ECN 101
Problem Set 6
Due Date: Thursday December 3
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) ¯ac increases by 1 percentage point.
d) ¯ag decreases by 2 percentage points.
e) ¯aim decreases by 2 percentage points.
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
their imports from that country.
d) A housing bubble bursts, so that housing prices fall by 20 percent and
new home sales drop sharply.
Problem 3: Suppose that the amount of goods that the US imports depends
not only on potential output (as in our baseline model), but also on the current
state of the economy. In other words, when the economy is booming, imports
go up. To incorporate this channel into the model assume that
IMt
¯ Yt
= ¯aim + ¯n ˜ Yt: (1)
1
The rest of the model remains unchanged.
a) Derive the new IS curve under this specification.
b) How does the parameter ¯n show up in the new IS curve? What is the
economic explanation for that?
Problem 4: Using the IS-MP diagram, explain what happens to the economy
if there is a temporary consumption boom that lasts for one period.
a) Initially, suppose the FED keeps nominal interest rate unchanged.
b) Now suppose you were the chairman of the FED. What action would you
take and why? (Refer to the IS-MP diagram)
Now consider the the full short-run model (that is, include the Phillips curve
and allow the economy to evolve over time). Redo parts (a) and (b) above. Be
sure to provide graphs for output and inflation over time.
Problem 5: If your goal is to stabilize output, explain how you would change
the interest rate in response to the following events (or shocks). In each case,
show the effects on the economy in the short run using the IS-MP diagram.
a) Consumers become pessimistic about the state of the economy and future
productivity growth.
b) Improvements in technology increase the marginal product of capital.
c) A booming economy in Europe this year increases demand for US goods.
d) A housing bubble bursts. Housing prices decline by 20 percent, and new
homes sales drop sharply.
Problem 6: Suppose the slope of the Phillips curve, i.e. the parameter ¯v,
increases. How would the results differ from the Volcker disinflation example
considered in this chapter? What kind of changes in the economy might influence
the parameter ¯v?
2

ECN 101
Problem Set 6
Due Date: Thursday December 3
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) ¯ac increases by 1 percentage point.
d) ¯ag decreases by 2 percentage points.
e) ¯aim decreases by 2 percentage points.
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
their imports from that country.
d) A housing bubble bursts, so that housing prices fall by 20 percent and
new home sales drop sharply.
Problem 3: Suppose that the amount of goods that the US imports depends
not only on potential output (as in our baseline model), but also on the current
state of the economy. In other words, when the economy is booming, imports
go up. To incorporate this channel into the model assume that
IMt
¯ Yt
= ¯aim + ¯n ˜ Yt: (1)
1
The rest of the model remains unchanged.
a) Derive the new IS curve under this specification.
b) How does the parameter ¯n show up in the new IS curve? What is the
economic explanation for that?
Problem 4: Using the IS-MP diagram, explain what happens to the economy
if there is a temporary consumption boom that lasts for one period.
a) Initially, suppose the FED keeps nominal interest rate unchanged.
b) Now suppose you were the chairman of the FED. What action would you
take and why? (Refer to the IS-MP diagram)
Now consider the the full short-run model (that is, include the Phillips curve
and allow the economy to evolve over time). Redo parts (a) and (b) above. Be
sure to provide graphs for output and inflation over time.
Problem 5: If your goal is to stabilize output, explain how you would change
the interest rate in response to the following events (or shocks). In each case,
show the effects on the economy in the short run using the IS-MP diagram.
a) Consumers become pessimistic about the state of the economy and future
productivity growth.
b) Improvements in technology increase the marginal product of capital.
c) A booming economy in Europe this year increases demand for US goods.
d) A housing bubble bursts. Housing prices decline by 20 percent, and new
homes sales drop sharply.
Problem 6: Suppose the slope of the Phillips curve, i.e. the parameter ¯v,
increases. How would the results differ from the Volcker disinflation example
considered in this chapter? What kind of changes in the economy might influence
the parameter ¯v?
2