-
mestic central bank, the exchange rate would appreciate (it would rise above 𝐸0 ).
To keep it at 𝐸0 , the central bank will have to intervene. This intervention will
have to lower the domestic interest rate by the same amount by which the foreign
one has gone down, thus shifting the LM curve downwards till 𝐿𝑀1 . In the new
equilibrium (point 1), the decrease in the domestic interest rate has raised ag-
gregate demand and equilibrium output. As for net exports, they will now be
lower, since domestic income is higher and the exchange rate unchanged.
b. How would your answer have changed if, when 𝑖 ∗ falls, foreign output 𝑌 ∗ had
also gone up, rather than remaining constant? In the same graph used before,
denote by ‘2’ the equilibrium that the economy would have reached in this case
(lower 𝑖 ∗ and higher 𝑌 ∗ ) and compare it to the equilibrium (‘1’) where the
economy settles when to vary is just the foreign interest rate. Finally, explain in
which of the two cases the intervention of the central bank (consisting in a
change in the money supply aimed at keeping the exchange rate constant) will
have to be quantitatively larger.
In this case, the interest parity condition line will still shift downwards, while the
...........................................................................................................................
increase in 𝑌 ∗ , that – other things the same – leads to higher net exports, shifts
...........................................................................................................................
the IS curve to the right in the first panel (𝐼𝑆2 ). The increase in domestic output
is now larger, since in this case the demand for domestically produced goods
...........................................................................................................................
goes up not only because of the fall in the interest rate, but also because of the
...........................................................................................................................
rise in the demand by foreigners. The central bank’s intervention, aimed at keep-
ing 𝐸 constant, must therefore be larger than before. More specifically, the do-
...........................................................................................................................
mestic money supply will have to be raised by more than when the only change
...........................................................................................................................
taking place was the one in 𝑖 ∗ − now it will have to go up not only to make sure
that the domestic interest rate falls by the same amount as the foreign one, but
...........................................................................................................................
also to prevent the increase in income, and therefore money demand, caused by
...........................................................................................................................
the rise in 𝑌 ∗ from pushing the domestic interest rate above the new level 𝑖 ∗′ con-
sistent with the fixed exhange rate.
389
Question 18
rate, output and the exchange rate. Market participants expect that the exchange rate
will be kept fixed at the current level 𝐸0 also in the future, so that 𝐸 𝑒 = 𝐸0 .
a. Suppose the central bank announces a devaluation of the currency − that is, it
announces that, effective immediately, the value at which the exchange rate is
kept fixed is lowered to 𝐸1 < 𝐸0 . In addition, assume that individuals, who did
not expect this announcement, revise accordingly the value of the exchange rate
they expect to prevail in the future, so that now 𝐸 𝑒 falls to 𝐸 𝑒 ′ = 𝐸1 . Analyze
in the graph, and explain, the effects of the devaluation on domestic output, in-
terest rate and money supply, denoting by ‘1’ the new equilibrium that the econ-
omy will reach.
𝐼𝑆0 𝐼𝑆1
𝑖 𝑖
0 1 𝐿𝑀0 1 0
𝑖0 = 𝑖 ∗
𝑌̂0 𝑌̂1 𝑌 𝐸 𝑒′ = 𝐸1 𝐸 𝑒 = 𝐸0 𝐸
390
The open economy
In the right-hand panel, the curve representing the interest parity condition shifts
′
upwards, now going through the new point (𝐸 = 𝐸 𝑒 = 𝐸1 ; 𝑖 = 𝑖 ∗ ). In the first
panel, there is a rightward shift of the IS curve, due to the fact that, for given do-
mestic and foreign prices, the devaluation depreciates the real exchange rate, thus
raising net exports and therefore the demand for domestically produced goods. In
both panels, the new equilibrium is at point 1, where output is higher and the do-
mestic interest rate still equal to the foreign one (as it must necessarily be the case
if, as in the present setting, individuals expect the exchange rate to take on in the
future the same value it is taking on today). In the move from the old to the new
equilibrium, the central bank must have increased the money supply. In fact, the
increase in income caused by the devaluation raises money demand. If 𝑀 were kept
constant, the domestic interest rate would raise above the foreign one, and the ex-
change rate above the value 𝐸1 at which the central bank now wants it to remain
constant. Money supply will have to be raised by the amount needed to make sure
that, even though income is higher, the domestic interest rate remains at its initial
level, 𝑖0 = 𝑖 ∗ .
b. Suppose that, before the devaluation, both the domestic country and the rest of
the world were in a medium-run equilibrium, with income at its natural level
and zero inflation. In addition, assume that the inflation rate is determined
according to the following Phillips curve:
𝜋 = (𝛼/𝐿)(𝑌 − 𝑌𝑛 )
Once price adjustment − as implied by the previous equation − is taken into
account, do you think that a devaluation can permanently affect the level of
income of a country? Why, or why not? Discuss [Hint: no formal analysis is
required; just describe the likely dynamic adjustment of the economy following
a devaluation].
As we have just concluded, the devaluation will rise output above its natural
level. Domestic prices will start rising and, given that foreign prices are constant,
...........................................................................................................................
the real exchange rate will start appreciating, thus hurting the price-competitive-
...........................................................................................................................
ness of domestically produced goods and worsening the trade balance. It follows
that, in the figure above, sooner or later the curve labeled 𝐼𝑆1 will start shifting
...........................................................................................................................
to the left. As long as output is above its natural level, this process will continue.
...........................................................................................................................
Eventually, the economy will converge to the same medium-run equilibrium pre-
vailing before the devaluation (‘0’), with a real exchange rate − on impact lower
...........................................................................................................................
because of the fall in 𝐸 − back to its initial level, due to the rise in domestic
prices.
391
Question 19
rate, output and the exchange rate. Initially, market participants expect that the ex-
𝐸0 .
a. Suppose that, in the initial equilibrium, income is below its natural level. Given
that, as discussed in the answer to the previous question, a decision to devalue
leads a higher equilibrium output in a country under a fixed exchange rate re-
gime, individuals start expecting an impeding devaluation. It follows that the
future expected exchange rate decreases from 𝐸 𝑒 = 𝐸0 to 𝐸 𝑒′ = 𝐸1 , with 𝐸1 <
𝐸0 . Analyze in the graph the effects of this downward revision in the expecta-
tions on the exchange rate that will prevail in the future on the levels of domestic
income and interest rate, assuming that the central bank intends to keep the ex-
change rate fixed at 𝐸0 .
𝑖 𝐼𝑆0 𝑖
1 𝐿𝑀1 1
𝑖1
0 𝐿𝑀0 0′
𝑖0 = 𝑖 ∗ 0
𝑌̂1 𝑌̂0 𝑌 𝐸 𝑒′ = 𝐸1 𝐸 𝑒 = 𝐸0 𝐸
392
The open economy
In the right-hand panel, the curve representing the interest parity condition shifts
′
upwards, now going through the new point (𝐸 = 𝐸 𝑒 = 𝐸1 ; 𝑖 = 𝑖 ∗ ). In the first
panel, the IS curve does not shift, as net exports do not depend on the value that
the exchange rate is expected to take on in the future, but rather on the value the
exchange rate is taking on today (a value that the central bank is keeping con-
stant at 𝐸0 ). To make sure that 𝐸 remains at 𝐸0 even after expectations of a de-
valuation have emerged, the central bank will have to raise the domestic interest
rate to 𝑖1 . In fact, if 𝑖 remained at the initial level, 𝑖0 , in the right-hand side panel
we would go from point 0 to 0’, with an exchange rate that depreciates immedi-
ately. As implied by the interest parity condition, to prevent this drop in the ex-
change rate, the central bank will have to set the domestic interest rate to a level
that exceeds the foreign one by an amount equal to the expected devaluation of
the domestic currency,
(𝐸1 − 𝐸0 )
𝑖1 − 𝑖0 = − .
𝐸0
b. Which type of economic policy (monetary or fiscal; exansionary or

contractionary) could prevent the expectations of an impending devaluation
studied before from changing equilibrium output? Explain.
As we already know, under a fixed exchange rate regime fiscal policy is the only
macroeconomic policy that can affect equilibrium income. In this case, since
equilibrium output tends to fall, the fiscal policy intervention that is called for is
an expansionary one. As for the role of monetary policy, and as discussed before,
it will have to make sure that the domestic interest rate takes on a value consistent
with the fixed exchange rate, given 𝑖 ∗ and the new value of 𝐸 𝑒 .
393
Question 20
True or False?
a. An expansionary monetary policy rises equilibrium income under flexible ex-

