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# ps3ans - ECON 305: INTERMEDIATE MACROECONOMICS SPRING 2011...

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ECON 305: INTERMEDIATE MACROECONOMICS SPRING 2011 MARK MOORE PROBLEM SET 3: SOLUTIONS A. CHAPTER 5 Quick Check 1. a. True. b. True. c. False. d. False. The balanced budget multiplier is positive (it equals one), so the IS curve shifts right. e. False. f. Uncertain. An increase in government spending leads to an increase in output (which tends to increase investment), but also to an increase in the interest rate (which tends to reduce investment). g. True. 2. a. Y =[1/(1- c 1 )][ c 0 - c 1 T + I + G ] The multiplier is 1/(1- c 1 ). b. Y =[1/(1- c 1 - b 1 )][ c 0 - c 1 T + b 0 - b 2 i + G ] The multiplier is 1/(1- c 1 - b 1 ). Since the multiplier is larger than the multiplier in part (a), the effect of a change in autonomous spending is bigger than in part (a). An increase in autonomous spending now leads to an increase in investment as well as consumption. c. Substituting for the interest rate in the answer to part (b), Y =[1/(1- c 1 - b 1 + b 2 d 1 / d 2 )][ c 0 - c 1 T + b 0 +( b 2 / d 2 )( M / P )+ G ]. The multiplier is 1/(1- c 1 - b 1 + b 2 d 1 / d 2 ). d. The multiplier is greater (less) than the multiplier in part (a) if ( b 1 - b 2 d 1 / d 2 ) is greater (less) than zero. The multiplier as measured in part (c) measures the marginal effect of an increase in autonomous spending on equilibrium output. As such, the multiplier is the sum of two effects: a direct effect of output on demand and an indirect effect of output on demand via the interest rate. The direct effect is equivalent to the horizontal shift of the IS curve. The indirect effect depends on the slope of the LM curve (since the equilibrium moves along the LM curve in response to a shift of the IS curve) and the effect of the interest rate on investment demand.

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The direct effect is captured by the sum c 1 + b 1 , which measures the marginal effect of an increase in output on the sum of consumption and investment demand. As this sum increases, the multiplier gets larger. The indirect effect is captured by the expression b 2 d 1 / d 2 and tends to reduce the size of the multiplier. The ratio d 1 / d 2 is the slope of the LM curve, and the parameter b 2 measures the marginal effect of an increase in the interest rate on investment. Note that the slope of the LM curve becomes larger as money demand becomes more sensitive to income (i.e., as d 1 increases) and becomes smaller as money demand becomes more sensitive to the interest rate (i.e., as d 2 increases). 3. a. The IS curve shifts left. Output and the interest rate fall. The effect on investment is ambiguous because the output and interest rate effects work in opposite directions: the fall in output tends to reduce investment, but the fall in the interest rate tends to increase it. b.
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## This note was uploaded on 05/26/2011 for the course ECON 305 taught by Professor Dekle during the Spring '07 term at USC.

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ps3ans - ECON 305: INTERMEDIATE MACROECONOMICS SPRING 2011...

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