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ISL244E
Macroeconomics
Problem Session-5
by
Research Assistant
Serkan Değirmenci
D202/12-14.03.2012
# Today #
• GNH (2009), Macroeconomics in Context
- Chapter 11: Money and Monetary Policy
Review Questions (RQ): 14-15-16-17-18 (Page:
285)
 Exercises (E): 4 (Page: 286)
• Blanchard (2009), Macroeconomics:
#THE SHORT RUN# (CHP. 3 + CHP. 4 = CHP. 5)
- Chapter 3: The Goods Market: (btw pages: 65-84)
Quick Check (QC): 1-2-3 (Page: 82)
Dig Deeper (DD): 4-5-7 (Page: 82-83)
GNH-Chapter-11-RQ-14 (Page: 285)
14. What is the quantity equation?
ANSWER: (pages: 278-280)
*quantity equation: MV=PY, where M is the money supply, V is the velocity
of money, P is the price level and Y is the real output.
MV=PY
Y: real output or GDP (REAL GDP)
P: price level as measured by the (GDP deflator)
PY: nominal output (NOMINAL GDP)
M: level of money balances (M1 measure)
V: velocity of money
GNH-Chapter-11-RQ-15 (Page: 285)
15. What is the quantity theory of money?
ANSWER: (pages: 278-280)
*quantity theory of money: the theory that money supply is directly related
to nominal GDP, according to the equation MxVbar=PxY.
MV=PY with V assumed constant.
Y: real output or GDP (REAL GDP)
P: price level as measured by the (GDP deflator)
PY: nominal output (NOMINAL GDP)
M: level of money balances (M1 measure)
V: velocity of money
GNH-Chapter-11-RQ-16 (Page: 285)
16. Describe classical monetary theory.
ANSWER: (pages: 280)
*Classical monetary theory is based on the quantity theory of money, plus
In this
changes
in theconstant
money supply
have NO
the assumption
thatcase,
output
is always
at itscan
full-employment
level.
effect on the level of output.
The inability of changes in the money supply to affect
MV=PY
with
V constant
and Y=Y*.
real output
is called
MONETARY
NEUTRALITY.
The only variable on the left side that is not constant is
the money
supply,
while or
theGDP
only variable
on the right
Y: real
output
(REAL GDP)
side that is not constant is the price level.
Y*:
FULL
EMPLOYMENT
Thus, all
that
a change
in the money OUTPUT
supply can do is
prices.
P: change
price
level as measured by the (GDP deflator)
Rather than an increase in the money supply increasing
output,
this modeloutput
the only(NOMINAL
thing an increase
in the
PY:innominal
GDP)
money supply does cause inflation.
M: level of money balances (M1 measure)
V: velocity of money
GNH-Chapter-11-RQ-17 (Page: 285)
17. What is monetarism?
ANSWER: (pages: 280-281)
*monetarism: a theory associated with Milton Friedman, which claims that
macroeconomic objectives are best met by having the money supply grow at
a steady rate.
MV=PY, with V constant and a claim that a decrease in M can
cause both P and Y to decrease.
Y: real output or GDP (REAL GDP)
P: price level as measured by the (GDP deflator)
PY: nominal output (NOMINAL GDP)
M: level of money balances (M1 measure)
V: velocity of money
GNH-Chapter-11-RQ-18 (Page: 285)
18. Discuss how monetary expansion can lead to high inflation,
using the quantity equation.
ANSWER: (pages: 281-282)
If M rises and V and Y are constant or do not rise much, P must rise.
Y: real output or GDP (REAL GDP)
P: price level as measured by the (GDP deflator)
PY: nominal output (NOMINAL GDP)
M: level of money balances (M1 measure)
V: velocity of money
GNH-Chapter-11-E-4 (Page: 286)
4. Suppose the level of nominal GDP in Estilvania is $30 billion, and the
level of the money supply is $10 billion.
a. What is the velocity of money in Estilvania?
b. Suppose that the money supply increases to $15 billion and nominal
GDP rises to $45 billion. Which theory is supported?
c. Suppose that the money supply increases to $15 billion and nominal
GDP rises to $40 billion. Which theory is supported?
d. Suppose that the money supply decreases to $5 billion and as a result
both the price level and real GDP fall, so that nominal GDP falls to $15
billion. Which theory is supported?
e. Suppose that the money supply increases to $15 billion. Real GDP
stays the same, at its full-employment level, but the price level rises so
that nominal GDP becomes $45 billion. Which theory is supported?
