Macroeconomics I May 2026

Third-Term Workshop
May 2026

General instructions. The workshop is composed of four Questions with a total of 22 num-
bered exercises. Every exercise requires (i) a clear, labeled graphical representation, (ii) explicit
theoretical justication, and (iii) a verbal explanation of the economic mechanism. Answers without
graphs or without justication will be considered incomplete. Fixed prices (short-run analysis) are
assumed unless otherwise stated. In open-economy settings, small open economy with perfect
capital mobility is assumed, r = r∗ , unless otherwise stated.
Conventions and notation:
Y, r Output and domestic real interest rate
r∗ World interest rate (exogenous)
θ Country risk premium, so that r = r∗ + θ
e Nominal exchange rate (Mankiw's convention: e↑ is an appreciation of
the peso)
ē Fixed exchange rate announced by the central bank
M, P Nominal money supply and price level
G, T Government spending and tax revenue
I(r), C(Y − T ) Investment and consumption functions, with I′ < 0 and 0 < C′ < 1
N X(e) Net exports, with N X ′ (e) < 0 (Mankiw's convention)
L(r, Y ) Real money demand, with Lr < 0 and LY > 0

Question

ISLM Model: Closed Economy

Model Setting
Consider a closed economy with xed prices in the short run, described by the following equations:

Y = C(Y − T ) + I(r) + G (IS)

M
= L(r, Y ) (LM)
P
where the partial derivatives satisfy:

∂C ∂I ∂L ∂L
= C ′ ∈ (0, 1) <0 <0 >0
∂(Y − T ) ∂r ∂r ∂Y

Graphical and Mechanism Analysis

1. Pure expansionary scal policy

Consider a closed economy in initial equilibrium (Y0 , r0 ) at point A. The government decides to
increase public spending by ∆G > 0 nanced with debt, keeping T , M , and P constant.

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(a) Plot the (Y, r) plane with the curves IS0 , LM0 and the initial equilibrium A. Clearly identify
the new curve IS1 and the new equilibrium B. (b) By what magnitude does the IS curve shift
horizontally? Compare with the simple Keynesian multiplier and explain why the nal eect on Y
is smaller than the one predicted by such multiplier. (c) Explain step by step the money-market
adjustment mechanism that justies the rise in the interest rate. (d) Qualitatively determine the
eect on consumption C , investment I , and the public balance T −G. Is there crowding out ? Justify.

2. Contractionary monetary policy with IS of dierent slopes

A closed economy is in equilibrium when the central bank decides to reduce the nominal money supply
by ∆M < 0 to ght future inationary pressures. Assume that investment is highly sensitive to
the interest rate (very elastic/at IS).

(a) Plot the initial equilibrium and the LM shift. Compare it to a case where the IS is more vertical
(investment little sensitive to r). Draw two separate diagrams. (b) In which of the two cases does
monetary policy have a stronger eect on output? Justify algebraically by dierentiating the ISLM
system. (c) Explain in economic terms why the interest-elasticity of investment is critical for the
eectiveness of monetary policy.

3. Policy combination (policy mix )

The government and the central bank face a dilemma: output is below potential, but public debt is
very high, which limits scal space. They decide to implement simultaneously ∆G > 0 and ∆M > 0.
(a) Plot the simultaneous shifts of IS and LM. Clearly mark the initial equilibrium A, the equilibrium
with only scal policy B, and the nal equilibrium with both policies C. (b) How does the nal
interest rate compare with the initial one? Discuss under which condition stabilizing the interest rate
is achieved ( accommodating monetary policy ). (c) Explain why this policy mix avoids the crowding
out of private investment. (d) Which macroeconomic objectives does each authority pursue and how
do they complement each other?

4. Fiscal policy eectiveness and sensitivities

Consider two closed economies identical in everything except in the slopes of their curves. Economy
A has a very elastic LM (almost horizontal) and economy B has a very inelastic LM (almost vertical).