change rates, but does not affect income under fixed exchange rates.
True. Under flexible exchange rates, the decrease in the interest rate caused by
an expansionary monetary policy stimulates not only investment, but – by induc-
ing a depreciation of the exchange rate − also net exports, thus leading to an
increase in aggregate demand and equilibrium income.
On the contrary, under fixed exchange rates authorities must oppose to the po-
tential depreciation and intervene in the exchange rate market. This intervention,
which must necessarily consist in the purchase of the domestic currency and in
the selling of the foreign currency, must go on until money supply and the domes-
tic interest rate are back to the initial levels. It follows that equilibrium income
will not vary either. With fixed exchange rates, monetary policy cannot be used
to stimulate the economy.
394
The open economy
b. If financial investors only care about the expected rate of return, and therefore
want to hold only the assets with the highest expected rate of return, then from
the interest parity condition it follows that, under fixed exchange rates, the do-
mestic interest rate can only be equal to the foreign interest rate, 𝑖 = 𝑖 ∗.
False. Under fixed exchange rates, 𝑖 = 𝑖 ∗ if 𝐸̅ = 𝐸 𝑒 , that is, if individuals ex-

pect that the exchange rate will be kept fixed at the current level 𝐸̅ also in the
future. If, however, there are expectations of a future revaluation or devaluation,
𝐸̅ ≠ 𝐸 𝑒 , and the domestic interest rate 𝑖 will necessarily differ from 𝑖 ∗ . If, for
instance, there are expectations of an imminent devaluation of the exchange
rate, 𝐸̅ > 𝐸 𝑒 , and the domestic interest rate will have to be greater than the for-
eign interest rate in order to compensate investors for the expected deprecia-
tion of the domestic currency.
395
Question 21
a. Psi is an open economy with a flexible exchange rate. Illustrate graphically, and
explain, the effects of a decrease in the reserve ratio, θ, on output, the exchange
rate, and the trade balance of Psi. When answering, assume that – starting from
an initial interest rate that you will denote by 𝑖̅0 in the figure − the central bank
will not intervene to keep 𝑖 equal to 𝑖̅0 , but that it will allow the interest rate to
take on the new equilibrium value – to be denoted by 𝑖̅1 in the graph − that will
prevail after the fall in θ. Once 𝑖 has become equal to 𝑖̅1, the central bank will
however keep it at this new level from then on.
𝑖 𝑖
𝐼𝑆0
𝐼𝑆2 0 𝐿𝑀0 0
𝑖̅0
1 𝐿𝑀1 1
𝑖̅1
2
𝑌̂0 𝑌̂1 𝑌 𝐸1 𝐸0 𝐸
A reduction in the reserves ratio (i.e., a decrease in the parameter θ) raises the
the money supply (banks will lend out a larger fraction f any given amount of
...........................................................................................................................
deposits received by their customers; this will lead to more deposits, more loans,
...........................................................................................................................
more deposits ... and therefore to a larger 𝑀). If the central bank does not inter-
vene, this increase in 𝑀 lowers – let's say, from 𝑖̅0 to 𝑖̅1 < 𝑖̅0 − the interest rate
...........................................................................................................................
for which the money market is in equilibrium Since this new, lower 𝑖 by assump-
...........................................................................................................................
tion becomes the level at which the central bank will keep the interest rate, the
LM curve shifts downwards to 𝐿𝑀1 , and the new equilibrium becomes point 1.
......................................................................................................................................
................................................................................................................
396
The open economy
........................................................................................................................
In the new equilibrium, the interest rate is lower, the exchange rate has depreci-
ated, and income is higher. The direction in which net exports will change is
however uncertain – the exchange rate depreciation tends to rise them, but the
rise in income tends to worsen them.
b. Suppose now that the government of Psi implements a fiscal policy aimed at
bringing equilibrium output back to the level it was taking on before the decrease
in θ. What happens to the trade balance in this case? Explain.
In order to bring back income to its initial level, the government must implement
a restrictive fiscal policy, thus shifting the IS curve to the left, up to 𝐼𝑆2 . In the
final equilibrium, point 2 in the first graph and point 1 in the second one, income
will be at the same level as than at point 0, but the interest rate will be lower,
and the exchange rate weaker. Due to the exchange rate depreciation, in the new
equilibrium (point 1) net exports will be higher than in the initial equilibrium
(point 0).
397
Question 22
Consider an open economy under a flexible exchange rate regime. Domestic

and foreign prices are constant and for simplicity both equal to 1 (𝑃 = 𝑃∗ =
1), consumption depends positively on disposable income, investment is en-
tirely exogenous (𝐼 = 𝐼 )̅ , net exports depend positively on foreign income,
negatively on domestic income, and positively on the real exchange rate, so
that the Marshall-Lerner condition is not met. Finally, 𝐺 and 𝑇 are exogenous,
and the country’s central bank chooses the domestic interest rate.
a. Will the IS curve of the “open economy IS-LM- – interest parity condition”
model that describes this economy will have a negative, zero or positive slope?
Why? Explain.
The IS will have a positive slope. In fact, if – starting from a goods market equi-
librium position – the interest rate goes up, investment does not change (it is
exogenous), the exchange rate will appreciate (via interest parity condition) and
net exports will increase, since they depend positively on the real exchange. To
go back to goods market equilibrium, the supply of goods will have to rise. It
follows that goods market equilibria with higher levels of 𝑖 are in this case asso-
ciated with higher levels of 𝑌 – the IS curve will be positively sloped in the (𝑌, 𝑖)
plane.
398
The open economy
b. Suppose that the government of this economy raises 𝐺̅ . To prevent this fiscal
policy intervention from affecting the equilibrium level of income, the central
bank intervenes by changing the policy rate. To make sure that equilibrium in-
come will remain constant, should the central bank increase or decrease the pol-
icy rate? Following these fiscal and monetary policy interventions, which of the
three curves (the IS, the LM, and that representing the interest parity condition)
will shift in the plane where they are drawn, and in which direction? Finally,
discuss how the exchange rate, money supply, money demand, consumption,
investment, government purchases of goods and services, and net exports will
have changed in the new equilibrium that the economy will reach. Explain.
The increase in 𝐺̅ shifts the IS to the right. To prevent income from rising, the
central bank will have to cut the policy rate, thus shifting downwards the LM
curve until it crosses the new IS for the initial value of 𝑌. In fact, in this economy
a decrease in the interest rate depreciates the exchange rate and lowers net ex-
ports, and with them the demand for goods. The curve that represents the interest
parity condition will not shift following these fiscal and monetary policy inter-
ventions (its position in the plane depends on 𝐸 𝑒 and 𝑖 ∗ , which have not changed).
In the new equilibrium, 𝐸 will be lower (because 𝑖 is lower), money supply 𝑀
higher (an increase needed to decrease the policy rate), money demand higher
by the same amount by which 𝑀 has gone up (𝑖 is lower, 𝑌 unchanged), con-
sumption unchanged (like disposable income), investment unchanged (it is exog-
enous), net exports smaller (due to the exchange rate depreciation), and 𝐺̅ of
course higher. Being 𝑌 unchanged, one can also conclude that net exports will
have gone down by the same amount by which 𝐺̅ has been raised.
399
Question 23
Gamma is an economy that trades goods, services and financial assets with the rest
of the world, under a flexible exchange rate regime. In Gamma, changes in the au-
tonomous components of the demand for domestic goods are the main cause of the
observed fluctuations in real GDP. Starting from an initial equilibrium like point ‘0’
in the graph, sometimes the level of autonomous demand is high, leading to an 𝐼𝑆
curve such as 𝐼𝑆1 in the figure; sometimes it is however low, so that the 𝐼𝑆 curve
shifts to the left in the graph (𝐼𝑆2 ). Economists Jack and Jill are asked which mone-
tary policy rule − the one assumed in the 'standard' version of the IS-LM model, in
which the central bank chooses a value for the interest rate, or the alternative one, in
which the central bank chooses the nominal money supply − would, in their opinion,
help minimize the variability of output around its initial level, 𝑌0 , caused by such
demand fluctuations. Jack thinks that the best option is for the central bank to choose
the interest rate, and keep it at the chosen value; on the contrary, Jill suggests that
the central bank should choose a level for the money supply, and then let the interest
rate to take on any value that, given this choice of 𝑀, is consistent with the macroe-
conomic equilibrium.
a. In the pair of graphs ‘open economy IS-LM - interest parity condition’ below,
show the equilibrium levels of output that, under flexible exchange rates, will
prevail when the central bank chooses the interest rate and, following the fluc-
tuations in demand just discussed, the IS curve shifts to the right (𝐼𝑆1 ) or to the
left (𝐼𝑆2 ). In the figure, make sure to denote the corresponding equilibrium lev-
els of output by 𝑌1 and 𝑌2 , respectively.
𝐼𝑆1
𝑖 𝐼𝑆0 𝑖
𝐿𝑀0𝑀
𝐼𝑆2
𝑖1
0 𝐿𝑀0𝑖 0’
𝑖̅0
𝑖2
𝑌2 𝑌2′ 𝑌0 𝑌1′ 𝑌1 𝑌 𝐸2 𝐸0 𝐸1 𝐸
400
The open economy
In this case, the LM curve (𝐿𝑀0𝑖 in the graph) is, as usual, horizontal at the level
of the interest rate chosen by the central bank (denoted by 𝑖̅0). The equilibrium
levels of output 𝑌1 and 𝑌2 prevailing as autonomous demand fluctuates are shown
in the figure. In the case of a positive (adverse) demand shock – that is, IS curve
that shifts to the right (left) – the central bank makes sure that the interest rate
remains at 𝑖̅0 by raising (lowering) the nominal money supply. And, since the
domestic interest rate does not change, the exchange rate will remain constant,
too.
b. In the same graph, denote by 𝑌1′ and 𝑌2′ the equilibrium levels of production that,
following the same changes in the autonomous components of aggregate de-
mand and the same shifts in the 𝐼𝑆 curve discussed before, would prevail should
the central bank choose the nominal money supply. On the basis of your answers
to this and to the previous point, do you agree with Jack or with Jill? Provide
the intuition for the lower output variability if the central banks behaves in the
way suggested by the economist whose view you share.
The equilibrium levels of output 𝑌1′ and 𝑌2′ prevailing when the central bank
chooses the money supply are shown in the figure. In the case of a positive (ad-
verse) demand shock, the rise (fall) in the demand for goods and in equilibrium
income will increase (decrease) the demand for money. Being money supply con-
stant at the level chosen by the central bank, the change in money demand will
lead to a higher (lower) interest rate. In turn, this change in the interest rate will
mitigate the impact on equilibrium output of the changes in autonomous demand
both directly, through its effect on investment, and indirectly, by affecting the
exchange rate. For instance, following a positive demand shock, both 𝑖 and 𝐸
will go up; this leads to an increase in output smaller than the one that would
prevail in the case studied in the previous point of this question, where the central
bank was keeping constant the interest rate, rather than the money supply. Jill is

