PS5 Answer Key
University of California, Davis
ECN 101
Problem Set 5
Problem 1: Suppose the parameters of the IS curve are a
¯ = 0, ¯b = 3/4, r¯ =
0.02, and the real interest rate is initially R = 0.02. Explain what happens to short run output in each of the following scenarios (consider each one separately).
a) R rises to 4 percent.
b) R falls to 1 percent.
c) a
¯c increases by 1 percentage point.
d) a
¯g decreases by 2 percentage points.
e) a
¯im decreases by 2 percentage points.
Answer to Problem 1: This is just a straightforward application of the IS formula. You can verify that the changes in short-run output will be as follows:
a) A fall of a fall of 1.5 percent.
b) An increase of 0.75 percent.
c) An increase of 1 percent.
d) A decrease of 2 percent.
e) An increase of 2 percent.1
Problem 2: For each of the following changes in the macro-economy, show how to think about them using the IS curve, and explain how GDP is affected in the short-run. a) The government offers a temporary tax credit: for each dollar of investment that firms undertake, they receive a credit that reduces the taxes they pay on corporate income.
b) A booming economy in Asia this year leads to an unexpected increase of the demand of Asian consumers for US goods.
c) US consumers suddenly appreciate French products and sharply increase
1
Notice that whenever it is one of the a
¯ parameters that changes, the change in output has the same magnitude and sign. This is something we already knew from setting up the model. 1
their imports from that country.
d) A housing bubble bursts, so that housing prices fall by 20 percent and new home sales drop sharply.
Answer to Problem 2:
a) This is an increase in a
¯i . If the government gives temporary tax breaks for investment goods, then regardless of the interest rate, firms want to buy more investment goods. That is an intercept shift (to the right), not a slope shift.
b) This is an increase in a
¯ex . Foreigners want to buy more US produced goods. This shifts the
ECN 101
Problem Set 5
Problem 1: Suppose the parameters of the IS curve are a
¯ = 0, ¯b = 3/4, r¯ =
0.02, and the real interest rate is initially R = 0.02. Explain what happens to short run output in each of the following scenarios (consider each one separately).
a) R rises to 4 percent.
b) R falls to 1 percent.
c) a
¯c increases by 1 percentage point.
d) a
¯g decreases by 2 percentage points.
e) a
¯im decreases by 2 percentage points.
Answer to Problem 1: This is just a straightforward application of the IS formula. You can verify that the changes in short-run output will be as follows:
a) A fall of a fall of 1.5 percent.
b) An increase of 0.75 percent.
c) An increase of 1 percent.
d) A decrease of 2 percent.
e) An increase of 2 percent.1
Problem 2: For each of the following changes in the macro-economy, show how to think about them using the IS curve, and explain how GDP is affected in the short-run. a) The government offers a temporary tax credit: for each dollar of investment that firms undertake, they receive a credit that reduces the taxes they pay on corporate income.
b) A booming economy in Asia this year leads to an unexpected increase of the demand of Asian consumers for US goods.
c) US consumers suddenly appreciate French products and sharply increase
1
Notice that whenever it is one of the a
¯ parameters that changes, the change in output has the same magnitude and sign. This is something we already knew from setting up the model. 1
their imports from that country.
d) A housing bubble bursts, so that housing prices fall by 20 percent and new home sales drop sharply.
Answer to Problem 2:
a) This is an increase in a
¯i . If the government gives temporary tax breaks for investment goods, then regardless of the interest rate, firms want to buy more investment goods. That is an intercept shift (to the right), not a slope shift.
b) This is an increase in a
¯ex . Foreigners want to buy more US produced goods. This shifts the