GNH-Chapter-11-E-4 (Page: 286)-answer
ANSWER:
a. V = 3 (That is, according to MV=PY, 10V=30).
b. Quantity theory of money. (V is constant)
c. Keynesian theories (V is variable) (page: 280)
d. Monetarism (V is constant, and a drop in M causes a drop in
both P and Y)
e. Classical theory (V is constant and Y is constant at full
employment).
(This might arguably be a Keynesian theory with output
happening to be at its full employment level, but for the fact
that V is constant.)
B-Chapter-3-QC-1 (Page: 82)
1.
Using the information in this chapter, label each of following statements true, false,
or uncertain. Explain briefly.
a.
b.
The largest component of GDP is consumption. (T) (page: 67-table 3-1)
Government spending, including transfers, was equal to 19% of GDP in
2006. (F)-Government spending excluding transfers was 19% of GDP.
The propensity to consume has to be positive, but otherwise it can take
on any positive value. (F)- The propensity to consume must be less than one
c.
for our model to make sense. (page: 69)
d.
e.
f.
Fiscal policy describes the choice of government spending and taxes
and is treated as exogenous in our goods market model. (T) (page: 70)
The equilibrium condition for the goods market states that
consumption equals output. (F) (page: 71)
An increase of one unit in government spending leads to an increase
of one unit in equilibrium output. (F)- The increase in output is one times the
multiplier. (page: 72)
g.
An increase in the propensity to consume leads to a decrease in output. (F)
(page: 72)
B-Chapter-3-QC-2 (Page: 82)
2. Suppose that the economy is characterized by
the following behavioral equations:
C = 180 + 0.8YD
I = 160
G = 160
T = 120
Solve for the following variables.
a. Equilibrium GDP (Y)
b. Disposable income (YD)
c. Consumption spending (C)
B-Chapter-3-QC-2 (Page: 82)-answer (pages: 70-72)
2.
a.
Y=C+I+G
Y = 180 + 0.8(Y-120) + 160 + 160
Y = 2020
b.
YD = Y – T = 2020 – 120 = 1900
c.
C = 180 + 0.8YD
C = 180 + 0.8(1900) = 1700
B-Chapter-3-QC-3 (Page: 82)
3. Use the economy described in problem 2.
a. Solve for equilibrium output. Compute total
demand. Is it equal to production? Explain.
b. Assume that G is now equal to 136. Solve for
equilibrium output. Compute total demand. Is it
equal to production? Explain.
c. Assume that G is equal to 136, so output is given
by your answer to (b). Compute private plus
public saving. Is the sum of private and public
saving equal to investment? Explain.
B-Chapter-3-QC-3 (Page: 82)-answer (pages: 67-75 + 78-79)
3.
a. Equilibrium output is 2020.
Total demand = C + I + G = 1700 + 160 + 160 = 2020.
Total demand equals production.
We used this equilibrium condition to solve for output.
b. Output falls by (24 times the multiplier) = 24/(1-.8) = 120.
So, equilibrium output is now 1900.
Total demand = C + I + G = 180+0.8(1780) + 160 + 136 = 1900.
Again, total demand equals production.
c. Private saving = Y – C – T = 1900 – 180 - 0.8(1780) – 120 = 176.
Public saving = T – G = 120 – 136 = -16.
National saving (or in short, saving) equals private plus public saving, or 160.
National saving equals investment.
This statement is mathematically equivalent to the equilibrium condition,
total demand equals production.
In other words, there is an alternative (and equivalent) equilibrium
condition: national saving equals investment. (READ: 78-79)
B-Chapter-3-DD-4 (Page: 82)
4. The balanced budget multiplier.
For both political and macroeconomic reasons, governments
are often reluctant to run budget deficits.
Here, we examine whether policy changes in G and T that
maintain a balanced budget are macroeconomically neutral.
Put another way, we examine whether it is possible to affect
output through changes in G and T so that the government
budget remains balanced. Start from equation (3.8).
B-Chapter-3-DD-4 (Page: 82)-cont.
4.
a.
b.
c.
d.
e.
By how much does Y increase when G increases by one unit?
By how much does Y decrease when T increases by one unit?
Why are your answers to (a) and (b) different?
