Problem Set 2 Introduction to Macroeconomics 2021/2022 PDF

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Universitat Pompeu Fabra Introduction to Macroeconomics 2021‐2022 Problem set 2

Section A. Problems 1. In 2020, the coronavirus and its consequences such as the lockdown translated into a decline in consumption of the families. How could the lockdown influence autonomous consumption and the propensity to consume? Represent graphically the consumption function in 2019 and that by the end of 2020. Explain briefly the implications on the short term GDP, income, of that economy. How will that change influence the multiplier?

2019

2020

With Covid two changes in the consumption function can be identified. The first is a decrease in c0 as confidence of consumers decreases and uncertainty about the future increases, triggering consumers to decrease their consumption of durables. The second is a decrease in the marginal propensity to consume, c1 because for the same income, some services are not available (restaurants, traveling for vacation) and thus cannot be consumed. The result is a higher marginal propensity to save. The red line represents the aggregate demand. The first graph corresponds to 2019. The graph on the right, representing aggregate demand after Covid, has a lower autonomous spending, because of the decrease in c0 and a lower slope, because of the decrease in the marginal propensity to consume c1.

2. Focusing just on the GOODS Market, so far we have assumed that the fiscal policy variables G (public expenditure) and T (taxes) are independent of the level of income. In the real world, however, this is not the case. Taxes typically depend on the level of income and so tend to be higher when income is higher.

Consider the following economy: C = c0 + c1(Y‐T). T = t1Y G and I are both constant. Assume that t1 is between 0 and 1. 2.1. Solve for the equilibrium output. Y = ... Y = (1/(1-c1(1-t1)))*(c0+I+G) 2.2. What is the multiplier in this case? Explain how this multiplier works. The multiplier is 1/1-c1(1-t1) meaning that it depends on both the value of c1 (the marginal propensity to consume) and t1 (the taxing index). 2.3. Imagine now that taxes become exogenous, so they do not depend on income but are instead fixed and equal to T. What is the multiplier now? compare it with the one obtained in 2.2 The multiplier would then be 1/1-c1, since only the marginal propensity to consume (c1) would depend on Y. 2.4 For a better understanding of 2.3: regarding the effects of taxes on the economy, check if the economy responds more, less or the same, to changes in autonomous spending when taxes depend on income or when T are constant (exogenous). Try to explain why it is so. The values will vary more when taxes (T) are constant, since the only thing they would change is the height of the curve of consumption, while the taxes that depend on income would change its steepness. In this case the multiplier is smaller, because some of the change in income will be paid as tax, so production will not increase by the same amount as income (Y) and production will increase less when taxes depend on income than when they do not.

3. In late 2017, we could read in The Guardian: ...”Responding to a survey commissioned by Positive Money just before the June election, 85% were unaware that new money was created every time a commercial bank extended a loan, while 70% thought that only the government had the power to create new money....” 3.1 Explain briefly: ...”new money was created every time a commercial bank extended a loan...” Once a commercial bank has enough money to meet its reserve requirements, it can lend any remaining amounts to individuals and corporations that need “credit”.

The loan’s amounts are deposited into a borrower’s checking accounts, which are all liquid for the purchase of goods and services. 3.2 What can you say about: ...” only the government had the power to create new money....” This isn’t correct, since it is the Central Bank, the authority deciding on the amount of money supplied or created, so the government hasn’t any power over the creation of new money.

4. Check the information here and:

4.1 Explain the expected impact of that reserve coefficient along time on the Overall Money Supply. As we know, the reserve coefficient or reserve ratio dictates the reserve amount required to be held in cash by banks, who can either keep the cash on hand or leave it with a local Federal Reserve Bank. If the Federal Reserve decreases the reserve coefficient, it lowers the amount of cash that banks are required to hold in reserves, which increases the nation’s money supply and expands the economy. When the reserve coefficient decreases, the money multiplier increases. 4.2 Detail some decisions which can be adopted by the Central Bank to influence the money supply. For example, for increasing the Money supply, the Central bank can: If the aim is to increase the money supply, the Central Bank can lower the discount rate that banks pay on short-term loans from the Federal Reserve Bank. Doing so, the economic activity boosts, and it increases the Money supply.

