THE CHINESE UNIVERSITY OF HONG KONG

DEPARTMENT OF ECONOMICS

ECON3021
INTERMEDIATE MACROECONOMIC THEORY

PROBLEM SET 3
1. In the lecture, we derived the effect of an increase in government spending to
output if the price level is fixed. We derived the government spending multiplier.
Now, consider an increase in taxes. Derive the tax multiplier and show the effect
of taxes on output via the Keynesian Cross diagram. For simplicity, assume the
consumption function has the form: c0 + c1(Y-T), where c0 is a constant term, c1
is the marginal propensity to consume, Y is income and T is taxes.

Since Y = C + I + G + (X – M)

Substitute in the consumption function and differentiate with respect to Taxes gives:

Y C  I G  X M
Y  c0  c1 (Y  T )  I  G  X  M
c0  c1T  I  G  X  M
Y
1  c1
Y c1

T (1  c1 )

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2. A shift of the LM curve can occur for which of the following reasons? Explain your
answer
a) A change in the nominal supply of money
b) A change in the demand for money due to a change in the interest rate
c) A change in the demand for money due to a change in income
d) A change in the price level

A change in the nominal supply of money (hence real supply as well as prices remain
unchanged) affects the interest rate at all levels of income, so the LM curve would shift.

A change in the demand for money due to a change in the interest rate is a movement along
the LM curve (see how the LM curve is derived in the lecture notes).

A change in the demand for money due to a change in income is also the way the LM curve
was derived, so too it does not shift the LM curve.

A change in the price level affects the supply of real money, so as in a) this will shift the
LM curve.

3. Suppose consumption is independent of current income. Which of the following(s)

a) There is no IS Curve
b) The government spending multiplier is unity
c) A change in investment will have no effect on real income
d) The IS curve is downward sloping

If consumption in independent of income, the c1 =0 in the consumption function (C = c0 +

The equation of the government spending multiplier is 1/(1-c1), so when c1 =0, the
multiplier is equal to one.

Changes in investment will continue to affect income (if the autonomous component
changes, the IS will still shift).

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 4. New Hamland’s econometricians have estimated the followings:

Consumption Function: C = 200 + 0.75 (Y-T)

a) Derive the IS and LM curves. Illustrate these curves on a diagram.

The IS curve: Y = E = C + I + G
= 200 + 0.75 (Y-100) + 200 – 25r + 100
=> r = 17 – 0.01Y

The LM Curve: MD = MS
Y – 100r = (1000/2)
=> r = 0.01Y -5

b) Find the interest rate and output such that the goods and the money markets are in
equilibrium.

Equating the IS and the LM relations yield:

17 – 0.01Y = 0.01Y – 5
=> Y = 1100

Substitute this value of Y into either the IS or the LM equation:

r=6

c) Derive the Aggregate Demand Curve. Illustrate the Aggregate Demand curve on
a diagram.

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Now, do not substitute the value of P (Prices) in the LM equation, as price is a variable
in the Aggregate Demand curve. The Aggregate Demand curve shows the relationship
between price and output such that both the goods and the money markets are in
equilibrium – equate the IS and LM equations yield:

17 – 0.01Y = 0.01Y – 10/P

Thus the aggregate demand curve is downward sloping in the (P, Y) space.

d) Is fiscal or monetary policy more effective in changing aggregate demand?

The easiest way to answer this question is to use the result in the lecture notes regarding the
relative efficacy of fiscal and monetary policies: Y
G m
 2
Y I1
 ( M / P)
Here: m2 (the sensitivity of money demand to interest rate) is 100, and I1 (the sensitivity of
investment to the interest rate) is 25. So the relative efficacy ratio is 100/25 = 4. Since
this ratio is above 1, fiscal policy is more effective than monetary policy.

The alternative way to do this is to equate the IS and the LM equations again, but letting G
and M/P become variables. Then partially differentiate output Y with respect to these two
items, and you should get the same answer.

Notice that practically it may be difficult to apply these results due to the Lucas Critique –
changes in fiscal policy/monetary policy may affect the underlying behavioral parameters
(e.g. the values of m2 and I1 may change as the new fiscal/monetary policy is in place). This
is a big attack from the new-classical economists on Keynesians.