Assignment 2

Intermediate Macro
Assignment 2
OBL Chapters 5 & 6 & 7 & 8 & 9
1. Consider the following numerical example of the IS-LM model:
C = 200 + 0.25YD
I = 150 + 0.25Y - 1000i
G = 250
T = 200
i = 0.05
a. Derive the IS relation. (Hint: You want an equation with Y on the left side and
everything else on the right.)
b. The central bank sets an interest rate of 5%. How is that decision represented in the
equations?
c. What is the level of real money supply when the interest rate is 5%? Use the
expression: (M/P) = 2Y - 8000i
d. Solve for the equilibrium values of C and I, and verify the value you obtained for Y by
adding C, I, and G.
e. Now suppose that the central bank increases money supply to 1840?. How does this
change the LM curve? Solve for Y, I, and C, and describe in words the effects of an
expansionary monetary policy.
f. Return to the initial situation in which the interest rate set by the central bank is 5%.
Suppose that government spending increases to G = 400. Summarise the effects of
an expansionary fiscal policy on Y, I, and C. What is the effect of the expansionary
fiscal policy on the real money supply?
2. Use the IS-LM model to answer the following questions:
a. Explain in detail what effect a Fed sale of bonds will have on: (1) the LM
curve; and (2) the IS curve.
b. Suppose there is a simultaneous increase in government spending and

reduction in the money supply. Explain what effect this particular policy mix
will have on output and the interest rate. Based on your analysis, do we know
with certainty what effect this policy mix will have on investment? Explain.
c. Suppose there is a fiscal contraction. Using the IS-LM curve illustrate the
contraction and discuss the effect on output and interest rates.
3. Assume that the interest rate, i, for Germany and Switzerland is 3.82%, and the
𝑒
expected rate of inflation, π , in Germany is 2.9% and for Switzerland it is 1.9%.
a. Compute the real interest rates for both countries using the exact formula.
b. Compute the real interest rates for both countries using the approximation formula.
c. Explain the difference between the real interest rates for Germany and Switzerland.
4. Consider a simple bank that has assets of 300, capital of 30, and checking deposits of
270. Recall from Chapter 4 that checking deposits are liabilities of a bank.
a. Set up the bank’s balance sheet.

b. Now suppose that the perceived value of the bank’s assets falls by 10. What is the
new value of the bank’s capital? What is the bank’s leverage ratio?
5. Illustrate and explain using the IS-LM model what would happen to output if bond
holders were to increase their aversion to risk and so their risk premium.
6. The natural rate of unemployment
Suppose that the markup of goods prices over marginal cost is 2%, and that the
wage-setting equation is W = P(1 - u), where u is the unemployment rate.
a. What is the real wage, as determined by the price-setting equation?
b. What is the natural rate of unemployment?
c. Suppose that the markup of prices over costs increases to 4%. What happens to the
natural rate of unemployment? Explain the logic behind your answer.
7. Illustrate (using the WS and PS relations) and explain the effects of an increase in the
minimum wage on the equilibrium real wage, the natural rate of unemployment, the
natural level of employment, and the natural level of output.
8. Exploring the natural rate of unemployment
a. The equation of the Phillips curve from 1980 to 1999 for Country X is
π𝑡 − π𝑡−1 = 6. 2% − 1. 1𝑢𝑡
Calculate and define the natural rate of unemployment using this curve.
b. The equation of the Phillips curve from 2000 to 2020 for Country X is
π𝑡 = 2. 4% − 1. 02𝑢𝑡
Here the natural rate of unemployment cannot immediately be calculated from this Phillips
curve. Explain why.
9. The medium-run equilibrium is characterized by four conditions: Output is equal to

potential output 𝑌 = 𝑌𝑛 and the real policy rate 𝑟𝑛 must be chosen by the central
bank so: The unemployment rate is equal to the natural rate 𝑢 = 𝑢𝑛. The real policy
interest rate is equal to the natural rate of interest 𝑟𝑛 where 𝑟𝑛 is defined as the
( ) ( )
policy rate where 𝑌𝑛 = 𝐶 𝑌𝑛 − 𝑇 + 𝐼 𝑌𝑛, 𝑟𝑛 + 𝑥 + 𝐺. The expected and actual
𝑒
rate of inflation π is equal to the anchored or target rate of inflation π. This implies
the nominal policy rate 𝑖 = 𝑟𝑛 + π.
𝑒
a. If the level of expected inflation is formed so π equals π., explain the
behaviour of inflation in a medium-run equilibrium.
b. Write the IS relation as 𝑌 = 𝐶(𝑌 − 𝑇) + 𝐼(𝑌, 𝑟 + 𝑥) + 𝐺. Suppose 𝑟𝑛 is

3%. If x increases from 4 to 5%, how must the central bank change 𝑟𝑛 to
maintain the existing medium run equilibrium. Explain in words.
10. lllustrate and explain using the IS-LM-PC model the medium term impact of Y
> Yn.
11. Use the IS-LM-PC model to illustrate how the economy adjusts to an increase in
taxes both in the short run and in the medium run.

Assignment 2

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Assignment 2

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Intermediate Macro

OBL Chapters 5 & 6 & 7 & 8 & 9

1. Consider the following numerical example of the IS-LM model:

2. Use the IS-LM model to answer the following questions:

b. Suppose there is a simultaneous increase in government spending and

a. Set up the bank’s balance sheet.

6. The natural rate of unemployment

a. What is the real wage, as determined by the price-setting equation?

b. What is the natural rate of unemployment?

8. Exploring the natural rate of unemployment

9. The medium-run equilibrium is characterized by four conditions: Output is equal to

b. Write the IS relation as 𝑌 = 𝐶(𝑌 − 𝑇) + 𝐼(𝑌, 𝑟 + 𝑥) + 𝐺. Suppose 𝑟𝑛 is

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