ECON1102 Macroeconomics 1- Marginal Propensity To Consume

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ECON1102 Macroeconomics 1

1. (a) Show that the value of the multiplier in the three-sector version of the Keynesian model as set out in the following equations is: . (10 marks)

AE = C + I + G  (income accounting identity)

C  = C*+ c(Y-tY) (behavioural relation for consumption) where c is the marginal propensity to consume and t is the tax rate

I =I* (behavioural relation for investment)

G = G* (behavioural relation for government purchases)

In equilibrium, Y= AE

(b)  Using the IS-LM model, trace through what happens to the interest rate and output if the following policy changes are made: monetary policy is tightened and the government expands its spending. (10 marks)

2. (a) Suppose that an economy is operating with 25% inflationand 3% unemployment (which we will assume is consistent with full-employment output) and that the monetary authorities decide to act to get inflation under control. Outline what will happen if we assume an expectations-augmented Phillips curve in unemployment-inflation (12 marks)

(b) A set of Phillips curves in output-inflation space can be defined as:

p = p-1+ a(y-ye) or, more explicitly including a subscript for the time period as:

pt = p t -1+ a(y-ye). Draw a set of such Phillips curves for a=2 and explain what the parameter a tells us about how an economy would respond to tight monetary policy. (8 marks)

3. In the IS-PC-MR modelit is assumed that the Central Bank has in mind a target rate of inflation but is also concerned about output (and, therefore, employment). This idea is represented by a “loss function” such as L = (y-ye)2 + b(p-pT)2.

• Ifb>1, sketch a set of such loss functions in output-inflation space. (5 marks)
• The Phillips curve of the formp = p-1+ a(y-ye) acts as a constraint on getting loss down to zero. Show how to use Phillips curves to derive a monetary policy rule for a Central Bank which has the sort of loss function described in (a). (5 marks)
• In setting monetary policy, a Central Bank needs knowledge of parameters such as a, b, yeand pT. Explain what each of these parameters is and their importance in setting monetary policy. (10 marks)

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