U6301 Macroeconomics for International and Public Affairs Martsella Davitaya
Columbia University | SIPA
Problem Set #8
Suggested Solutions
_____________________________________________________________________________
Deadline. 11:59 pm April 18, 2024
Instructions. The electronic version (either scanned or typed up) of solutions must be uploaded to
CourseWorks by the indicated deadline. Solutions submitted after the deadline will receive 0 points.
Solutions submitted via email will receive 0 points. Solutions can be submitted individually or by a
group of up to 4 students. You can work in a group with students from sections 1, 2, 3, and 4 only. If
you work in a group, please indicate all names and UNI-s on top of the first page.
Problem 1. Derivation of LM curve
In a particular economy the real money demand function is
𝑀𝐷
= 3000 + 0.1𝑌 − 10000𝑖
𝑃
Assume that 𝑀𝑆 = 6000, P=2.0, and 𝜋 𝑒 = 0.02.
a) What is the real interest rate, r, that clears the asset market when Y=8000? When Y=9000? Graph the
LM curve.
Substitute 𝜋 𝑒 = 0.02 to real money demand equation to get
𝑀𝐷
= 2800 + 0.1𝑌 − 10000𝑟
𝑃
Money market clears when 𝑀𝐷 = 𝑀𝑆 , so in equilibrium
3000 = 2800 + 0.1𝑌 − 10000𝑟
1
𝑟 = −0.02 + 𝑌
100000
When 𝑌 = 8000, 𝑟 = −0.02 + 0.08 = 0.06. When 𝑌 = 9000, 𝑟 = −0.02 + 0.09 = 0.07.
b) Repeat part a) for M=6600. How does the LM curve in this case compare with the LM curve in part
a)?
3300 = 2800 + 0.1𝑌 − 10000𝑟
1
𝑟 = −0.05 + 𝑌
100000
When 𝑌 = 8000, 𝑟 = −0.05 + 0.08 = 0.03. When 𝑌 = 9000, 𝑟 = −0.05 + 0.09 = 0.04. The LM curve shifts
down, since the same level of Y gives a lower r in equilibrium.
c) Use M=6000 again and repeat part a) for 𝜋 𝑒 = 0.03. Compare the LM curve in this case with the one
in part a).
The real money demand is now
𝑀𝐷
= 2700 + 0.1𝑌 − 10000𝑟
𝑃
Money market clears when 𝑀𝐷 = 𝑀𝑆 , so in equilibrium
3000 = 2700 + 0.1𝑌 − 10000𝑟
1
𝑟 = −0.03 + 𝑌
100000
When 𝑌 = 8000, 𝑟 = 0.05. When 𝑌 = 9000, 𝑟 = 0.06. The LM curve shifts down, since there is a higher real
interest rate for every given level of output. The LM curve shifts down by one percentage point (the increase in
𝜋 𝑒 ) because for any given Y, the same nominal interest rate clears the asset market. With an unchanged nominal
interest rate, the increase in 𝜋 𝑒 is matched by an equal decrease in r.
Problem 2. IS-LM and price adjustment
The labor demand in an economy is
𝑁𝐷 = 1000 − 100𝑤
The labor supply curve is
𝑁𝑆 = 55 + 10(1 − 𝑡)𝑤
where t is the tax rate on wage income, which is 0.5.
Desired consumption and investment are
𝐶 = 300 + 0.8(𝑌 − 𝑇) − 200𝑟
𝐼 = 258.5 − 250𝑟
Taxes and government purchases are
𝑇 = 20 + 0.5𝑌
𝐺 = 50
Money demand is
𝑀𝐷
= 0.5𝑌 − 250(𝑟 + 𝜋 𝑒 )
𝑃
The expected rate of inflation, 𝜋 𝑒 , is 0.02, and the nominal money supply 𝑀𝑆 = 9150.
a) What are the general equilibrium levels of the real wage, employment, and output, if production
function is given by 𝑌 = 10𝑁 − 0.005𝑁 2 ?
̅ = 100 and 𝑤
From labor market equilibrium condition 𝑁𝐷 = 𝑁𝑆 , 𝑁 ̅ = 9. Hence, 𝑌̅ = 950.
b) For any level of output, Y, find an equation that gives the real interest rate, r, that clears the goods
market; this equation describes the IS curve. (Hint: Write the goods market equilibrium condition
and solve for r in terms of Y and other variables.) What are the general equilibrium (long-run) values
of the real interest rate, consumption, and investment?