right.
401
Question 24
a. We are at time 𝑡. Use the non-approximated form of the interest parity condition
to write the current period exchange rate, 𝐸𝑡 , as a function of the current and
future expected interest rates for each year over the next 𝑛 years, as well as of
𝑒
the expected exchange rate for time 𝑡 + 𝑛 + 1, 𝐸𝑡+𝑛+1 .
The (uncovered) interest parity condition is, in its non-approximated form,

𝐸𝑡
(1 + 𝑖𝑡 ) = (1 + 𝑖𝑡∗ ) ( 𝑒 ).
𝐸𝑡+1
Solving for 𝐸𝑡 , one gets:
(1 + 𝑖𝑡 ) 𝑒
𝐸𝑡 = 𝐸 . (∗)
(1 + 𝑖𝑡∗ ) 𝑡+1
Updating by one period and taking expectations of both sides, yields:
𝑒 )
(1 + 𝑖𝑡+1
𝑒
𝐸𝑡+1 = 𝐸𝑒 . (∗∗)
∗𝑒
(1 + 𝑖𝑡+1 ) 𝑡+2
Plugging in the right-hand side of (∗), one can write the current exchange rate
as:
𝑒 )
(1 + 𝑖𝑡 )(1 + 𝑖𝑡+1
𝐸𝑡 = 𝐸𝑒 . (∗∗∗)
∗𝑒
(1 + 𝑖𝑡∗ )(1 + 𝑖𝑡+1 ) 𝑡+2
𝑒
Following the same steps to eliminate 𝐸𝑡+2 [that is, updating equation (∗∗) by
𝑒
one period, and plugging the resulting expression for 𝐸𝑡+2 in the right-hand side
𝑒 𝑒
of equation (∗∗∗)], and then 𝐸𝑡+3 , 𝐸𝑡+4 , etc., yields:
𝑒 )
(1 + 𝑖𝑡 )(1 + 𝑖𝑡+1 𝑒 )
⋯ (1 + 𝑖𝑡+𝑛
𝐸𝑡 = 𝐸𝑒 . (∗∗∗∗)
∗ ∗𝑒 ∗𝑒
(1 + 𝑖𝑡 )(1 + 𝑖𝑡+1 ) ⋯ (1 + 𝑖𝑡+𝑛 ) 𝑡+𝑛+1
The current exchange rate therefore depends positively on the current and future
expected short-term interest rates over the next 𝑛 years, negatively on the foreign
short-term interest rates expected over the same period, and positively on the
exchange rate expected to prevail at time 𝑡 + 𝑛 + 1 – or, if you want, on the value
of the exchange rate expected to prevail in the long-run.
402
The open economy
b. Explain how each of the following announcements – which, made at time 𝑡, are
unexpected, and believed, by financial markets participants – affects the time 𝑡
exchange rate, 𝐸𝑡 [Hint: assume that, in each period, the functioning of the eco-
nomic system is described by a static IS-LM model, with consumption and in-
vestment depending on contemporaneous variables only]:
b.1 a permanently more expansionary monetary policy abroad, implemented

from time 𝑡 + 2 onwards;
b.2 a permanently more expansionary fiscal policy, and a permanently more

restrictive monetary policy, at home, from time 𝑡 + 1 onwards;
b.3 the emergence of expectations of a progressive, lasting worsening of

the country's current account balance.
b.1 Abroad, the interest rate will be lower from time 𝑡 + 2 onwards. From equa-
tion (∗∗∗∗) it follows that 𝐸𝑡 will rise – the domestic currency will appreci-
ate.
𝑖 policy-mix will lead to an increase𝑖 in the domestic interest rate from
b.2 The 𝐿𝑀0
time 𝑡 + 1 onwards, thus 𝐿𝑀2
0 appreciating the current exchange rate.
0
b.3 Persistent and widening

