Second Semester 2016/17 Coventry University

Intermediate Economics 2
(201ECN)

Revision 01 on Macroeconomics
(w/c 23rd January 2017)

The IS-TR Model (Part 1)

Exercise 1.1
Define the following terms:

a. Domestic absorption,

b. Tobin’s q,

c. Real exchange rate.

Exercise 1.2
Consider the following short-run macroeconomic model:

Y S = Y + Z, (1)
D
Y = C + I + G + X, (2)
Z = Z(A, σ ), (3)
+ +
C = C(Ω,Y − T ), (4)
+ +
I = I(q , i ), (5)
+ −
X = X(A∗ , σ ), (6)
+ −
S D
Y =Y . (7)

Notation
A Domestic absorption (C + I + G) I Investment X Exports Z Imports
A∗ Foreign absorption (C∗ + I ∗ + G∗ ) i interest rate Y Output σ Real exchange rate
C Consumption q Tobin’s q YD Demand for goods (domestic/foreign prices)
G Government spending T Taxes YS Supply of goods Ω Wealth

Please solve each of the following exercises:

a. Provide an economic interpretation of each equation.

b. Provide an economic explanation of every partial derivative specified in Equation (3) to (6).

c. Solve the model and use a diagram to illustrate the solution.

Exercise 1.3
Consider the following three scenarios:

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Scenario Variable ”Before” ”After”

Interest Rate 0.05 = 5% 0.06 = 6%
A
Investment 200 195
Interest Rate 0.03 = 3% 0.05 = 5%
B
Investment 600 540
Interest Rate 0.03 = 3% 0.01 = 1%
C
Investment 600 660
Please solve each of the following exercises:
a. For each scenario, calculate the interest semi-elasticity of investment and interpret your result.

b. For each scenario, calculate the interest elasticity of investment and interpret your result.

Exercise 1.4
For each of the following events, explain how the IS curve will respond and illustrate the response in a
diagram:
a. An increase in taxes.

b. A decrease of Tobin’s q.

c. An increase in foreign absorption.

Exercise 1.5
Define the following terms:
a. Real money supply,

b. Nominal money demand,

c. Liquidity preference.

Exercise 1.6
Consider the following short-run macroeconomic model:

MS = M
P, (8)
M D = kY , (9)
k = k( i ), (10)
−
M = MD.
S
(11)

Notation
i Interest rate MD Demand for money
k Liquidity preference MS Supply of money
M Money P Price level
Y Output

Please solve each of the following exercises:

a. Provide an economic interpretation of each equation.

b. Provide an economic explanation of the partial derivative specified in Equation (10).

c. Solve the model and use a diagram to illustrate the solution.

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Exercise 1.7
The Taylor rule stipulates that a central bank should set its policy rate i such that:

i = ī + a (π − π̄) + b Y −
Ȳ
Ȳ
,

where ī reflects the ’neutral interest rate’, π and Y denotes actual inflation and output, π̄ and Ȳ denotes
the inflation target and the output target, and a and b are non-negative parameters.

a. Interpret the neutral interest rate ī as well as the actual interest rate i.

b. Interpret the parameters a and b.

Exercise 1.8
For each of the following events, explain how the TR curve will respond:

a. A decrease of the inflation rate,

b. An increase in the output target.

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Answers to Exercise 1.1

Exercise 1.1.a
Domestic absorption refers to domestic spending on both, domestically produced and imported goods
and services. Formally, domestic absorption A can be defined as:

A = C + I + G,

where C denotes domestic consumption, I denotes domestic investment and G denotes domestic gov-
ernment spending.

Exercise 1.1.b
Tobin’s q is defined as:
Market value of installed capital
Tobin’s q = Replacement cost of installed capital .
That is:

• The numerator of Tobin’s q is the firms’ value as priced by the stock market.

• The denominator of Tobin’s q is the amount that would have to be spent to replace the capital
goods incorporated in existing firms.

Exercise 1.1.c
The real exchange rate σ is defined as:
SP
σ= P∗ ,
where S denotes the nominal exchange rate (in British terms, i.e. in terms of foreign currency per unit
of domestic currency), P denotes the domestic price level, and P∗ denotes the foreign price level. That
is:

• The numerator reflects the price level of domestic goods in foreign currency.

• The denominator reflects the price level of foreign goods in foreign currency.

Answers to Exercise 1.2

Exercise 1.2.a
The system of equations reflects the goods market of an economy:

• Equation (1) reflects the domestic (Y ) and foreign (Z) supply of goods.

• Equation (2) reflects the domestic (C + i + G) and foreign (X) demand for goods.

• Equation (3) reflects the import function.

• Equation (4) reflects the consumption function.

• Equation (5) reflects the investment function.

• Equation (6) reflects the export function.

• Equation (7) reflects the equilibrium condition for the domestic goods market.

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Exercise 1.2.b
You can find a detailed economic explanation of the partial derivatives in Burda & Wyplosz (2013, pp.
238-240).

