UNIVERSITY OF SOUTHERN CALIFORNIA

Department of Economics: Spring 2017

ECON 305: Intermediate Macroeconomics

MIDTERM EXAM

February 21, 2017

There are three questions on this exam. A complete exam will have answers to
all three questions. Good luck!
Question 1: The Goods Market

Suppose the goods market is described by the following behavioral relations:

𝐶 = 𝑐0 + 𝑐1 𝑌 𝐷

𝐼 = 𝑖0 + 𝑖1 𝑌

𝑇 = 𝑡0 + 𝑡1 𝑌

𝑌𝐷 = 𝑌 − 𝑇

and G (government spending) is greater than zero and exogenous. Assume that the
values of c1, t1 , and i1 are between 0 and 1, and that c0 is greater than zero.

a) Interpret and describe in words what each of the behavioral relations

represents. Solve for equilibrium output, Y, as a function of autonomous and
exogenous variables only.

C = c0 + c1YD is the consumption function. Consumption expenditure of

households on real GDP has an autonomous component, c0, which is the
value of consumption that would occur if disposable income were zero. It
also has a component that increases with disposable income, c1YD,
so as household disposable real income rises households consume higher
levels of GDP. c1 is the marginal propensity to consume out of disposable
income. It is less than one because each unit of additional real income is
divided between consumption and savings. Here, YD = Y – T is the definition
of disposable income which is real income (equal to real GDP) minus net
taxes, T. Net taxes equals taxes paid by households less government income
transfers to households.

T = t0 + t1Y describes how net taxes on households are determined. Net taxes
have an autonomous component, t0, which is the value of net taxes that
would be paid if household income were zero (this could be negative if
transfers exceed taxes at zero income, which is probably the case). Net taxes
also increase proportionally with income, t1Y, so as household real income
rises net taxes increase in proportion. t1 is the value of this proportion (e.g.
0.3). Taxes usually increase roughly in proportion to income while transfers
tend to decline with income. It is usually less than one; governments do not
tax away all of each additional unit of income.

I = i0 + i1Y is an investment function. Investment expenditure of firms

on real GDP has an autonomous component, i0, which is the
value of investment that would occur if firms’ sales were zero (this could be
negative if inventory investment were negative and also could include
depreciation expenditure). It also has a component that increases with sales
 of firms, which increase with the level of output or GDP, i1Y, so as output and
GDP rise, sales increase, and firms invest higher levels of output in building
new capital.

Write down the equilibrium condition: 𝑌 = 𝑍 = 𝐶 + 𝐼 + 𝐺 , or

𝑌 = 𝑐0 + 𝑐1 𝑌 − 𝑐1 𝑡0 − 𝑐1 𝑡1 Y + 𝑖0 + 𝑖1 𝑌 + G

Solve for Y.

1
𝑌=( ) (𝑐0 + 𝑖0 + 𝐺 − 𝑐1 𝑡0 )
1 − 𝑐1 + 𝑐1 𝑡1 − 𝑖1

b) Write down the multiplier for autonomous spending changes from your
solution in a). How does an increase in c1 affect the value of the multiplier?
Explain this result.

1
( )
1 − 𝑐1 + 𝑐1 𝑡1 − 𝑖1

An increase in c1 has two effects. It increases the multiplier directly because

for any increase in autonomous spending leading to higher GDP, Y, and
income, households now consume a higher fraction of the increase in
income, raising demand and output by a larger amount. Consumption is
more sensitive to higher income. However, a higher c1 also means that
consumption is more sensitive to any increase in net taxes due to higher
autonomous spending, GDP and income; such increases in the income
sensitive part of net taxes reduces consumption by a larger amount through
𝑐1 𝑡1. The net effect is positive however; 1 − 𝑐1 + 𝑐1 𝑡1 − 𝑖1 = 1 − 𝑐1 (1 −
𝑡1 ) − 𝑖1 is decreasing in 𝑐1 with 𝑡1 < 1, and hence the multiplier is
increasing in 𝑐1 .

c) How does the dependence of taxes on output through t1 affect the value of
the multiplier, compared to a situation in which taxes were independent of
output and t1 = 0? Explain.

A higher (positive) t1 decreases the multiplier because for any increase in

autonomous spending leading to higher GDP and hence earned income, Y,
disposable income declines due to higher taxes; T increases. Thus,
compared to a case where taxes do not depend on income, the impact of
higher autonomous demand, output, and earned income for disposable
income is diminished. Household consumption expenditure and the
endogenous portion of total demand thus increase by less as a result. That
 the effect is negative is clear; 1 − 𝑐1 + 𝑐1 𝑡1 − 𝑖1 = 1 − 𝑐1 (1 − 𝑡1 ) − 𝑖1 is
increasing in 𝑡1 , and hence the multiplier is decreasing in 𝑡1 .

d) How does the dependence of investment on output through i1 affect the

value of the multiplier compared to a situation in which investment was
independent of output and i1 =0? Explain.

A higher (positive) i1 increases the multiplier because for any increase in

autonomous spending leading to higher GDP and hence earned income, Y,
firms’ sales increase and their investment spending rises as a result. Thus,
compared to a case where investment does not depend on income, total
demand rises by more in response to the endogenous increases in output
and income resulting from an increase in autonomous spending because of
this dependence. This increases the multiplier effects of higher autonomous
spending for output. That the effect is positive is clear; 1 − 𝑐1 + 𝑐1 𝑡1 − 𝑖1 =
1 − 𝑐1 (1 − 𝑡1 ) − 𝑖1 is decreasing in 𝑖1 , and hence the multiplier is increasing
in 𝑖1 .