1 current account deficits are not sustainable
1 indefi-
nitely, as they imply that the country keeps borrowing from 2abroad, thus in-
2
creasing its foreign debt. It is therefore reasonable to assume that individuals
will start expecting that, sooner or 𝐼𝑆0later, the exchange rate will fall − that is,
𝐼𝑆
that eventually a depreciation will 2 be needed to restore the price -competi-
𝐼𝑆1
tiveness of domestic goods and bring the dynamics of the current account
under control.𝑌̂This
1 decrease
𝑌̂0 in 𝑌the level of the exchange 𝐸rate
1 that
𝐸0 financial
𝐸
𝑒
investors expect to prevail in the long-run, 𝐸𝑡+𝑛+1 , leads to an immediate
depreciation of the currency, as clear from equation (∗∗∗∗) above.
403
Chapter 6 - Government debt and economic
growth
* Question 1
[A graphical analysis of the evolution of the debt-to-GDP ratio]
Write down the government budget constraint as an equation that, for given values
of the real interest rate (𝑟), of the growth rate of the economy (𝑔) and of the primary
deficit-to-GDP ratio (𝑑), relates the debt-to-GDP ratio (𝐵⁄𝑌) at time 𝑡 to the value
of the same ratio at time 𝑡 − 1. Use that equation to graphically analyze the evolution
of the ratio 𝐵⁄𝑌 in the following four cases, providing the intuition underlying your
conclusions:
a. 𝑟 < 𝑔 and 𝑑 > 0.
𝐵𝑡
45° debt/GDP line
𝑌𝑡
𝑏̅
𝑏2
𝑏1
𝑑
𝑏0 𝑏1 𝑏2 𝑏̅ 𝐵𝑡−1
𝑌𝑡−1
The debt-to-GDP ratio evolves over time as implied by the following equation:
...........................................................................................................................
𝐵𝑡 𝐵𝑡−1 𝐵𝑡−1 𝐺𝑡 − 𝑇𝑡
− = (𝑟 − 𝑔) + , (∗)
...........................................................................................................................
𝑌𝑡 𝑌𝑡−1 𝑌𝑡−1 𝑌𝑡
...........................................................................................................................
or, defining 𝑏 ≡ 𝐵⁄𝑌, solving for 𝑏 and assuming that the primary deficit-to-
𝑡
GDP ratio remains constant over time, so that (𝐺𝑡 − 𝑇𝑡 )⁄𝑌𝑡 ≡ 𝑑 ∀𝑡,
...........................................................................................................................
...........................................................................................................................
𝑏𝑡 = (1 + 𝑟 − 𝑔)𝑏𝑡−1 + 𝑑. (∗∗)
In the (𝑏𝑡−1 , 𝑏𝑡 ) plane, (∗∗) is the equation of a straight line with vertical inter-
...........................................................................................................................
cept equal to 𝑑 and slope (1 + 𝑟 − 𝑔). Being 𝑑 > 0, this line – the “debt/GDP
...........................................................................................................................
line” in the figure – crosses the vertical axis for the positive value that, by as-
sumption, the primary deficit-to-GDP ratio takes on in the economy under con-
...........................................................................................................................
sideration.
406
...........................................................................................................................
Furthermore, its slope is positive, but smaller than one (for realistic values of
𝑟 and 𝑔, the term 1 + 𝑟 − 𝑔 is, as we shall always assume, greater than zero even
...........................................................................................................................
when 𝑟 < 𝑔), and will therefore cross the straight, 45° line going through the
...........................................................................................................................
origin drawn in the figure for a positive value, let’s call it 𝑏̅, of the debt-to-GDP
ratio.
...........................................................................................................................
To understand how the figure we have just drawn helps determine the dynamics
...........................................................................................................................
of the debt-to-GDP ratio starting from any value of the same ratio inherited from
...........................................................................................................................
the past, let us suppose that we are at time 𝑡 = 1 and that, at time zero, the debt-
to GDP ratio was 𝑏0 . One uses the debt/GDP line to read, on the vertical axis,
the implied value for the debt ratio that will prevail today, 𝑏1 . At 𝑡 = 2, the value
of 𝑏1 so determined becomes the debt ratio inherited from the previous period,
and can be used to determine 𝑏2 in the very same way we used 𝑏0 to determine
𝑏1 . In particular, using the 45° line we can transfer 𝑏1 from the vertical to the
horizontal axis, and then use the debt/GDP line to read, on the vertical axis, the
implied value for 𝑏2 . Proceeding in a similar fashion time after time, one can
determine the whole sequence of the values that 𝑏 will take on from today on-
wards.
As clear from the figure, in the case under consideration the debt-to-GDP ratio
increases over time, but at a decreasing rate, and ends up converging to the con-
stant value 𝑏̅. When 𝑏 takes on this latter value, corresponding to the intersection
between the debt/GDP line and the 45° line, today’s 𝑏 is the same as yesterday’s,
and the debt ratio will remain constant at this common value over time. Because
of this, 𝑏̅ is referred to as the steady state value of the debt-to-GDP ratio. Ana-
lytically, its expression can be derived by setting 𝑏𝑡 = 𝑏𝑡−1 = 𝑏̅ in equation (∗)
or equation (∗∗), and solving, to get:
𝑑
𝑏̅ = .
𝑔−𝑟
To understand why, in this economy, 𝑏 converges to a constant value, remember
that the budget constraint of the government implies that, were the primary
budget balanced, the stock of debt would grow at the rate 𝑟. Since income 𝑌
grows at the rate 𝑔, and given that in this economy 𝑟 < 𝑔 by assumption, if the
primary budget were balanced the debt ratio 𝐵/𝑌 would converge to zero. How-
ever, by assumption 𝑑 is not equal to zero, but positive; it follows that 𝑏 will not
converge to zero, but to that positive value such that the increase in the debt ratio
due to the fact that 𝑑, the second term on the right-hand side of equation (∗), is
positive is exactly offset by the decrease in the debt ratio due to the first term
(remember that 𝑟 < 𝑔).
407
b. 𝑟 > 𝑔 and 𝑑 > 0.

debt/GDP line
𝐵𝑡
𝑌𝑡 45°
𝑏2
𝑏1
𝑑
𝑏̅
𝑏0 𝑏1 𝑏2 𝐵𝑡−1
𝑌𝑡−1
In this case, 𝑏 tends to +∞ – the dynamics of the debt ratio is unsustainable –

for any positive value of the debt ratio inherited from the past (that is, for any
𝑏0 > 0). In fact, being 𝑟 > 𝑔, 𝑏 would grow over time even if the primary budget
were balanced; since 𝑑 > 0 (the government is running primary deficit), it will
grow at an even faster rate.
c. 𝑟 > 𝑔 and 𝑑 < 0.
...........................................................................................................................
In this economy, the fact that 𝑟 exceeds 𝑔 tends to raise the debt ratio over time,
...........................................................................................................................
while the primary surplus (𝑑 < 0) tends to lower it. As clear from equation (∗),
which of the two, opposing forces will prevail depends on the value of the ratio
𝐵𝑡−1 ⁄𝑌𝑡−1 inherited from the past. As shown in the next figure, if this ratio is
high, greater than the steady state value of the debt ratio, 𝑏 will keep rising over
time, while it will keep shrinking over time if its initial level, 𝑏0 , is ‘small’, less
than the steady state value 𝑏̅.
408
debt/GDP line
𝐵𝑡 45°
𝑌𝑡
𝐵𝑡−1
𝑏0′ 𝑏̅ 𝑏0
𝑌𝑡−1
𝑑
d. 𝑟 < 𝑔 and 𝑑 < 0.
In this final case, 𝑏 converges to a negative steady state value [to check your
understanding of the analysis carried out in this question, use equation (∗) to
explain why] – in the steady state, the government will be a creditor. This, of
course, provided that it will keep running primary surpluses, and will not trans-
form – maybe well before 𝑏 has turned negative – those surpluses into deficits,
eventually putting an end to the tendency of the debt ratio to fall over time.
𝐵𝑡 45°
𝑌𝑡
debt/GDP line
𝑏̅
𝑏0 𝐵𝑡−1
𝑑
𝑌𝑡−1
409
Question 2

0, a debt-to-GDP ratio of 100%: 𝑏0 ≡ 𝐵0 ⁄𝑌0 = 1. Moreover, the real interest
respectively (𝑟 = 0.03, 𝑔 = 0.05). Finally, the ratio of the primary deficit to
GDP is 4%, assumed to be constant over time. Write down the equation that
gives the dynamics of the debt ratio 𝑏 (≡ 𝐵⁄𝑌) and use it to calculate the value
of the debt-to-GDP ratio at times 𝑡 = 1 and 𝑡 = 2, and the steady state level of
𝑏, 𝑏̅. Will the debt ratio diverge over time, or converge to its steady state value?
Why, or why not?
The equation that allows us to analyze the change of the debt ratio over time is:
𝐵𝑡 𝐵𝑡−1 𝐵𝑡−1 𝐺𝑡 − 𝑇𝑡
− = (𝑟 − 𝑔) + ,
𝑌𝑡 𝑌𝑡−1 𝑌𝑡−1 𝑌𝑡
which, defining 𝑏 ≡ 𝐵⁄𝑌, can be equivalently written as:
𝑏𝑡 = (1 + 𝑟 − 𝑔)𝑏𝑡−1 + 𝑑,
where (𝐺𝑡 − 𝑇𝑡 )⁄𝑌𝑡 (≡ 𝑑) is the ratio of the primary deficit to GDP. Using in
the latter equation the quantitative information we have been provided with, it is
straightforward to compute 𝑏1 = 1.02, 𝑏2 = 1.0396 and 𝑏̅ = 2.
The debt ratio clearly converges over time to its steady state value. Indeed, since
in this economy 𝑟 < 𝑔, the debt ratio would decrease over time towards zero,
were 𝑑 = 0. Given that, however, 𝑑 is positive (the government is running a pri-
mary deficit), 𝑏 increases, but at a decreasing rate, tending over time to its steady
state level (𝑏̅ = 2).
410
b. Suppose now that the government intends to stabilize 𝑏 at the value observed at
𝑡 = 0. In other words, the government wants 𝑏 to continue to take on the value
1 both in period 𝑡 = 1 and in all subsequent periods. To achieve this goal, the
Government is considering the possibility of generating a permanent change in
the ratio of the primary deficit to GDP. Compute the value that this ratio should
take on to stabilize 𝑏 at the value 1 forever, and explain whether it implies that
the Government should implement a restrictive or an expansionary fiscal policy.
Since 𝑏𝑡 = (1 + 𝑟 − 𝑔)𝑏𝑡−1 + 𝑑, in order to stabilize at 1 the debt-to-GDP ratio

