ECON 204 Fall 2006
INTERMEDIATE MACROECONOMIC THEORY
Answer all questions. Total mark: 40 marks
Question 1: Textbook page 300 Q4. (10 marks)
Question2: Textbook page 300 Q5. (10 marks)
a. The downward sloping line represents the money demand function
D(M/P)?1000?100r. Wit M=1000 and P=2, the real money supply
S(M/P)?500. The real money supply is independent of the interest rate and is,
therefore, represented by the vertical line.
S 10 (M/P)
500 1000 M/P
b. We can solve for the equilibrium interest rate by setting the supply and demand
for real balances equal to each other: 500=1000-100r, so r=5. Therefore, the
equilibrium real interest rate equals 5 percent.
c. If the price level remains fixed at 2 and the supply of money is raised from 1000
to 1200, then the new supply of real balances S(M/P) equals 600. We can solve
Sfor the new equilibrium interest rate by setting the new (M/P) equal to
D(M/P): 600=1000-100r, so r=4. Thus, increasing the money supply from 1000
to 1200 causes the equilibrium interest rate to fall from 5 percent to 4 percent.
d. To determine at what level the central bank should set the money supply to raise
DSthe interest rate to 7 percent, set (M/P)(M/P) equal to : M/P=1000-100r.
Setting the price level at 2 and substituting r=7, we find: M=600. For the central
bank to raise the interest rate from 5 percent to 7 percent, it must reduce the
nominal money supply from 1000 to 600.
Question 3: Textbook page 325 Q8. (10 marks)
a. The analysis of changes in government purchases is unaffected by making money
demand dependent on disposable income instead of total expenditure. An increase
in government purchases shifts the IS curve to the right, as in the standard case.
The LM curve is unaffected by this increase. Thus, the analysis is the same as it
R LM IS 2
Y1 Y2 Y
b. A tax cut causes disposable income Y-T to increase at every level of income Y.
This increases consumption for any given level of income as well, so the IS curve
shifts to the right, as in the standard case. If money demand depends on
disposable income, however, then the tax cut increases money demand, so the LM
curve shifts upward. Thus, the analysis of a change in taxes is altered drastically
by making money demand dependent on disposable income. As shown in the
figure, it is possible for a tax cut to be contractionary.
Y2 Y1 Y
Question 4: Textbook page 324 Q4. (10 marks)
a. The IS curve represents the relationship between the interest rate and the level of
income that arises from equilibrium in the market for goods and services. That is, it
describes the combinations of income and the interest rate that satisfy the equation
Y=C(Y-T)+I(r)+G. If investment does not depend on the interest rate, then nothing in the
IS equation depends on the interest rate; income must adjust to ensure that the quantity of
goods produced, Y, equals the quantity of goods demanded, C+I+G. Thus, the IS curve is
vertical at this level, as shown below:
Monetary policy has no effect on output, because the IS curve determines Y. Monetary
policy can affect only the interest rate. In contrast, fiscal policy is effective: output
increases by the full amount that the IS curve shifts.
b. The LM curve represents the combinations of income and the interest rate at
which the money market is in equilibrium. If money demand does not depend on
the interest rate, then we can write the LM equation as M/P=L(Y). For any given
level of real balances M/P, there is only one level of income at which the money
market is in equilibrium. Thus, the LM curve is vertical, as shown below:
Fiscal policy now has no effect on output; it can affect only the interest rate. Monetary
policy is effective: a shift in the LM curve increases output by the full amount of the shift.
c. If money demand does not depend on income, then we can write the LM equation
as M/P=L(r). For any given level of real balances M/P, there is only one level of
the interest rate at which the money market is in equilibrium. Hence, the LM
curve is horizontal, as shown below:
IS LM1 r
Fiscal policy is very effective: output increases by the full amount that the IS curve
shifts. Monetary policy is also effective: an increase in the money supply causes the
interest rate to fall, so the LM curve shifts down.
d. The LM curve gives the combinations of income and the interest rate at which the
supply and demand for real balances are equal, so that the money market is in
equilibrium. The general form of the LM equation is M/P=L(r,Y). Suppose
income Y increases by $1. How much must the interest rate change to keep the
money market in equilibrium? The increase in Y increases money demand. If
money demand is extremely sensitive to the interest rate, then it takes a very small
increase in the interest rate to reduce money demand and restore equilibrium in
the money market. Hence, the LM curve is nearly horizontal, as shown below: 1 r IS LM
An example may make this clearer. Consider a linear version of the LM equation:
M/P=eY-f* r. Note that as f gets larger, money demand becomes increasingly sensitive to the interest rate. Rearranging this equation to solve for r, we find r=(e/f)Y-(1/f)(M/P). We
want to focus on how changes in each of the variables are related to changes in the other
variables. Hence, it is convenient to write this equation in terms of changes: ?r=(e/f) ?Y-
(1/f) ?(M/P). The slope of the LM equation tells us how much r changes when Y changes,
holding M fixed. If ?(M/P)=0, then the slope is ?r/?Y=(e/f). As f gets very large, this
slope gets closer and closer to zero.
If money demand is very sensitive to the interest rate, then fiscal policy is very effective:
with a horizontal LM curve, output increases by the full amount that the IS curve shifts.
Monetary policy is now completely ineffective: an increase in the money supply does not
shift the LM curve at all. We see this in our example by considering what happens if M
increase. For any given Y (so that we set ?Y=0), ?r/?(M/P)=(-1/f); this tells us how
much the LM curve shifts down. As f gets larger, this shift gets smaller and approaches
zero. (This is in contrast to the horizontal LM curve in part (c), which does shift down.)