Macro Theory
M. Finkler
Answers to Problem Set #6
1a.
As foreign and domestic assets become more substitutable, the CF becomes flatter,
because a small change in the interest rate now has a larger effect on capital flows.
b.
A flatter CF curve, similar to increased interest rate sensitivity, translates into a flatter IS
curve.
c.
If the IS curve become flatter, shifts in the LM curve translate into larger changes in Y
and smaller changes in r. This means that the Fed has less control over interest rates.
d.
As noted in c, a flatter IS curve means monetary policy would have greater influence on
output.
r
LM1
LM2
ISflat
ISsteep
Y
2a.
In the Mundell-Fleming variation of the IS-LM model, changes in interest rates are
required to change the level of investment without affecting Y or e. Consider four options:
↑MP and ↑ FP – this would raise income (violating the assumptions)
↑MP and ↓ FP – this would reduce the interest rate but this will lower the exchange rate as
capital would flow out (violating the assumptions)
↓MP and ↓FP – this would reduce income (and violate the assumptions)
↓MP and ↑FP – this would raise the interest rate which would cause e to rise so capital would
flow in (violating the assumptions).
b.
Policymakers could ↑MP, ↓FP, and place quotas on imports. These opposite pressures
for MP and FP would mean lower interest rates and unchanged income. The fall in interest rates
would cause the exchange rate to fall and investment to rise. To counter the downward pressure
on the exchange rate, import controls could be imposed. Investment in this case would rise, but
contractionary FP and increased net exports would bring Y back to its initial level.
c.
Policymakers could follow the same policies as in part b for MP and FP which again
could be designed to yield lower r and the same Y with increased I. If the lower interest rate set
in the home country, which puts downward pressure on the exchange rate, is matched by similar
policies abroad (↑MP, ↓FP), capital outflow would not take place since the exchange market
balance would not change (since relative interest rates would not have changed.) In this case,
increased I, the same Y, and the same e could be generated.
3. Strategy: plug the LM equation into the IS equation and solve for AD in terms of P.
AD = a + e + G - d*[(k/n)*AD - M/h + P/h]
1 - b*(1-t)
AD*[1 - b*(1-t) + d*(k/n)] = a + e + G + (d/h)*M - (d/h)*P
Now solve for AD to yield:
AD = a + e + G + (d/h)*M - (d/h)*P
1 - b*(1-t) + d*k/h
This is the AD curve; it has slope Δ P/ Δ AD = - 1 - b*(1-t) + d*k/h
d/h
b. Strategy: plug the LD curve into the production function & solve for Y in terms of P.
Y = s1*[d0 - d1*(W/P) + d2*K] + s2*K
= s1*d0 - s1*d1*(W/P) + [s1*d2 + s2]*K
This is the AS equation. Note: As P increases, W/P falls so Y increases.
c. Consider the case where tax rates (t) increase. Analysis of the tax decrease case follows the
same process, but all shifts are in the opposition direction.
Begin with two primary shifts:
1. The LS curve shifts toward the vertical axis and
2. The AD curve shifts towards the origin and becomes steeper, since the IS curve shifts
in and becomes steeper.
W/P
Ls' Ls
P
AS
AD
Ld
AD'
L
Y
The first shift affects the calculation of the unemployment rate, the market clearing level in the
labor market, as well as the long run position of the AS curve. The second shift affects both the
goods market and the position along the labor demand curve.
Results: Prices, output, and the quantity of labor demanded fall while unemployment rises.
Since the IS curve shifts in (as t rises) and the LM curve shifts away from the vertical axis (as P
falls), with Y falling, r must fall.
4. An increase in defense expenditures can be modeled as a rise in G. As a consequence AD
shifts out, and P and Y rise. In the labor market, an increased price level leads to a decreased
real wage; thus, the quantity of labor demanded rises. Since the rise in G also represents an
outward shift of the IS curve, initially r must rise. Since prices rise, the LM curve shifts up, so r
rises for a second reason. Summary: output, prices and interest rates rise while real wages fall.
P
AS
W/P
AD
Ls
r
Ld
LM
IS
Y
L
Y
5. A fall in oil prices leads to a rise in raw materials (RM), a positive supply shock. This
translates into two shifts:
1. Upward shift in the production function and
2. Outward shift in the labor demand curve.
When we re-derive the AS curve, we find that it has shifted to the right.
Y
W/P
Ls
P
Ld
L
AS
AD
L
Y
Result: Output, employment, and real wages rise while prices fall. Be sure to align the position
in the labor market with that in the goods market.
6. If the Federal Reserve reduces M, the LM curve would shift back. In the goods market, the
Aggregate Demand curve would shift down (and become steeper). As a result, both output and
prices would fall. In the labor market, W/P would rise; therefore, the quantity of labor demanded
would fall. Since the LM has shifted back, along a given IS curve, r would rise.
W/P
Ls
P
AS
Ld
AD
L
Y
7.
If money (nominal) wages are fully indexed to the price level, then changes in prices will
not affect real wages; thus, changes in Aggregate Demand will have no effect on the quantity of
labor demanded or on output. In such an economic environment, monetary or fiscal policy
cannot be used to moderate cycles.
Essentially, nominal wages adjust with changes in the cost of living; so W becomes
endogenous. The results of changes in AD parallel those generated from Model 1 despite the
different stopping point in the labor market. Graphically, changes in P lead to changes in W that
leave the labor market unchanged; AD and AS shifts counter each other in output terms in the
goods market.
W/P
Ls
P
AS’
AS
AD’
Ld
AD
L
Y