at time 𝑡 = 1 – that is, in order to make 𝑏1 = 𝑏0 – the government must set 𝑑 at
the unique value that solves:
0 = (𝑟 − 𝑔)𝑏0 + 𝑑.
Since 𝑟 = 0.03, 𝑔 = 0.05, and 𝑏0 = 1, in this economy the above condition be-
comes 0 = − 0.02 · 1 + 𝑑. Solving, we get 𝑑 = 0.02 – the government will have
to lower the primary deficit-to-GDP ratio from 4% to 2%. This of course re-
quires a restrictive fiscal policy.
411
Question 3
At time 𝑡, a country inherits from the previous period a stock of government debt
0
greater than zero, corresponding to the debt-to-GDP ratio 𝑏𝑡−1 in the graph below.
Assuming that the real interest rate is smaller than the rate of growth of the economy,
and that the government runs a primary surplus,
a. show in the graph the steady state debt-to-GDP ratio in this economy and ex-
plain if, absent any intervention, the debt-to-GDP ratio of the country will con-
verge or not to this stationary level;
𝐵𝑡 45°
𝑌𝑡
debt/GDP line
𝐵𝑡
𝑌𝑡 𝑑′
𝑏̅ 0
𝐵𝑡−1
𝑑 𝑏𝑡−1
𝑌𝑡−1
𝐵𝑡−1
𝑌𝑡−1
The steady state debt-to-GDP ratio, 𝑏̅ < 0 in the graph, is that value of 𝐵⁄𝑌 for
which the debt/GDP line (the continuous, bold line in the figure) crosses the 45°
line going through the origin. The debt-to-GDP ratio will converge to that steady
state following the arrowed path in the graph.
412
b. show in the graph the change in the ratio between the primary balance and GDP
0
needed to stabilize the debt-to-GDP ratio at the value 𝑏𝑡−1 from time 𝑡 onwards.
Explain.
0
To stabilize the debt-to-GDP ratio at the level 𝑏𝑡−1 , at time 𝑡 the government
will have to run a primary deficit. As a ratio to GDP, the primary balance will
have to go from the value 𝑑 < 0 (primary surplus) in the graph to a level 𝑑 ′ > 0
(primary deficit) such that the new debt/GDP line (the dashed, bold line in the
0
figure) crosses the 45° line exactly for a debt-to-GDP ratio equal to 𝑏𝑡−1 .
413
Question 4
a. Consider the following graph:
𝐵𝑡 debt/GDP line
In the figure, the bold straight line,
𝑌𝑡
45° that gives the time 𝑡 debt/GDP ra-
tio as a function of the same ratio
𝑏𝑡+1 in the previous period, is parallel
to the 45° line going through the
𝑏𝑡 origin.
𝑑 In this economy, what is the rela-
tive size of the growth rate of real
GDP and of the real interest rate?
Is the government running a pri-
0
𝑏𝑡−1 𝑏𝑡 𝑏𝑡+1 𝐵𝑡−1 mary deficit or a primary surplus?
𝑌𝑡−1 Explain.
The equation of the debt/GDP line is:

𝐵𝑡 𝐵𝑡−1 𝐺𝑡 − 𝑇𝑡
= (1 + 𝑟 − 𝑔) + .
𝑌𝑡 𝑌𝑡−1 𝑌𝑡
Its vertical intercept is therefore (𝐺𝑡 − 𝑇𝑡 )/𝑌𝑡 (≡ 𝑑) and its slope 1 + 𝑟 − 𝑔.
From the graph it is easy to conclude that the vertical intercept is positive; it
follows that 𝑑 > 0 (the government is running a primary deficit). Moreover,
since the slope of the line is 45°, we can conclude that 1 + 𝑟 − 𝑔 = 1, so that
𝑟 = 𝑔.
414
0
b. Assuming that the debt-to-GDP ratio at time 𝑡 − 1 was 𝑏𝑡−1 , show in the graph
the values that this ratio will take on at times 𝑡 and 𝑡 + 1. Will the debt-to-GDP
ratio converge to a steady state value 𝑏̅? If not, why? If yes, show in the figure
this steady state value and explain whether it is stable (that is, if 𝑏 will converge
to it independently of the value of the debt-to-GDP ratio inherited from the past,
0
𝑏𝑡−1 ) or unstable (in which case, 𝑏 will take on the steady state value if and only
0
if 𝑏𝑡−1 = 𝑏̅).
Since in this economy 𝑟 = 𝑔, the dynamics of debt/GDP ratio is given by the

equation:
𝐵𝑡 ⁄𝑌𝑡 − 𝐵𝑡−1 ⁄𝑌𝑡−1 = 𝑑.
Being 𝑑 > 0, absent any policy intervention the debt/GDP ratio will keep rising
over time, and therefore will not converge to a stationary value (in the economy
under consideration, a steady state value of the debt/GDP ratio does not exist).
415
Question 5

0, a debt-to-GDP ratio of 60%: 𝑏0 ≡ 𝐵0 ⁄𝑌0 = 0.6. In addition, the real interest
respectively (𝑟 = 0.06, 𝑔 = 0). Finally, the ratio of the primary deficit to GDP
is 3%. Write down the relation that describes the dynamics of the debt ratio (the
government budget constraint), and use it to compute the debt-to-GDP ratio 𝑏
for times 𝑡 = 1 and 𝑡 = 2. Will this ratio converge over time to a steady state
value 𝑏̅ > 0? Why, or why not? Represent this specific case in the graph that
one uses to study the evolution of the debt ratio over time.
𝐵𝑡
𝑌𝑡 45°
0.03
𝑏0 𝑏1 𝑏2 𝐵𝑡−1
𝑌𝑡−1
...........................................................................................................................
The dynamics of the debt ratio in this economy is the one implied by the equation
...........................................................................................................................
𝑏𝑡 = (1 + 𝑟 − 𝑔)𝑏𝑡−1 + 𝑑, where 𝑏 ≡ 𝐵⁄𝑌, and 𝑑 is the ratio of the primary
deficit to GDP. Given the numerical values that 𝑟, 𝑔, 𝑑 and 𝑏0 take on in this
...........................................................................................................................
case, it is easy to compute 𝑏1 = 0.666, 𝑏2 = 0.736. The debt ratio does not
............................................................................................................................
converge to a steady state. Since 𝑟 > 𝑔 and 𝑑 > 0, in the graph the debt/GDP
line does not intersects the 45-degree line in the first quadrant [its slope is
1.06 (> 1) ]. Being 𝑏0 positive, 𝑏 tends to +∞.
416
b. Suppose now that, rather than a deficit, the same country runs a primary surplus
of 6% of GDP. How would your answer to the previous point of this question
change? Compute the debt ratio at times 𝑡 = 1 and 𝑡 = 2, and its steady state
value, 𝑏̅. Will the debt ratio converge to 𝑏̅? Explain, using the graph below to
motivate your conclusions.
𝐵𝑡
45°
𝑌𝑡
𝑏0 𝑏̅ = 1 𝐵𝑡−1
−0.06
𝑌𝑡−1
...........................................................................................................................
If 𝑑 = −0.06, following the same steps described above one can compute 𝑏1 =
...........................................................................................................................
0.576, 𝑏2 = 0.551.
The steady state debt ratio is in this case:
...........................................................................................................................
−𝑑 0.06
...........................................................................................................................
𝑏̅ = = = 1.
(𝑟 − 𝑔) 0.06
...........................................................................................................................
This steady state value will never be reached: 𝑏 tends to decrease over time, since
...........................................................................................................................
𝑏0 < 1 and the slope of the debt/GDP line is still 1.06 (> 1). Notice that, in this
economy, the fact that 𝑟 > 𝑔 tends, other things the same, to raise 𝑏 over time;
...........................................................................................................................
on the other hand, the primary surplus tends to lower it. Given the magnitude of
...........................................................................................................................
the primary surplus, in this example the second of the two forces just mentioned
prevails, and 𝑏 ends up decreasing over time.
...........................................................................................................................
417
Question 6
The current time period is 𝑡. For country XYZ, the dynamics of the debt/GDP ratio
0
can be determined on the basis of the figure below, where 𝑏𝑡−1 is the debt/GDP ratio
inherited from the last period. Having explained if, in this country, the economy’s
growth rate is larger or smaller than the real interest rate, and if the primary budget
is in surplus or in deficit, suggest two ways in which policy-makers could stabilize
0
at 𝑏𝑡−1 the debt-to-GDP ratio prevailing at time 𝑡 (that is, two ways in which they
0
could make sure that the debt/GDP ratio will amount to 𝑏𝑡−1 also at time 𝑡). Explain.
Debt/GDP line
𝐵𝑡
𝑌𝑡
45°
0
𝑌𝑡−1
Since the debt/GDP line has a negative vertical intercept, 𝑑 < 0 (the government
runs a primary surplus); and since the slope of the same line is greater than 1,
𝑟 > 𝑔. Being 𝑏𝑡−10
greater than 𝑏̅, the steady state debt/GDP ratio, in this econ-
0 0
omy 𝐵⁄𝑌 would keep rising over time. To freeze it at 𝑏𝑡−1 , one has to make 𝑏𝑡−1
a steady state; in turn, this requires the debt/GDP line to shift, or alternatively
rotate, so as to intersect the dashed line with unit slope going through the origin
0
exactly for 𝑏𝑡−1 . This can be engineered:
 for a given slope of the debt/GDP line, by lowering its vertical intercept
– that is, by making the primary surplus even larger;
 for a given vertical intercept, by decreasing the slope of the debt/GDP
line – something that could for instance follow from the choice of a lower
policy rate 𝑟 set by the central bank, or from other policy interventions
leading to a higher 𝑔,
or, finally, through a combination of interventions leading to the changes just
described.
418
Question 7
By making explicit reference to the government budget constraint – and, should you
find it helpful, also to the diagram employed to perform a graphical analysis of the
evolution of the debt-to-GDP ratio over time −, explain if and why you agree, or do
not agree, with the following statement:
“In a country where 𝑟 > 𝑔 and that inherits from the previous period a stock of
government debt 𝐵𝑡−1 > 0, the debt-to-GDP ratio will keep growing over time,
and this irrespective of the value – by assumption, constant – that 𝑑, the ratio of
the primary deficit to GDP, takes on”.
The statement is incorrect.

