Middle East Technical University

Department of Economics
Fall 2010
Econ 502-Macroeconomic Theory I
Date: 03.11.2010
Date due: 16.11.2010

Exercise Set #2
(Questions 1,2,3, and 4 are homeworks due.
Total:100 points)

1. (25 points) Consider an economy described by the following system of equations:

Y =K = A(N=K)1:10 (Production function)

N=K = 0 (w=p)
1 ( 1 < 0; labor demand function)
I = I(r) (I 0 < 0)
C = C(Y T) (0 < C 0 < 1)
C +I +G = Y (National income identity)
M=p = m(r; Y; W ) (money market equilibrium)
mY > 0; mr < 0; mW = 1 (1)

The endogenous variables are

Y; C; I; r; N; p
The exogenous variables are
K; M; w; T; G
with
dK = 0
Let

M +B > 0
dM + dB = 0

Recognize now the money demand described above is also a function of the real wealth held by
the public, W :
M +B
W = +K
p
Establish the stability of the system given above. Then, describe the comparative statics e¤ects on
Y; N; P and r of

1
 a. An increase in the money supply through an open market operation, i.e. dM > 0 but
dM + dB = 0:
b. A once-and-for-all increase in the money supply, not supported by an open market opera-
tion, i.e. dM > 0 but dB = 0:
2. (25 points) Assume an economy in which money matters: the monetary authority can in‡uence
the interest rate, real output and employment, and the price level at any given point in time. Also,
the …rms of this economy are price takers, at least in the labor market, so the marginal product of
labor and the real wage are equal at every moment. Now, suppose that a constant-purchasing-law is
passed, a law that requires all …rms to compensate employees for any change in the commodity price
level by increasing money wages proportionately, i.e.
w
= , a constant
p
What is the signi…cance of this law for the monetary authority? Is it still able to in‡uence real
output and employment, the interest rate, and the price level? Show using a simple model of an
economy.

3. (25 points) Describe how, if at all, each of the following developments a¤ect the IS and/or the
LM curve, and the equilibrium (r; Y ):
a. Taxes fall.
b. Government purchases fall, and at the same time the central bank changes its policy rule to set
a higher real interest rate at a given level of output than before.
c. The demand for money increases (that is, consumer preferences change so that at a given
interest rate and Y they want to hold more real balances than before).
d. Investment demand becomes less sensitive to the interest rate.
4. (25 points) The government budget in the standard Keynesian Model.
a. The balanced budget multiplier. Suppose that aggregate demand is simply given by
C(Y T ) + I(r) + G.
(i) How do equal increases in G and T a¤ect the position of the IS curve? Speci…cally, what is the
e¤ect on Y for a given level of r? (i.e. what is the magnitude of the shift in IS curve?)
(ii) How do equal increases in G and T a¤ect the position of the AD curve? Speci…cally, what is
the e¤ect on Y for a given level of P ? (i.e. what is the magnitude of the shift in AD curve?)
b. Automatic stabilizers. Suppose now that tax revenues, instead of being autonomous, are a
function of income, T = T (Y ); T 0 (Y ) > 0: With this change, …nd how an increase in T 0 (Y ) a¤ects the
following:
(i) the slope of the IS curve.
(ii) the e¤ect of a change in G on Y for a given P .
5. Sargent 1987 page 74, Q1.
6. What are the units of the following variables: ; w; N; p; Y; C; I; G; K; M; B; M +B p ;
M +B
p