Intermediate Macroeconomic Theory: 4 questions

Please answer these four questions in details

Question No. 1

Consider the following equation:
Y = 1/ (1−c1) [ c0 + I + G c1T ].

The notations have their usual meanings as discussed in class and in the textbook.

  1. By how much does Y decrease when tax increases by 1 unit? 3pts
  2. Suppose the economy starts with a balanced budget, G = T. Now both G and T
    increase by 1 unit each. What is the change in equilibrium GDP? 3pts
  3. Are balanced budget changes in G and T macroeconomically neutral? Explain
    in a few words.

Question No. 2

a. Define the IS and LM curves and describe their slopes.

b. Show on a graph of IS_LM model, how a tax rebate will affect equilibrium output
and interest rate?

c. What is a multiplier effect in the context of the IS_LM model? What factor does the
value of the tax multiplier depend on? Explain in detail.

Question No. 3

a. The real interest rate is frequently negative. See Figure 6-2 in your textbook.
Under what circumstances can it be negative? If so , then why not just hold cash
instead of bonds?

b. Consider the risk premium formula presented in your textbook:
(1+i) = (1-p)(1+i+x)+p(0), the symbols have their usual meanings (as given in
chapter 6).

i. If the probability of bankruptcy is 10%, what is the risk premium if the
interest rate on a risk free bond is 1%? Show your work.

ii. Calculate the nominal interest for a borrower when the probability of
bankruptcy is 5% and the nominal policy interest rate is 3%. Show your

c. Using the graph for the extended IS_LM model (the one with real interest
rate and output), analyze what happened during the 2008 Financial crisis.
Explain clearly why policies failed to avoid a major recession? (Note: page
limit for part( d) is 1 page).

Question No. 4

4. Graphically illustrate (using wage-setting (WS) and price-setting (PS) relations)
and explain the effects of a reduction in markup on equilibrium real wage, the
natural rate of unemployment, the natural level of employment, and the natural level
of output.

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