From 𝑆 = 𝐼, −334 + 0.6𝑌 + 200𝑟 = 258.5 − 250𝑟, so
0.004
𝑟 = 1.317 − 𝑌
3
With full-employment output of 950, using this in the IS curve and solving for r gives r=0.05. Plugging these
results into the consumption and investment equations gives C=654 and I=246.
c) For any level of output, Y, find an equation that gives the real interest rate that clears the asset
market; this equation describes the LM curve. [Hint: As in part (b), write the appropriate equilibrium
condition and solve for r in terms of Y and other variables.] What is the general equilibrium (long-
run) value of the price level?
Setting money demand equal to money supply gives 9150/P=0.5Y-250(r+0.02). With Y=950 and r=0.05, solving
for P gives P=20.
d) Provide the IS-LM-FE graph using the equations you found in parts a) - c).
1.317
-1.85
=950
e) Suppose that government purchases increase to G=72.5. Now what are the general equilibrium
(long-run) values of the real wage, employment, output, the real interest rate, consumption,
investment, and price level? Show the long-run effects of increase in G in the IS-LM-FE diagram.
0.004
𝑟 = 1.367 − 𝑌
3
With Y= 950, using this in the IS curve and solving for r gives r=0.1, the LM curve gives P=20.56. Plugging
these results into the consumption and investment equations gives C=644 and I=233.5. The real wage,
employment, and output are unaffected by the change. IS curve shifts to the right, increase in price level shifts
LM curve up.
C
0.10
B
0.05
A
Problem 3. Shocks in IS-LM-FE Framework, Short- and Long-run Equilibria
Use the IS–LM-FE model to determine the effects of each of the following on the general equilibrium
values of the real wage, employment, output, real interest rate, consumption, investment, and price
level. Indicate with A, B, and C the equilibrium before the shock, short-run equilibrium, and long-run
equilibrium respectively. Assume that A is at full employment.
a) A reduction in the effective tax rate on capital that increases desired investment.
The increase in desired investment shifts the IS curve to the right. In the long run, the price level rises, shifting
the LM curve up to restore equilibrium. Since the real interest rate rises, consumption declines. In summary,
there is no change in the real wage, employment, or output; there is a rise in the real interest rate, the price level,
and investment; and there is a decline in consumption.
b) The expected rate of inflation rises.
The rise in expected inflation shifts the LM curve down. In the long run, the price level rises, shifting the LM
curve up to restore equilibrium. Since the real interest rate is unchanged, consumption and investment are
unchanged. In summary, there is no change in the real wage, employment, output, the real interest rate,
consumption, or investment; and there is a rise in the price level.
A=C
c) An influx of working-age immigrants.
The labor supply curve shifts to the right. This leads to a decline in the real wage rate and an increase in
employment. The rise in employment causes an increase in output, shifting the FE line to the right. In the long
run, the price level must decline, shifting the LM curve down. Since output increases and the real interest rate
declines, consumption and investment increase. In summary, the real wage, the real interest rate, and the price
level decline; and employment, output, consumption, and investment rise.
A
d) Increased usage of automatic teller machines that reduces the demand for money.
The reduction in the demand for money gives results identical to those in part b).
Problem 4. Money Markets and IS-LM
Suppose an increase in robberies in the streets makes people hold less money.
a) How does this event affect the money market in the short-run if the Fed keeps the money supply
constant? Graph the effects of this shock in the money market and IS-LM diagrams.
The demand for money shifts left. The interest rate falls and the quantity of money remains unchanged. The LM
curve shifts right. The interest rate falls and output rises.
b) How does this event affect the money market in the short-run if the Fed keeps the interest rate
constant? Graph the effects of this shock in the money market and IS-LM diagrams.
The demand for money shifts left. The Fed decreases the money supply so that the intersection between the vertical
money supply and the demand for money schedules occurs at the interest rate that prevailed in the economy before
robberies started. The LM curve shifts right and then the Fed changes money supply so it shifts back.
Figure for a) Figure for b)