Introductory Macroeconomics, Hilary Term 2024

Week 6 Problem Set

1. Describe and illustrate how, if at all, the following changes affect the LM curve:


1. An increase in the demand for money;


2. An increase in government purchases;


3. An increase in the supply of money;


4. A decrease in the price level;


5. A decrease in output;


2. Consider a closed economy IS-LM model. The components of expenditure are given by the following equations:
   
   C = 100 + 0.5*(Y-T)
   G = G
   T = T
   I = 100 - 10*r
   
   where C is consumption, Y income, T lump-sum taxation, G government purchases, I investment and r the real interest rate. (G and T are exogenously determined byt the government.) Money demand (M^d) and money supply (M^s) are defined as follows:
   
   M^=d = 0.5*Y - 20*r
   M^=s = 200
   


1. Calculate the equilibrium values of income and the real interest rate in terms of the fiscal instruments G and T.


2. Calculate the partial derivatives δY/δG and δY/δT. Use your results to find the value of the balanced budget multiplier in this model. Carefully explain the intuition behind the theory of the balanced budget multiplier.


3. The government has announced plans to increase both G and T by 10. The central bank argues that this will cause income to increase too rapidly, and decides to vary the money supply in order to keep income at its level prior to the fiscal intervention. By how much must the money supply change in order for this objective to be achieved?


4. An economist commenting on the central bank decision writes "The reduction in the money supply is bad news for companies, who will be forced to reduce investment. In contrast, consumer spending will be unaffected." In the context of the IS-LM model presented in this question, are these statements true or false? Explain your answer carefully.

This question is from the 2009 prelims paper.


3. Suppose a central bank is considering two alternative policies: i) holding the money supply constant (possibly requiring active responses to changing conditions), and ii) holding the interest rate constant by adjusting the money supply.
   
   According to the IS-LM model, which policy will do a better job stabilising output if
   
   
   1. All shocks to the economy arise from exogenous changes in the demand for goods and services.
   2. All shocks to the economy arise from exogenous changes in the demand for money.
   
   This question is from Mankiw & Taylor.


4. What determines the steepness of:
   
   
   1. The IS curve?
   
   
   2. The LM curve?
   
   
5. Explain whether borrowing constraints increase or decrease the potency of fiscal policy to influence aggregate demand in each of the following cases:
   
   
   1. a temporary tax cut;
   
   
   2. an announced future tax cut.
   
   
   
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