Exercise 1.2.c
Model Solution We can solve the model in two steps. Insertion of (1) and (2) in (7) results in:
Y + Z = C + I + G + X. (12)
Insertion of (3), (4), (5) and (6) in (12) results in:
Y + Z(A, σ ) = C(Ω,Y − T ) + I(q , i ) + G + X(A∗ , σ ),
+ + + + + − + −

Y = C(Ω,Y − T ) + I(q , i ) + G + X(A∗ , σ ) − Z(A, σ ). (13)

+ + + − + − + +

Diagram
LHS,
RHS
LHS (Supply)

RHS (Demand)

𝑌0∗

𝑌0∗ Output Y

Answers to Exercise 1.3

Exercise 1.3.a
Definition of the Interest Semi-elasticity of Investment The interest semi-elasticity ε of investment
is defined as:  
 ∂I 
ε =  ∂Ii  , (14)
 
 
where I denotes investment and i denotes the interest rate. That is:
• The numerator reflects the relative change of investment (expressed in percent).
• The denominator reflects the absolute change of the interest rate (expressed in percentage points).

Calculation of the Interest Semi-elasticity of Investment Using the data given in the exercise, we
obtain:
Scenario Variable Absolute Change Relative Change
0.01
Interest Rate +0.01 + 0.05 = +0.200 = +20.0%
A 5
Investment −5 − 200 = −0.025 = −2.5%
0.02
Interest Rate +0.02 + 0.03 = +0.667 = +66.7%
B 60
Investment −60 − 600 = −0.100 = −10.0%
0.02
Interest Rate −0.02 − 0.03 = −0.667 = −66.7%
C 60
Investment +60 + 600 = +0.100 = +10.0%
Using the definition (14) of the interest semi-elasticity ε of investment, we can conclude:

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• In Scenario A, the interest semi-elasticity ε of investment is given by:

 
 ∂I 
ε =  ∂Ii  ,
 
 
 −0.025 
ε =  +0.01  = |−2.5| = 2.5.

• In Scenario B, the interest semi-elasticity ε of investment is given by:

 
 ∂I 
ε =  ∂Ii  ,
 
 
ε =  −0.100
 
+0.02 = |−5.0| = 5.0.


• In Scenario C, the interest semi-elasticity ε of investment is given by:

 
 ∂I 
ε =  ∂Ii  ,
 
 
ε =  +0.100
 
−0.02 = |−5.0| = 5.0.


Interpretation of the Result: We can conclude:

• In Scenario A, an increase in the interest rate of one percentage point reduces investment by 2.5
percent.
• In Scenario B, an increase in the interest rate of one percentage point reduces investment by 5.0
percent.
• In Scenario C, an increase in the interest rate of one percentage point reduces investment by 5.0
percent.

Exercise 1.3.b
Definition of the Interest Elasticity of Investment The interest elasticity ε of investment is defined
as:  
 ∂I 
ε =  ∂Ii  , (15)
 
 i 
where I denotes investment and i denotes the interest rate. That is:
• The numerator reflects the relative change of investment (expressed in percent).
• The denominator reflects the relative change of the interest rate (expressed in percent).

Calculation of the Interest Semi-elasticity of Investment Using the data given in the exercise, we
obtain:
Scenario Variable Absolute Change Relative Change
0.01
Interest Rate +0.01 + 0.05 = +0.200 = +20.0%
A 5
Investment −5 − 200 = −0.025 = −2.5%
0.02
Interest Rate +0.02 + 0.03 = +0.667 = +66.7%
B 60
Investment −60 − 600 = −0.100 = −10.0%
0.02
Interest Rate −0.02 − 0.03 = −0.667 = −66.7%
C 60
Investment +60 + 600 = +0.100 = +10.0%
Using the definition (15) of the interest elasticity ε of investment, we can conclude:

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Second Semester 2016/17 Coventry University

• In Scenario A, the interest elasticity ε of investment is given by:

 
 ∂I 
ε =  ∂Ii  ,
 
 i 
ε =  −0.025
 
+0.200 = |−0.125| = 0.125.


• In Scenario B, the interest elasticity ε of investment is given by:

 
 ∂I 
ε =  ∂Ii  ,
 
 i 
 −0.100 
ε =  +0.667  ≈ |−0.150| = 0.150.

• In Scenario C, the interest elasticity ε of investment is given by:

 
 ∂I 
ε =  ∂Ii  ,
 
 i 
 +0.100 
ε =  −0.667  ≈ |−0.150| = 0.150.

Interpretation of the Result: We can conclude:

• In Scenario A, an increase in the interest rate of one percent reduces investment by 0.125 percent.

• In Scenario B, an increase in the interest rate of one percent reduces investment by 0.150 percent.

• In Scenario C, an increase in the interest rate of one percent reduces investment by 0.150 percent.

