Econ 304 Sonoma State University Fall 2007 Dr. Robert Eyler Suggested Answers to Homework #4 1.The interest rate is the “price” in most macroeconomic models. a.The IS-LM model looks like a supply and demand framework on purpose. Explain why real GDP is the “quantity” in this market, and why the real interest rate is this market’s “price”. Real GDP is the quantity in this “market” because it represents the macroeconomy’s purchasing power. The IS-LM model is a mix of nominal (money) and real (goods) markets. Real GDP reflects the production level of goods and services given costs of both production and consumption. The real interest rate is the price in this market because it is a combination of the nominal rate of interest, inflation expectations and other risks. For example, as inflation expectations rise, the real interest rate falls and consumption rises as a reaction. This assumes that nominal interest rates are less mobile than general prices. However, the combination of nominal rates and prices provides the real price of both consumption and production, the real interest rate. b.Where is the labor market in this IS-LM graph? Explain. The labor market is inside the IS curve, because the goods market combines both the use of labor income for consumption (including imports) and the production of goods and services, y. This is best seen in the IS-LM analog to the real business cycle (RBC) model, where the RBC model suggests that only real shocks lead to business cycle propagation. When labor becomes marginally more productive, the IS curve shifts to the right as more spending takes place, assuming that wages rise as firms look to purchase the marginally more productive labor units. The unemployed worker may also take signals from policy to increase labor supply, shifting IS to the tight as these unemployed workers become employed and enhance spending at the macroeconomic level. 2.We looked at a lot of examples of the IS-LM model in this class. a.Show the effects of a fiscal expansion in symbols, words and the IS-LM graph. The symbology is as follows: G↑or T↓⇒y ↑⇒Mdshifts to the right ⇒r↑⇒Id↓⇒y↓The net effects of these movements are for interest rates to rise and for real GDP to rise, where the government is acting like another consumer. The real interest rate rising reflects macroeconomic scarcity. The arrows show that the movement from one equilibrium to the other is not along the LM curve but in a disequilibrium fashion to the new rate-GDP combination.
y* y2 r2 r* y LM IS2IS r b.Show the effects of a fiscal contraction in symbols, words and the IS-LM graph. The symbology is as follows: G↓or T↑⇒y ↓⇒Mdshifts to the left ⇒r↓⇒Id↑⇒y↑The net effects of these movements are for interest rates to fall and for real GDP to fall, where the government is reducing its spending or forcing consumers to reduce spending due to higher taxes. The real interest rate falling reflects a lower scarcity of money and goods and services. The arrows show that