Suppose that the economy starts with a balanced budget: G=T.
If the increase in G is equal to the increase in T, then the budget
remains in balance. Let us now compute the balanced budget
multiplier.
Suppose that G and T increase by one unit each. Using your
answers to (a) and (b), what is the change in equilibrium GDP? Are
balanced budget changes in G and T macroeconomically neutral?
How does the specific value of the propensity to consume affect
your answer to (a d)? Why?
B-Chapter-3-DD-4 (Page: 82)-answer
4.
a.
b.
c.
d.
e.
Y increases by 1/(1-c1)
Y decreases by c1/(1-c1)
The answers differ because spending affects
demand directly, but taxes affect demand
indirectly through consumption, and the
propensity to consume is less than one.
The change in Y equals 1/(1-c1) - c1/(1- c1)=1.
Balanced budget changes in G and T are
not macroeconomically neutral.
The propensity to consume has no effect because
the balanced budget tax increase aborts the
multiplier process. Y and T both increase by one
unit, so disposable income, and hence
consumption, do not change.
B-Chapter-3-QC-5 (Page: 82-83)
5. Automatic stabilizers
So far in this chapter, we have assumed that the
fiscal policy variables G and T are independent of
the level of income. In the real world, however,
this is not the case. Taxes typically depend on the
level of income and so tend to be higher when
income is higher. In this problem, we examine how
this automatic response of taxes can help reduce
the impact of changes in autonomous spending on
output.
B-Chapter-3-QC-5 (Page: 82-83)-cont.
5. Consider the following behavioral equations:
C = c0 + c1YD
T = t0 + t1Y
YD = Y – T
G and I are both constant. Assume that t1 is between 0 and
1.
a. Solve for equilibrium output.
b. What is the multiplier? Does the economy respond more
to changes in autonomous spending when t1 is 0 or when t1
is positive? Explain.
c. Why is fiscal policy in this case called an automatic
stabilizer?
B-Chapter-3-QC-5 (Page: 82-83)-answer
5.
a.
Y=c0+c1YD+I+G implies
Y=[1/(1-c1+c1t1)][c0-c1t0+I+G]
b.
The multiplier=1/(1-c1+c1t1)<1/(1-c1), so the economy
responds less to changes in autonomous spending when t1
is positive. After a positive change in autonomous
spending, the increase in total taxes (because of the
increase in income) tends to lessen the increase in output.
After a negative change in autonomous spending, the fall in
total taxes tends to lessen the decrease in output.
c.
Because of the automatic effect of taxes on the economy,
the economy responds less to changes in autonomous
spending than in the case where taxes are independent of
income. Since output tends to vary less (to be more stable),
fiscal policy is called an automatic stabilizer.
B-Chapter-3-QC-7 (Page: 83)
7. Investment and income
This problem examines the implications of
allowing investment to depend on output.
Chapter 5 carries this analysis much further and
introduces an essential relation-the effect of the
interest rate on investment-not examined in this
problem.
B-Chapter-3-QC-7 (Page: 83)-cont.
7.
a. Suppose the economy is characterized by the following behavioral
equations:
C = c0 + c1YD
YD = Y – T
I = b0 + b1Y
Government spending and taxes are constant. Note that investment now
increases with output. (Chapter 5 discusses the reasons for this relation.)
Solve for equilibrium output.
b. What is the value of the multiplier? How does the relation between
investment and output affect the value of the multiplier? For the
multiplier to be positive, what condition must (c1 + b1) satisfy? Explain
your answers.
c. Suppose that the paramater b0, sometimes called business
confidence, increases. How will equilibrium output be affected? Will
investment change by more or less than the change in b0? Why? What
will happen to national saving?
B-Chapter-3-QC-7 (Page: 83)-answer
7.
a.
Y=C+I+G
Y=[1/(1-c1-b1)]*[c0-c1T+b0+G]
b.
Including the b1Y term in the investment equation increases
the multiplier. Increases in autonomous spending now
create a multiplier effect through two channels:
consumption and investment. For the multiplier to be
positive, the condition c1+b1<1 is required.
c.
Output increases by b0 times the multiplier. Investment
increases by the change in b0 plus b1 times the change in
output. The change in business confidence leads to an
increase in output, which induces an additional increase in
investment. Since investment increases, and saving equals
investment, saving must also increase. The increase in
output leads to an increase in saving.
to be continued…

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