Question 2: The Money Market

Suppose that money demand is given by

𝑀𝑑 = 𝑃𝑌(0.5 − 𝑖 )
where PY is nominal GDP and i is the interest rate on bonds. Also let M denote the
supply of money by the Federal Reserve. Assume there are no banks or bank
deposits.

a) Depict the money demand function in a graph in which M and i are on the
axes. Why does the money demand function slope (up or down) in the way
that you have drawn it?

The money demand function is downward sloping in this space. At higher

bond interest rates, households want to hold more bonds and less money in
their wealth portfolio and conversely for lower bond interest rates. The
money demand function is drawn for a given level of nominal income.

b) Suppose that PY = 500 and M = 200. Solve for the interest rate at which the
money market is in equilibrium. Draw a diagram depicting this equilibrium
and label the equilibrium values of M and i on the diagram.

Write out the equilibrium condition:

𝑀 = 𝑃𝑌(0.5 − 𝑖 )

200 = 500(0.5 − 𝑖 ) = 250 − 500𝑖

 250 − 200 50
𝑖= = = 0.1.
500 500

The money demand curve should intersect a vertical money supply function
at an interest rate of 10% and a money supply of 200.

c) Suppose the Federal Reserve wants to set the interest rate equal to 5 percent.
What level must it set the money supply M at to achieve this interest rate,
assuming that nominal GDP continues to be equal to 500? Explain how the
Fed changes the money supply, and how the money supply differs from the
level of 200 in b). Explain why it differs from the level of 200 in b).

Solve the money market equilibrium condition by setting i=0.05, and finding
the M that is consistent with equilibrium at this interest rate.

𝑀 = 𝑃𝑌(0.5 − 0.05)

𝑀 = 500(0.5 − 0.05) = 250 − 500𝑥0.05

𝑀 = 250 − 25 = 225.

This implies that to reduce the interest rate on bonds, the Fed must increase
the amount of money, from 200 to 225. It achieves this increase by printing
currency, and using it to purchase bonds from households in an open market
operation. To persuade households to sell bonds and hold more money in
exchange, the Fed offers higher bond prices to households and this reduces
the interest rate on bonds as the Fed desires.

d) Suppose that the level of nominal GDP increases from 500 to 550. The Fed
continues to set the money supply to achieve an interest rate of 5 percent, as
you assumed in b). Depict the effect of the increase in nominal GDP for the
money demand function in a graph. Compute the level of the money supply
the Fed must set to achieve its interest rate target, and depict this policy in
your graph.

The money demand function shifts to the right in a graph of money demand
against the bond interest rate.

𝑀 = 𝑃𝑌(0.5 − 0.05)

𝑀 = 550(0.5 − 0.05) = 275 − 550𝑥0.05

𝑀 = 275 − 27.5 = 247.5

In the graph, the interest rate of 5 percent is a horizontal line, and the vertical
money supply curve must shift to the right from 225 to 247.5.
Question 3: The IS-LM Model

Consider the following IS-LM model:

𝐶 = 500 + 0.5𝑌 𝐷

𝐼 = 250 + 0.25𝑌 − 500𝑖

𝐺 = 250

𝑇 = 250

𝑀 𝑑
( ) = 5𝑌 − 200,000𝑖
𝑃

𝑀/𝑃 = 5000

a) Write down the IS relation, and describe in words what the IS relation
represents. Depict the associated IS curve in a diagram (don’t worry about
numerical axis labels).

Write down the equilibrium condition for the goods market:

𝑌 =𝑍 =𝐶+𝐼+𝐺

𝑌 = 500 + 0.5𝑌 − 0.5𝑇 + 250 + 0.25𝑌 − 500𝑖 + 250

𝑌 = 500 + 0.5𝑌 − 125 + 250 + 0.2𝑌 − 500𝑖 + 250

𝑌 = 875 + 0.75𝑌 − 500𝑖

0.25𝑌 = 875 − 500𝑖

500
𝑌 = 875/0.25 − ( )𝑖
0.25

𝑌 = 3500 − 2000𝑖

IS curve is downward sloping in (i,Y) space.

b) Derive the LM relation, and describe in words what the LM relation represents.
Depict the associated LM curve in a diagram (don’t worry about numerical axis
labels). What does the variable, P, denote? Be specific.
 Write down the equilibrium condition for money market and solve for Y as a
function of i:

𝑀/𝑃 = 5𝑌 − 200,000𝑖

5000 = 5𝑌 − 200,000𝑖

5𝑌 = 5000 + 200,000𝑖

200,000
𝑌 = 5000/5 + ( )𝑖
5

𝑌 = 1000 + 40,000𝑖

The LM curve is upwards sloping in (Y,i) space. P denotes the GDP deflator.

c) Solve for short-run equilibrium real output, Y, and the equilibrium interest
rate, i, by combining the IS and LM relations. In what direction will these
equilibrium values change if the Federal Reserve increases the money supply?
Show the effects of an increase in an IS-LM diagram. (Hint: Go back to the
money market equilibrium diagram first, and see what happens to the interest
rate needed for money market equilibrium for any given output level. Use this
to alter the LM curve).

Set output in the IS relation equal to output in the LM relation and solve for i:

3500 − 2000𝑖 = 1000 + 40,000𝑖

2500 = 38,000𝑖

2500
𝑖= = 0.0658
38,000

This is the equilibrium interest rate. Substitute back into either IS or LM to

compute equilibrium output:

𝑌 = 1000 + 40,000𝑖

𝑌 = 1000 + 2631.58 = 3631.58

If M/P increases, the LM curve shifts to the right in an IS-LM diagram. The
equilibrium output level rises and the equilibrium interest rate falls.

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