ps1_answer_sheet - Economics 134 Spring 2012 Professor...

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1 Economics 134 Professor Christina Romer Spring 2012 Professor David Romer SUGGESTED ANSWERS TO PROBLEM SET 1 1. a. The conditions indicate that we should consider the IS-MP model, since the central bank is following a monetary policy rule for the interest rate, not targeting the money supply. Under the new monetary policy rule, every given level of output, other things held constant, is associated with a lower target real interest rate set by the central bank. Thus the described change in the monetary policy rule is reflected in the IS-MP model as a downward shift of the MP curve. In the new equilibrium, output is higher and the real interest rate is lower: Y 1 > Y 0 , r 1 < r 0 . b. The conditions indicate that we should consider the IS-LM model, since the central bank is targeting the money supply rather than the interest rate. If the central bank raises its target for the money stock it means that the money supply in the economy increases from (M/P) S 0 to (M/P) S 1 and, hence, for any given level of output, the nominal interest rate is lower (below left graph). Assuming that expected inflation is unaffected, the LM curve shifts downwards, resulting in higher equilibrium output and a lower equilibrium real interest rate: Y 1 > Y 0 , r 1 < r 0 . IS MP 0 MP 1 r Y r 0 r 1 Y 1 Y 0
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2 c. An increase in consumption for every level of disposable income shifts the planned expenditure curve upwards, resulting in higher output for every given interest rate. Thus the IS curve shifts to the right. Since the monetary policy rule remains the same, the MP curve is unaffected. In the new equilibrium, output and the real interest rate are higher: Y 1 > Y 0 , r 1 > r 0 . M/P E 0 E Y Y’ Y 0 E=Y E 1 IS r Y r 0 r 1 Y 1 Y 0 r 0 LM 0 LM 1 L(i,Y 0 ) i i 0 i 0 (M/P) S 1 (M/P) S 0 IS 0 r r 1 r 0 Y Y’ Y 0 IS 1 MP Y 1
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3 2. a. With this change in the consumption function, C=C(Y-T, r), we still have a downward- sloping IS curve, since increases in r still reduce planned expenditures. (An increase in r now lowers consumption as well as investment, so the IS curve is flatter.) The increase in G shifts the planned expenditure curve up (from E 0 to E 1 , left graph), and thus the IS curve shifts out (from IS 0 to IS 1 , right graph). Both the real interest rate and output rise: Y 1 > Y 0 , r 1 > r 0 . Since consumption is now a positive function of output but a negative function of the real interest rate,
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ps1_answer_sheet - Economics 134 Spring 2012 Professor...

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