It is true that, with 𝐵𝑡−1 > 0, if 𝑟 > 𝑔 and if the government primary balance
is zero or in deficit, so that 𝐷𝑡 ≡ 𝐺𝑡 − 𝑇𝑡 ≥ 0 and therefore 𝑑𝑡 ≡ 𝐷𝑡 ⁄𝑌𝑡 = 𝑑 ≥
0 for all 𝑡, the debt-to-GDP ratio will be growing over time. In fact, from the
government budget constraint 𝐵𝑡 = (1 + 𝑟)𝐵𝑡−1 + 𝐷𝑡 it follows that, with
𝐷𝑡 = 0, the stock of government debt would grow at the rate 𝑟, and the debt
ratio 𝑏 ≡ 𝐵⁄𝑌 would keep increasing over time (because, being 𝑟 > 𝑔, the nu-
merator of that ratio, 𝐵, would grow faster than the denominator, 𝑌). And it is
also true that if 𝐷𝑡 is not zero, but rather positive, so that the government runs
a primary deficit in all periods, 𝑏 would grow at an even faster rate.
If, however, the government runs a primary surplus (𝑑 < 0), the debt ratio
could end up falling over time even if 𝑟 > 𝑔, as the third Figure in the answer
to Question 1 of this Chapter confirms. This would be the case if, for a given
debt ratio 𝑏𝑡−1 inherited from the past, the primary surplus – that tends to lead
to a lower 𝑏 – is large enough to more than offset the impact on the debt ratio
of the fact that 𝑟 is greater than 𝑔, or alternatively if, for a given 𝑑 < 0, 𝑏𝑡−1
is small enough.
419
* Question 8
a. Consider a country with a zero primary deficit-to-GDP ratio (𝑑 = 0), and in

which the real interest rate and the rate of growth of the economy are constant
and equal to 𝑟 = 𝑟̅ and 𝑔 = 𝑔̅ , respectively, with 𝑟̅ < 𝑔̅ and 1 + 𝑟̅ − 𝑔̅ > 0.
Write down the equation that gives the dynamics of the debt-to-GDP ratio for
this economy (the government budget constraint) and derive the steady state
value of that ratio. Assuming that at time 𝑡 the economy inherits from the past a
0
debt-to-GDP ratio equal to 𝑏𝑡−1 > 0, explain if, and why, the economy will ever
converge to that steady state. Use the graph below to motivate your answer.
𝐵𝑡 45°
𝑌𝑡 debt/GDP line
0
0 𝐵𝑡−1
𝑏𝑡−1
𝑌𝑡−1
Being 𝑑 = 0, the dynamics of the debt-to-GDP ratio is given by the equation
𝑏𝑡 = (1 + 𝑟̅ − 𝑔̅ )𝑏𝑡−1 ,
the bold line in the figure above. As clear from the graph, in this economy there
is just one steady state debt-to-GDP ratio, 𝑏̅ = 0. Since, by assumption, 𝑟̅ < 𝑔̅ ,
the economy will converge to this value of 𝑏 starting from any debt-to-GDP ratio
inherited from the past.
420
b. Suppose now that the interest rate at which the government can borrow is no
longer equal to 𝑟̅ , but rather to 𝑟̅ + 𝑣𝑏𝑡−1 , where 𝑣 is a positive parameter. In
other words, the real interest rate is no longer constant, but increasing in the debt-
to-GDP ratio (𝑏) prevailing in the last period. The growth rate of the economy
is however stiIl constant and, as before, 𝑟̅ < 𝑔̅ and 1 + 𝑟̅ − 𝑔̅ > 0. Repeat the
analysis carried out in order to answer the previous point of this question. In
particular, derive the expression of the steady state debt-to-GDP ratio, explain if
and why 𝑏 will converge to a steady state, and represent graphically.
debt/GDP
line
45°
𝐵𝑡
𝑌𝑡
0
0
𝑏𝑡−1 𝑏̿ 00
𝑌𝑡−1
Since now 𝑟 = 𝑟̅ + 𝑣𝑏𝑡−1 , the evolution of the debt-to-GDP ratio over time is
given by the equation
𝑏𝑡 = (1 + 𝑟̅ + 𝑣𝑏𝑡−1 − 𝑔̅ )𝑏𝑡−1
2
= (1 + 𝑟̅ − 𝑔̅ )𝑏𝑡−1 + 𝑣𝑏𝑡−1 ,
the bold curve in the figure. As usual, to find the steady state values of the debt-
to-GDP ratio one has to set 𝑏𝑡 = 𝑏𝑡−1 in the equation above, and then solve.
There are now two steady state values of 𝑏 (two intersections between the parab-
ola and the 45° line): zero, as before, and the new steady state 𝑏̿ = (𝑔̅ − 𝑟̅ )⁄𝑣
(a positive quantity, given the hypotheses on the values the parameters take on
in this economy). If the initial debt-to-GDP ratio happens to be less than 𝑏̿, as
before there will be convergence to the steady state 𝑏̅ = 0. But if the initial debt-
to-GDP ratio is greater than 𝑏̿, then 𝑏 will tend to +∞. In fact, 𝑟 = 𝑟̅ + 𝑣𝑏𝑡−1
and 𝑏𝑡−1 > 𝑏̿ = (𝑔̅ − 𝑟̅ )⁄𝑣 imply 𝑟 > 𝑔 and therefore, with a zero primary def-
icit, an unsustainable dynamics of the debt-to-GDP ratio.
421
Question 9
3 1
tion function is 𝑌 = 𝐾 ⁄4 𝑁 ⁄4 and the rate of depreciation, 𝛿, is equal to 0.1.
Calculate the propensity to save 𝑠 for which the steady state level of capital per
worker is 100. Represent graphically this steady state.
𝑌 ⁄𝑁
𝛿 · (𝐾𝑡 ⁄𝑁)
(𝑌⁄𝑁 )∗′ 𝑓(𝐾𝑡 ⁄𝑁)
(𝑌⁄𝑁)∗ ′
𝑠 · 𝑓(𝐾𝑡 ⁄𝑁)
𝐸′ 𝑠 · 𝑓(𝐾𝑡 ⁄𝑁)
𝐸
(𝐾/𝑁)∗ (𝐾 ⁄𝑁)∗′ 𝐾 ⁄𝑁
When the steady state level of capital per worker is 100, steady state output per
worker is:
3⁄
𝑌 ∗ 𝐾 ∗ 4
3⁄
( ) = [( ) ] = 100 4.
𝑁 𝑁
In steady state, a situation in which capital and output per worker are constant,
saving and investment per worker (recall that, in a closed economy goods market
equilibrium, saving equals investment) are just enough to cover depreciation,
and capital and output per worker are constant.
422
...........................................................................................................................
It follows that, in steady state:
...........................................................................................................................
𝑌 𝐾
...........................................................................................................................
𝑠 =𝛿 ,
𝑁 𝑁
...........................................................................................................................
a condition that, in the economy we are studying, can be written as:
...........................................................................................................................
3
𝑠 · 100 ⁄4 = 0.1 · 100.
Solving, 𝑠 ≌ 0.32.
b. Assuming that the economy is initially in the steady state just described, explain
and represent graphically what happens to capital per worker, output per worker
and the growth rate of the economy following a reduction in the marginal pro-
pensity to consume.
A decrease in the marginal propensity to consume is equivalent to an increase in