(a) Characterize which economic conditions give rise to an almost-horizontal LM and to an almost-
vertical LM (think about the elasticities of money demand). (b) Apply the same expansionary scal
policy ∆G > 0 to both economies. Plot in separate panels. (c) In which economy is scal policy
more eective at moving output? Justify graphically and verbally. (d) Connect your answer to the
concept of liquidity trap and discuss the relevance of this discussion for post-2008 economic policy.

Question

MundellFleming Model: Open Economy

Model Setting
Consider a small open economy (SOE) with perfect capital mobility that behaves according to the

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following equations:

Y = C(Y − T ) + I(r∗ ) + G + N X(e) (IS∗ )

M
= L(r∗ , Y ) (LM∗ )
P
r = r∗

Where r∗ is the world interest rate, e is the nominal exchange rate (Mankiw's convention: ∂N X/∂e <
0), and P̄ and P̄ ∗ are assumed xed in the short run. The IS∗ curve has a negative slope in the
(Y, e) plane; the LM∗ curve is vertical.

Graphical and Mechanism Analysis

5. Expansionary scal policy under exible exchange rate

A small open economy with perfect capital mobility and a exible exchange rate implements an
increase in public spending ∆G > 0.
(a) Plot in the (Y, e) plane the initial and nal equilibria, explicitly showing which curve shifts and
in what direction. (b) Explain step by step, via the international capital ow, why r does not rise
in equilibrium even though IS
∗ shifts to the right. (c) Determine the eects on Y , e, N X , and I . Is
there crowding out ? If so, of what kind? (d) Compare quantitatively with the closed-economy case
of Exercise 1. In what sense is scal policy said to be less powerful in this regime?

6. Monetary policy under xed exchange rate

A central bank that maintains a xed exchange rate ē tries to implement a monetary expansion
∆M > 0 to stimulate economic activity.

(a) Plot the initial attempted shift of LM

∗ and show why the economy reverts to the initial equilib-
rium. (b) Explain in detail the exchange-rate arbitrage mechanism that forces the central bank to
contract M. (c) Conclude on the ineectiveness of monetary policy in this regime. Which policy
instrument does the central bank retain? (d) Under which conditions could the central bank break
the peg? Briey discuss speculative attacks.

7. Increase in country risk premium

A rating agency downgrades the country's sovereign debt. Foreign investors now demand an addi-
tional return θ>0 to hold domestic assets. The risk-adjusted parity rate is r = r∗ + θ. Assume a
exible regime.
(a) Modify the IS
∗ and LM∗ equations incorporating θ and explain what happens to each curve in
the (Y, e) plane when θ ↑. (b) Plot the new equilibrium. In which direction do Y and e move?
Be careful: the result is not obvious. (c) Discuss the three practical reasons why output may not
increase despite the currency depreciation. (d) Analyze the self-fullling prophecy: if agents expect
the currency to depreciate tomorrow, why does it depreciate today?

8. Negative exports shock

The world economy enters a recession and external demand for the country's products falls sharply:

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exports decrease by an amount ∆X < 0 for each level of e. Analyze under (a) exible exchange rate
and (b) xed exchange rate.

(a) Flexible: Which curve shifts and in what direction? Plot the new equilibrium. Flexible:
(b)
Determine the eects on Y , e, N X . Explain why the exchange-rate adjustment insulates output
from the shock ( insulation eect). (c) Fixed: Show that without the possibility of exchange-rate
adjustment, output must fall. How does M adjust? What happens to the central bank's international
reserves? (d) Reect: the exible regime insulates from the shock but at the cost of what.

Question

Transmission Mechanisms: Macroeconomic Shocks

Instructions for this section

For each exercise, the student must structure the answer in six sequential steps: (i) identify the
variable initially aected by the shock; (ii) determine the curve that shifts and the direction; (iii)
describe the sequential adjustment in the goods market and in the money market (and, if applicable,
in the foreign-exchange market); (iv) characterize the new equilibrium; (v) quantify (in sign) the
nal eects on Y , r , e, I , C , N X ; (vi) provide a complete graphical representation, with all curves,
equilibria, and shifts labeled.