Answers to Exercise 1.4

Definition of the IS Curve The IS curve reflects all combinations of the level of output Y and the
interest rate i, for which the goods market is in equilibrium:

Y = C(Ω,Y − T ) + I(q , i ) + G + X(A∗ , σ ) − Z(A, σ ). (16)

+ + + − + − + +

Exercise 1.4.a
Response From the definition (16) of the IS curve, we can infer that if taxes T ↑:

,→ Disposable income Y − T ↓,

,→ Consumption C ↓,

,→ Excess supply,

,→ Output Y ↓.

Thus, the IS curve will shift to the left (from IS0 to IS1 ).

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Diagram
Interest
Rate i

IS1 IS 0
Output Y

Exercise 1.4.b
Response From the definition (16) of the IS curve, we can infer that if Tobin’s q ↓:

,→ Investment I ↓,

,→ Excess supply,

,→ Output Y ↓.

Thus, the IS curve will shift to the left (from IS0 to IS1 ).

Diagram
Interest
Rate i

IS1 IS 0
Output Y

Exercise 1.4.c
Response From the definition (16) of the IS curve, we can infer that if foreign absorption A∗ ↑:

,→ Exports X ↑,

,→ Excess demand,

,→ Output Y ↑.

Thus, the IS curve will shift to the right (from IS0 to IS1 ).

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Diagram
Interest
Rate i

IS1

IS 0
Output Y

Answers to Exercise 1.5

Exercise 1.5.a
Real money supply is the total amount of money available in an economy at a specific point in time,
expressed in terms of units of goods.

Exercise 1.5.b
Nominal money demand is the total amount of money that agents in an economy wish to hold at a
specific point in time, expressed in terms of units of money.

Exercise 1.5.c
The liquidity preference refers to the preference of agents for holding liquid assets like, e.g. money,
rather than less liquid securities or long-term interest-bearing investments.

Answers to Exercise 1.6

Exercise 1.6.a
The system of equations describes the money market of an economy.

• Equation (8) reflects the domestic real money supply, i.e. the total amount of money available in
an economy at a specific point in time, expressed in terms of units of goods.

• Equation (9) reflects the domestic real money demand, i.e. the total amount of money that agents
in the economy wish to hold at a specific point in time, expressed in terms of units of money.

• Equation (10) reflects the liquidity preference, i.e. the preference of agents in the economy for
holding liquid assets like, e.g. money, rather than less liquid securities or long-term interest-
bearing investments.

• Equation (11) reflects the equilibrium condition for the money market.

Exercise 1.6.b
You can find a detailed economic explanation of the partial derivative in Burda & Wyplosz (2013, pp.
215-216).

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Exercise 1.6.c
Model Solution We can solve the model in two steps. Insertion of (8) and (9) in (11) results in:
M
P = kY . (17)
Insertion of (10) in (17) results in:
M
P = k (i)Y .

Diagram
Interest
Rate i
𝑀0𝑆

𝑖0∗

𝑀0𝐷
𝑀0∗ Money Demand MD,
Money Supply MS

Answers to Exercise 1.7

Exercise 1.7.a
Interpretation of the Neutral Interest Rate ī: The anchor interest rate the central bank will want to
set if:
• actual inflation π is stabilised at its desired level π̄ (so that there is no inflation gap), and
• actual output Y is stabilised at its desired level Ȳ (so that there is no output gap).

Interpretation of the Actual Interest Rate i: The actual interest rate is higher, the:
• more actual inflation exceeds target inflation, i.e. the higher is the inflation gap,
• more actual output exceeds target output, i.e. the higher is the output gap.

Exercise 1.7.b
Interpretation of the Parameter a: This parameter reflects the responsiveness of the central bank’s
optimal policy rate to deviations of actual inflation from its desired level. It is likely to be higher, the
higher is the importance of the central bank’s inflation target relative to the output target.

Interpretation of the Parameter b: This parameter reflects the responsiveness of the central bank’s
optimal policy rate to deviations of actual output from its desired level. It is likely to be higher, the
higher is the importance of the central bank’s output target relative to the inflation target.

Answers to Exercise 1.8

Definition of the TR Curve The TR curve reflects all combinations of the level of output Y and the
interest rate i, for which the money market is in equilibrium under a Taylor rule:
i = ī + a (π − π̄) +b Y −
Ȳ
Ȳ
. (18)
| {z } |{z}
inflation output
gap gap

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Exercise 1.8.a
Response From the definition (18) of the TR curve, we can infer that if inflation rate π ↓

,→ optimal interest rate ↓,

,→ actual interest rate ↓.

Thus, the TR curve will shift downward (from T R0 to T R1 ).

Diagram
Interest
Rate i
TR0

TR1

Output Y

Exercise 1.8.b
Response From the definition (18) of the TR curve, we can infer that if output target Ȳ ↑

,→ optimal interest rate ↓,

,→ actual interest rate ↓.

Thus, the TR curve will shift downward (from T R0 to T R1 ).

Diagram
Interest
Rate i
TR0

TR1

Output Y

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