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Department of Economics

Macroeconomics

BSc(B)/HA, 2nd

semester, Spring 2010

To be discussed at the 1st tutorial

Relates mainly to Blanchard chapter 3

Problem set 1

Problem 1 (chapter 3)

Consider the following model of the economy:

Z ≡ C + I

C = MPC ∙ Y (MPC: marginal propensity to consume, c1 in Blanchard)

I = I ("planned", “intended”, “desired” investment)

Y = Z

1) Suppose the consumption function is C = 0.7Y and planned investment is 45

a) Draw a diagram showing the aggregate demand schedule

b) What is equilibrium output?

c) Describe in which sense there is a disequilibrium if actual output is equal to, say,

100

[unfortunately, Blanchard does not make much of this point – but nevertheless it is

an important point. Hint: discuss carefully the relation, at Y=100, between output

and sales as well as the relation between “intended”, “planned” investment and

actual total investment]

2) Beginning from equilibrium, investment demand now rises by 15

a) Explain, in purely verbal terms, the ensuing multiplier process

b) How much does equilibrium output increase?

c) How large is the multiplier in this case?

d) What makes up the difference between the eventual increase in output and the

initial increase in investment demand?

3) Assume that people now decide to save a higher proportion of their income: the

consumption function changes from C = 0.7Y to C = 0.5Y.

a) What happens to the equilibrium proportion of income saved?

b) What happens, qualitatively, to equilibrium

income [output]

consumption

investment

savings

4) Explain briefly what is meant by exogenous and endogenous variables by using

examples from above

5) Explain briefly the meaning of the following concepts: Identity, behavioural relation,

parameter, and equilibrium condition – by using examples from above

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Problem 2 (chapter 3)

Consider the following model of the economy in the short run:

Z C + I + G

C = co + c1(Y-T), with co>0 and 0<c1<1

G, T and I are exogenous

Y = Z

1) Explain in words what the macro-economic equilibrium is. Illustrate in a diagram.

2) Try to explain why it is true that output can be different from equilibrium output (“be out

of equilibrium”) for extended periods of time

3) Using the equations above, compute the equilibrium income level, disposable income,

private consumption and private saving using the numbers from Problem 2, Chapter 3

(p. 82 in Blanchard’s 5th

ed.), where autonomous consumption, investment, public

spending on goods and services and net tax revenue are, respectively, equal to 180, 160,

160 and 120, and where the marginal propensity to consume is put equal to 0.8 (NOTE:

these numbers are not, for some reason, the same as in the previous 4th

edition).

4) Compute the effect on the equilibrium income level if there is an increase in government

expenditure (i.e., compute the "multiplier"). Is the multiplier larger than or smaller than

one? Could it be equal to one? Explain.

Problem 3 (chapter 3)

In this problem [which is, admittedly, quite similar to problem 1.3 above], we consider the so-

called "Paradox of Saving" – a macroeconomic finding due to John Maynard Keynes. For

simplicity, we ignore the role of the government (i.e., set G = T = 0). Suppose the

consumption function is C(Y) = co + c1Y, where co>0 and 0<c1<1. Investment I is exogenous.

1) Derive the saving function. What is the marginal propensity to save (MPS)? How is the

MPS related to the marginal propensity to consume?

2) Show, using a diagram showing S and I as a function of Y, that an increase in the MPS

changes equilibrium income. Is saving in the new equilibrium larger than in the

previous, initial equilibrium? What is then the "paradox"?

3) Consider briefly how your conclusions in 2) would be modified if investment (like

consumption) depended positively on Y (this is actually an assumption adopted from

chapter 5 and onwards)

hint: draw the I-curve with a slope which is positive (but less than the slope of the S-

schedule)

4) On TV you hear a politician say: "In order to increase the country's wealth, it is obvious

that we must encourage people to save more."

Use your results above to evaluate this statement: do the results arrived at in 2) and 3)

run counter to this statement?