the savings rate. Assuming that this latter rises from 𝑠 to 𝑠 ′ > 𝑠, in the graph the
curve which represents saving/investment per worker as a function of capital per
worker shifts upwards. At point E, investment per worker now exceeds deprecia-
tion per worker, and capital per worker starts to increase. This process continues
until the economy reaches the new steady state E’, where both capital per worker
and output per worker are once again constant (i.e., the growth rate of the econ-
omy is zero), but at a level higher than before.
423
Question 10
1 1
tion function is 𝑌 = 𝐾 ⁄2 𝑁 ⁄2 and the rate of depreciation is 𝛿 = 0.05. Calculate
the propensity to save 𝑠 for which the steady state level of capital per worker is
200. Represent graphically this steady state.
𝑌 ⁄𝑁 𝛿 · (𝐾𝑡 ⁄𝑁)
(𝑌⁄𝑁 )∗ 𝑓(𝐾𝑡 ⁄𝑁)
𝑠 · 𝑓(𝐾𝑡 ⁄𝑁)
𝐸
(𝐾/𝑁)∗ 𝐾 ⁄𝑁
= 200
...........................................................................................................................
...........................................................................................................................
In steady state, output and capital per worker are constant, and investment per
worker is equal to the depreciation per worker − that is, the following condi-
...........................................................................................................................
tion holds:
...........................................................................................................................
𝐾 𝐾
𝑠·𝑓( ) = 𝛿 ,
...........................................................................................................................
𝑁 𝑁
......................................................................................................................................
where 𝑓(𝐾 ⁄𝑁) = 𝑌⁄𝑁 = (𝐾 ⁄𝑁) ⁄2 .
1
By substituting the values the parameters take on in this economy, and imposing
................................................................................................................
1
𝐾 ⁄𝑁 = 200, one gets 𝑠 · 200 ⁄2 = 0.05 · 200. Solving for 𝑠, the value of the
...........................................................................................................................
saving rate we are looking for is 𝑠 ∗ ≌ 0.71.
.
424
b. Assuming that the economy is initially in the steady state just described, explain,
and show in the graph, what happens to capital per worker, output per worker
and the growth rate of the economy following an increase in the rate of depreci-
ation, 𝛿.
𝛿 ′ · (𝐾𝑡 ⁄𝑁)
𝑌 ⁄𝑁
𝛿 · (𝐾𝑡 ⁄𝑁)
(𝑌⁄𝑁 )∗ 𝑓(𝐾𝑡 ⁄𝑁)
(𝑌⁄𝑁 )∗′ 𝑠 · 𝑓(𝐾𝑡 ⁄𝑁)
𝐸
𝐸′
(𝐾 ⁄𝑁)∗′ (𝐾/𝑁)∗ 𝐾 ⁄𝑁
Following the increase in δ, the line representing depreciation per worker be-
comes steeper. At point E, the initial steady state, investment per worker is now
smaller than depreciation per worker, and capital per worker starts to fall. This
process continues until the economy reaches the new steady state E’, where both
capital per worker and output per worker are once again constant (i.e., the
growth rate of the economy is zero), but at a level lower than before.
425
Question 11
The government of a closed economy, whose budget was previously balanced, starts
running a budget deficit equal to the percentage 𝜌 of the country’s GDP, with 0 <
𝜌 < 𝑠, where 𝑠 is the private saving rate.
a. Assuming that there is no technological progress and that both the private saving
rate and the population of the country are constant, show in the graph below the
impact of the emergence of a budget deficit (that is, of the increase in 𝜌 from
zero to a positive value) on output per worker and capital per worker in the
Solow growth model. Explain.
𝑌 ⁄𝑁 𝛿 · (𝐾𝑡 ⁄𝑁)
(𝑌⁄𝑁 )∗ 𝑓(𝐾𝑡 ⁄𝑁)
(𝑌⁄𝑁 )∗′ 𝑠 · 𝑓(𝐾𝑡 ⁄𝑁)
𝐸 (𝑠 − 𝜌) · 𝑓(𝐾𝑡 ⁄𝑁)
𝐸′
(𝐾 ⁄𝑁)∗′ (𝐾/𝑁)∗ 𝐾 ⁄𝑁
With a government that needs not to balance its budget, but that can now run
surpluses or deficits, national saving is, in this economy, the following function
..........................................................................................................................
of output:
..........................................................................................................................
𝑆𝑡 = 𝑠𝑌𝑡 − 𝜌𝑌𝑡 ,
where 𝑠𝑌𝑡 is private saving, and (−𝜌𝑌𝑡 ) public (government) saving.
426
Since, as always, 𝐼𝑡 = 𝐾𝑡+1 − 𝐾𝑡 + 𝛿𝐾𝑡 , by substituting in the goods market

equilibrium condition (𝑆𝑡 = 𝐼𝑡 ) the expressions for 𝑆 and 𝐼 written above, divid-
..........................................................................................................................
ing by the number of workers 𝑁, and finally rearranging terms, one gets:
..........................................................................................................................
𝐾𝑡+1 𝐾𝑡 𝐾𝑡 𝐾𝑡
− = (𝑠 − 𝜌)𝑓 ( )−𝛿 , (∗)
𝑁 𝑁 𝑁 𝑁
..........................................................................................................................
where 𝑓(𝐾 ⁄𝑁) = 𝑌 ⁄ 𝑁.
..........................................................................................................................
𝑡 𝑡
The first and the second term on the right-hand side of the equilibrium condition
(∗) are drawn in the graph above.
..........................................................................................................................
Initially, 𝜌 = 0 (the government budget is balanced) and the economy is in the
..........................................................................................................................
steady state equilibrium E, with capital per worker (𝐾 ⁄𝑁)∗ and output per
worker (𝑌⁄𝑁)∗ . When 𝜌 rises from zero to a positive value, the effect on the
..........................................................................................................................
economy is similar to that of a fall in the private saving rate, 𝑠: capital and output
......................................................................................
per worker start to decrease, and the economy converges over time to a new
steady state (point E’ in the graph) where both capital and output per worker are
permanently lower.
b. Will the budget deficit permanently affect the growth rate of the economy? Ex-
plain.
The fact that now the government runs a budget deficit leads to a permanent de-
crease in the saving rate of the economy. We know that, in the Solow model:
..........................................................................................................................
1) a change in the saving rate changes, temporarily and in the same direction,
......................................................................................................................................
the growth rate of the economy;
......................................................................................................................................
2) however, the change in the saving rate does not affect the growth rate of out-
put per worker in the long run; given the assumptions made about the economy,
.....................................................................................................
this growth rate will always be zero in the steady state, no matter what the saving
......................................................................................................................................
rate is (and therefore, no matter whether the government is running a budget
deficit, a surplus, or has a balanced budget).
......................................................................................................................................
We therefore conclude that the deficit does not change the rate at which this
.....................................................................................................
economy will grow in the long run − this growth rate will remain equal to zero.
However, as discussed before, the budget deficit causes the economy to converge
to a new steady state where the levels of capital per worker and output per worker
will be permanently lower.
427
Question 12
True or False?
a. “From the Solow model without technological progress it follows that, as the
saving rate s increases from its minimum value (0) to its maximum value (1),
steady-state capital per worker and output per worker first increase and then de-
crease”.
The statement is false. As it can be verified for instance by using the graph em-
ployed in the Solow model to analyse the evolution of capital per capita and in-
come per capita over time, an increase in the saving rate always leads to an
increase in the steady state levels of capital and output per capita. [To first in-
crease and then decrease as the saving rate increases from 0 to 1 is the steady
state level of consumption, and not capital or output per capita].
428
b. Using the Solow model without technological progress and assuming a constant
population (𝑔𝐴 = 𝑔𝑁 = 0), explain if and why you agree, or do not agree, with
the following statements:
b.1 an increase in the saving rate 𝑠 will always raise steady state output per
worker;
b.2 an increase in the saving rate 𝑠 will always raise steady state consumption
per worker.
b.1 True. An increase in the saving rate leads to a higher investment per worker,
and thus to an increase in capital per worker ̶ at least for a while, that is,
during the transition to the new steady state. Since output per worker is an
increasing function of capital per worker, an increase in 𝑠 will lead to a
steady state in which both capital and output per worker are permanently
higher.
b.2 False. An increase in the saving rate will increase consumption per worker
only if, in the initial steady state, capital per worker was less than the golden
rule level (the ratio K/N that maximizes steady state consumption per
worker). In the opposite case, an increase in the saving rate will reduce
consumption per worker in the steady state.
429
Question 13
a. Using the Solow model with technological progress, and assuming the economy
was initially in a steady state equilibrium, study in the graph below the effects
of a decrease in the saving rate on capital and output per effective worker, briefly
explaining the reasons for the observed changes in these variables.
𝐾
[𝛿 + 𝑔𝐴 + 𝑔𝑁 ] · ( )
𝑌/𝑁𝐴 𝑁𝐴
𝐾
∗
𝑓( )
(𝑌/𝑁𝐴) 𝑁𝐴
𝐾
(𝑌/𝑁𝐴)∗′ 𝑠 · 𝑓( )
𝐸 𝑁𝐴
𝐾
𝑠 ′ · 𝑓( )
𝑁𝐴
𝐸′
(𝐾/𝑁𝐴)∗ ′ (𝐾/𝑁𝐴)∗ 𝐾⁄𝑁𝐴
The saving rate decreases from 𝑠 to 𝑠 ′ < 𝑠. Since in goods market equilibrium
savings equal investment, a lower saving rate implies less investment per effec-
tive worker. Since at point E, the initial steady state, investment per effective
...........................................................................................................................
worker was at the level needed to keep 𝐾 ⁄𝑁𝐴 constant, the reduction in invest-
...........................................................................................................................
ment caused by the decrease in the saving rate implies that now 𝐾 ⁄𝑁𝐴 − and,
with it, 𝑌⁄𝑁𝐴 − will start to decrease. Over time, the economy will converge to
...........................................................................................................................
a new steady state (point E’ in the graph) in which both capital and income per
......................................................................................................................................
effective worker are permanently lower, and their rate of growth is once again
zero (and the growth rate of these variables measured in ‘per worker’ − or ‘per
................................................................................................................
capita’ − terms is equal to the rate of technological progress, as in the initial
steady state).
...........................................................................................................................
430
b. How would capital and output per effective worker change following an increase
in the rate of technological progress?
𝐾
[𝛿 + 𝑔𝐴′ + 𝑔𝑁 ] · ( ) 𝐾
𝑌/𝑁𝐴 𝑁𝐴 [𝛿 + 𝑔𝐴 + 𝑔𝑁 ] · ( )
𝑁𝐴
𝐾
∗
𝑓( )
(𝑌/𝑁𝐴) 𝑁𝐴
𝐾
𝑠 · 𝑓( )
(𝑌/𝑁𝐴)∗′ 𝐸 𝑁𝐴
𝐸′
(𝐾/𝑁𝐴)∗ ′ (𝐾/𝑁𝐴)∗ 𝐾⁄𝑁𝐴
If, when the economy was in a steady state like point E in the graph above, the
..................................................
rate of technological progress rises from 𝑔𝐴 to 𝑔𝐴′ > 𝑔𝐴 , investment per effec-
tive worker falls below the level needed to keep capital per effective worker con-
stant over time. Exactly as discussed before in connection with a fall in the saving
rate, capital and output per effective worker will fall for some time, until the
economy reaches a new steady state (point E’) in which both variables are once
again constant, but at a level permanently lower than in the initial steady state.
Notice that, in this economy, the balanced growth path (along which all variables
in ‘per worker’, or ‘per capita’, terms grow at the rate of technological progress)
is now steeper. Take, for instance, output per worker. Although 𝑌⁄𝑁 𝐴 is lower
in the new steady state, the growth rates of 𝑌 and of 𝑌⁄𝑁 will be higher – since,
in balanced growth, 𝑔𝑌 = 𝑔𝑁 + 𝑔𝐴 , 𝑔𝑌⁄𝑁 = 𝑔𝐴 and 𝑔𝐴 has gone up.
431
Question 14
Consider the Solow model, assuming positive rates of technological progress and
population growth, so that 𝑔𝐴 > 0 and 𝑔𝑁 > 0.
a. Assuming the usual aggregate production function, and denoting by 𝑠 the saving
rate and by δ the depreciation rate, represent in the graph below the steady state,
or state of balanced growth, of the economy. Clearly indicate the levels of output
per effective worker, investment per effective worker and consumption per ef-
fective worker in this steady state.
𝐾
[𝛿 + 𝑔𝐴 + 𝑔𝑁 ] · ( )
𝑌/𝑁𝐴 𝑁𝐴
𝐾
𝑓( )
𝑁𝐴
(𝑌/𝑁𝐴)∗
𝐾
𝑠 · 𝑓( )
𝑁𝐴
(𝐶/𝑁𝐴)∗
(𝐼/𝑁𝐴)∗
(𝐾/𝑁𝐴)∗ 𝐾 ⁄𝑁𝐴
In the graph, the steady state value of the variables is indicated with an asterisk.
432
b. Explain if and why you agree, or do not agree, with the following statements:
b.1 an increase in the saving rate leads to a new balanced growth path
characterized by a higher level of output per worker, but an un-
changed growth rate of 𝑌⁄𝑁;
b.2 the Solow model implies that, if the growth rate of population 𝑔𝑁 in-
creases, the economy will reach a new steady state where the
growth rate of aggregate output 𝑌 is unchanged, and the growth
rate output per worker 𝑌⁄𝑁 is lower.
b.1 True. In balanced growth, 𝑌⁄𝑁𝐴 = (𝑌⁄𝑁)/𝐴 is constant. Therefore, in