5. Let’s now think about the money market. Suppose Pedro’s yearly income is 30.000€, and his money demand function is given by: Md = €Y(0,25 – i). 5.1 Explain why the following statement is false. “Pedro’s money demand does not depend on the interest rate because only bonds yield an interest” Pedro’s money demand does very clearly depend on the interest rate (i), as it can be seen on the given demand function. People can have money in currency and bonds, and the amount of money that people decide to have in bonds depends on the interest rate.

5.2 What happens to the interest rate in Pedro’s country if there is a decrease in income affecting all the domestic economies and the Money supplied in that country does not vary? Represent graphically

The interest rate would decrease, as it can be seen on the graph, since the Md curve would move to the left while the Money supply line would stay the same, making the point where Md = M move down. 5.3 Consider the data provided at the beginning. What will be Pedro’s percentage change in money demand if the interest rate increases from 5% to 10%? And, how does it change if the interest rate decreases from 5% to 2%? Md = 30000*(0,25 – 0,05) = 6000 Md1 = 30000*(0,25 – 0,10) = 4500 Md2 = 30000*(0,25 – 0,02) = 6900 Case 1 = 5% to 10%: ((4500-6000)/6000)*100 = -25% Case 2 = 5% to 2%: ((6900-6000)/6000)*100 = 15% 5.4 There is now the fear of some banking system instability in Pedro’s country. How will this change Pedro’s allocation of money demand between currency and deposits? If everybody in the country reacts as Pedro does, what will happen to the money multiplier? And, what will happen to the total money supply? He will try to get as much of his money in liquid as possible, since he may fear the bank might collapse. If everyone did this, the multiplier would decrease to 1, and the supply would have to increase to a point where it couldn’t keep up with the demand (because of not enough reserves). 5.5 Consider that Pedro holds 27 euros in his wallet, 10.000 euros in German public debt (maturity 10 years), 3.000 euros in other financial assets with a maturity of 1 year, 6.000 euros in his bank (which can be

used immediately), 60 euros at home, and a house that has a value of 100.000 euros. How much money is he holding? 27 + 6000 + 60 = 6087€, since this is the only liquid money he currently has.

6. Assume the public holds no currency, the ratio of reserves to deposits is 0,02 and the demand for money is given by Md = €Y(0,8 –2i). Initially, the monetary base (H) is €61 billion, and nominal income is €4.200 billion 6.1 Calculate the demand function for the Central Bank money (H)

6.2 Determine the value of the money multiplier. Explain the meaning of the obtained value. Money money multiplier= 1/reserve ratio= 1/0,02= 50 6.3 Find the new interest rate (%) if the amount of central bank money increases by €5 billion and compare it with the interest rate before the monetary expansion. What can be concluded from this? Draw a graph which represents approximately this effect on the interest rate.

Section B. Reading

Read: “What Would Keynes Have Done? in The New York Times Nov. 28, 2008, By N. Gregory Mankiw, and answer the following questions: A/ “For many people, the sense of economic uncertainty is greater than they’ve ever experienced. When it comes to discretionary purchases, like a new home, a car, or a washing machine, wait‐and‐see is the most rational course.” How does this feeling of pessimism affect the behavior of the consumers? What variable decreases its value? This sense of economic uncertainty, as well as the feeling of pessimism has affected the behavior of the consumers drastically, in the way that the majority of households try to save more. However, if all households try to do the same, we could have a lower national income, which would prevent households from reaching their saving goals.

B/ “A bit more saving is not entirely unwelcome. Many economists have long lamented the United States saving rate, which is low by international and historical standards”, what variable changes now?

The fact that the sense of economic uncertainty is greater than everyone has ever experienced. In normal times, a fall in consumption could be compensated by an increase in investment, which includes spending companies in equipment and homes in new housing. but there are several factors that keep investment expenditure at bay. C/ “In principle, every dollar spent by the government could cause national income to increase by more than a dollar if it leads to a more vibrant economy and stimulates spending by consumers and companies...”. Explain why one dollar spent in G will increase Y more than 1 dollar. Through the government purchases multiplier, the $1 increase in government spending will lead to an increase in aggregate demand and national income, which will lead to an increase in induced spending....