9. Permanent increase in public spending (closed economy)

Congress passes a permanent increase in public infrastructure spending worth 2% of GDP.

Apply the six steps of transmission. Be especially careful to explain: (a) why the initial rise in Y
generates pressure in the money market; (b) how that pressure is reabsorbed via ↑ r; (c) what the
net eect on private investment is and why ( crowding out ).

10. Increase in household taxes (closed economy)

The government raises household income taxes by an amount ∆T > 0, keeping G constant.

Apply the six steps. Additionally: (a) compare the tax multiplier −C /(1 − C ) with the spending
′ ′
′
multiplier 1/(1 − C ). Why do they dier? (b) If the government raises G and T by the same
magnitude (balanced budget), is the eect on Y zero? Justify with Haavelmo's balanced-budget
theorem.

11. Increase in the international interest rate (exible regime)

The Federal Reserve raises r∗ by 200 basis points. The economy under analysis is a small open
economy with a exible exchange rate and perfect capital mobility.
Apply the six steps. Be explicit about: (a) the eect of ↑ r∗ on domestic investment (via the
condition r = r∗ ); (b) the exchange-rate readjustment that follows the change in the rate; (c) the
net eect on N X , and therefore on Y .

12. Capital ight (sudden stop ) under exible regime

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After an episode of political instability, foreign investors lose condence in the country. The risk
premium θ jumps abruptly.

Apply the six steps. Additionally discuss: (a) why this shock, unlike ↑ r∗ , has contradictory eects
∗ ∗ ∗ ∗
on IS and LM ; (b) which of the two eects (contraction of IS vs. expansion of LM ) dominates in
practice for an emerging economy, and why; (c) why central banks typically raise rates in response,
violating the model's prescription.

Question

True or False (with graphical justication)

Instruction: For each statement: (i) indicate whether it is True, False, or Partially true ; (ii)
provide a rigorous theoretical justication; (iii) draw the corresponding graph in the appropriate
model (ISLM or MundellFleming); (iv) if the statement is partially true, specify under which
conditions it becomes false. Answers without a graph will not be graded.

13. Under a exible exchange rate and perfect capital mobility, monetary policy is more
eective than scal policy at moving output in the short run.

14. An exogenous increase in money demand shifts the IS curve to the left.

15. With perfect capital mobility and a xed exchange rate, monetary policy loses all
ability to aect output, but the central bank retains control over the monetary base.

16. In a closed economy, expansionary scal policy is more eective the more sensitive
investment is to the interest rate.

17. The impossible trinity states that a country can simultaneously have perfect capital
mobility, a xed exchange rate, and an independent monetary policy, provided the
central bank accumulates sucient international reserves.

18. In the MundellFleming model, the LM∗ curve is vertical because money-market
equilibrium does not depend on the exchange rate.

19. A nominal depreciation of the exchange rate (Mankiw's convention: ↓ e) always

improves the trade balance immediately.

20. In the ISLM model, if the LM curve is horizontal (liquidity trap), an expansionary
scal policy generates no crowding out of private investment.

Question

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Macroeconomics I May 2026

Aggregate supply and the short-run tradeo between ination and unemployment

21. Monetary Volatility and Aggregate Supply with Imperfect Information

From the perspective of the aggregate-supply model with imperfect information: how can the volatil-
ity of the money supply inuence the slope of aggregate supply? What implications does it have for
the adjustment of prices vs. quantities?

22. Credibility and Disination Costs under Rational Expectations

According to the rational-expectations approach, if everyone believes that policymakers are commit-
ted to reducing ination, the cost of reducing it  the sacrice ratio  will be lower than if the public
is skeptical about the authorities' intentions. Why might this be true? How could credibility be
achieved?