balanced growth 𝑌⁄𝑁 must be growing at the rate 𝑔𝐴 , the growth rate of
technological progress. This rate is not affected by changes in 𝑠. An in-
crease in 𝑠 leads to an increase in the steady state levels of capital and
output per effective worker, though, as you can verify from the graph
above. During the transition towards this higher level of output per unit of
effective labor, output per worker grows temporarily at a rate greater than
𝑔𝐴 . Once the new steady state has been reached, 𝑌⁄𝑁 will remain at a
level higher than the one prevailing before the increase in the saving rate.
b.2 False. As already noted, in balanced growth 𝑌⁄𝑁𝐴 = (𝑌⁄𝑁)/𝐴 is con-

stant. This implies that, in the steady state, 𝑌 will grow at a rate equal to
𝑔𝐴 + 𝑔𝑁 . This rate is increasing in 𝑔𝑁 . Moreover, in balanced growth
𝑌⁄𝑁 grows at the rate 𝑔𝐴 , which does not depend on 𝑔𝑁 .
433
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Copyright © 2014, 2021 EGEA S.p.A.

Seventh edition: September 2021

Print: Logo s.r.l., Borgoricco (PD)

Part I. Problems and Questions

1. The goods and financial markets 3

Part II. Solutions

1. The goods and financial markets 219

A good exam question should test a range of abilities,

(…) Good exam questions are like a scarce natural

(…) Maybe the depressing job of grading exams is

Nick Rowe, “The depressing job of grading exams”,

For additional questions and problems, go to

Purchases from B Sales to consumers

Purchases from A Sales to consumers

Indirect taxes Exports

where, as always, the positive constant 𝑐0 is autonomous consumption, 𝑡 (a constant

The goods market of a nation is described by the following equations:

Consider a country consisting of the goods market only, where 𝐶 = 𝑐0 , 𝐺 = 𝐺̅ − 𝑔𝑌,

a. Write down the analytical expressions of autonomous spending, equilibrium in-

b. Suppose that the autonomous components of government purchases of goods

The goods market of a country is described by the following model:

b. Suppose that autonomous consumption and the autonomous component of net

b. Suppose that individuals experience an increase in their financial and hous-

a. The goods market of country Zeta is described by the following equations:

a. “Consider a simultaneous rise in the reserve ratio, θ, and in the fraction of

b. “A new law banning cash transactions above €500 induces individuals to

a. Define, briefly but rigorously, the following concepts:

a.1 ‘liquidity trap’;

In a closed economy, consumption, investment, government purchases of goods and

where 𝐼 ̅ is autonomous investment, the coefficients 𝑑1 and 𝑑2 , both positive, have

c. Derive the equilibrium values of 𝑌 and 𝑖. By how much will equilibrium

a. Gamma is a closed economy described by a standard IS-LM model,,1 given by

a. In country Macro, described by the IS-LM model, government purchases of

a. Gamma is a closed economy initially in goods and in money markets equilib-

a. Consider the economy of country Epsilon, described by an IS-LM model depart-

a.1 Write down the consumption function for this economy.

b. If, rather than a monetary expansion, to be implemented is going to be a fiscal

a. “The government of an economy described by a standard IS-LM model decides

The economy is described by an "extended" IS-LM model − that is, by an IS-LM

Consider an economy with constant prices described by an “extended” IS-LM

Consider an economy that is initially in medium run equilibrium, with an unemploy-

a. Define briefly, but rigorously, the following concepts:

a.1 “accelerationist” (sometimes also referred to as “expectations-

a. “A decrease in firms' market power leads to a fall in the inflation rate”.

Consider an economy described by the following equations:

a. By making reference to the graph “supply of goods-demand for goods” used to

a. Gamma is a closed economy with flexible prices described by an IS-LM-PC

a.1: 𝜋 𝑒 = 𝜋̅ a.2: 𝜋 𝑒 = 𝜋−1

Consider a country where 𝜋 𝑒 = 𝜋̅, investment is entirely exogenous (𝐼 = 𝐼 )̅ , and

Consider an economy described by an IS-LM-PC model with 𝜋 𝑒 = 𝜋̅. For simplicity,

a. Suppose that, due to a major, permanent fall in the autonomous components of

a. Represent the initial medium run equilibrium position of the economy, to be

Consider country Macro, described by an IS-LM-PC model and in which individuals

Consider a country where both investment (which, as usual, is also a function of 𝑌)

In country XYZ, the production function is 𝑌 = 𝐴 · 𝑁, where 𝐴 is a positive con-

a. Provide an economic interpretation of the costant 𝐴 and, in the graph below,

b. Compare the composition of aggregate demand prevailing in the initial and in