ECON 3012
PROBLEM 6
Answers
I. Af = (320 -.6200 + 450 + 210 – 600 + .0110,000 + 5001.20 + (5000.0510) = 320 – 120 +
450 + 210 – 600 + 100 + 600 + 250 = 1210; f = 1/(1 – .6 + .1) = 1/(.4 + .1) = 1/.5 = 2;  = 2(20
+ 500.05) = 2(20 + 25) = 245 = 90.
II.
A. Y = 21000 – 100i = 2000 – 100i .
B. 100 = .2Y – 10i  10i = .2Y – 100  i = .02Y – 10.
C. Step1: Substitute LM into IS: Y = 2000 – 100(.02Y – 10) = 2000 – 2Y + 1000  3Y = 3000
 Y0 = 1000.
Step 2: Substitute Y0 into LM: i0 = .021000 – 10 = 20 – 10 = 10.
Step 3: E0 = 1.20 – .05(10 – 10) = 1.20; I0 = 400 – 2510 = 400 – 250 = 150.
Step 4: NX0 = -600 + .0110,000 – .11000 + 5001.20 = -600 +100 –100 +600 = 0.
Step 5: D0 = 0.
III.
A. New IS: Y =21150 – 100i = 2300 – 100i.
Step 1: Y = 2300 – 100(.02Y – 10) = 3300 – 2Y  3Y = 3300  YA = 1100.
Step 2: Substitute YA into LM: iA = .021100 – 10 = 22 – 10 = 12.
Step 3: EA = 1.20 – .05(12 – 10) = 1.20 – 0.10 = 1.10; IA = 400 – 2512 = 400 – 300 = 100.
Step 4: NXA = -600 +.0110,000 – .11100 + 5001.10 = -600 + 100 – 110 + 550 = -60.
[Note the two influences on NX: Because Y increased, imports increased, and it went down;
and because i increased, E fell – the Canadian dollar appreciated –and it also went down.
The exchange rate effect is much larger here, as it probably is in the real world.]
Step 5: DA = +60.
ACTION: Government spending increases in the Real Sector – Goods Market – which,
including the multiplier process, increases Output, Y.
REACTION: This is ONLY in the Financial Sector – Financial Markets. Increased Output
increases Transactions Demand. Speculators have less Money in their portfolios; they
attempt to increase Money by selling Bonds. Supply of Bonds increases, Price of Bonds
falls, i increases.
There are TWO FEEDBACK effects:
FEEDBACK1: In the Real Sector, the increased interest rate reduces private Investment, I,
reducing Y.
FEEDBACK2: In the Foreign Sector, the increased interest rate reduces E, which increases
the price of Canadian Exports to USers and reduces the price of Canadian Imports to
Canadians. Both reduce NX, which reduces Y in the Real Sector.
Both the first and second feedback effects reduce Y. But the reduction in Y during
FEEDBACK must be less than the increase in Y during ACTION because the model is
stable, and we know this from the IS and LM curves before and after.
B. New LM: i = .02Y – 7.
Step 1: Y = 2000 – 100(.02Y – 7) = 2700 – 2Y  3Y = 2700  YB = 900.
Step 2: Substitute YB into LM: iB = .02900 – 7 = 18 – 7 = 11.
Step 3: EB = 1.20 – .05(11 – 10) = 1.20 – 0.05 = 1.15; IB = 400 – 2511 = 400 – 275 = 125.
Step 4: NXB = -600 +.0110,000 – .1900 + 5001.05 = -600 + 100 – 90 + 575 = -15.
[Note the two influences on NX: Because Y fell, imports fell, and it went up; because i
increased, E fell – the Canadian dollar appreciated – and it also went down. The exchange
rate effect is larger here, again as it probably is in the real world.]
Step 5: DB = +15.
ACTION: In the Financial Sector – Financial Markets – a lower M means speculators have
less Money in their portfolios; they attempt to increase Money by selling Bonds. Supply of
Bonds increases, Price of Bonds falls, i increases.
REACTION: There are TWO REACTIONS
REACTION1: In the Real Sector – Goods Market – the increased interest rate reduces
private investment I, reducing Y.
REACTION2: In the Foreign Sector, the increased interest rate reduces E, which increases
the price of Canadian Exports to ‘Muricans and reduces the price of Canadian Imports to
Canadians. Both reduce NX, which reduces Y. in the Real Sector. Both the first and second
REACTIONs reduce Y in the Real Sector.
FEEDBACK: The reduction in Y during the REACTIONs decreases Transactions Demand.
Speculators have more Money in their portfolios; they attempt to increase Bonds by buying
Bonds. Demand for Bonds increases, Price of Bonds increases, i falls. But the reduction in i
during FEEDBACK must be less than the increase in i during ACTION because the model
is stable and we know this from the IS and LM curves before and after.
C. New Af : Since Af = (c0 – c1 T + b0 + G + x0 + x1 Y* + x2 Ēe + x2 e1 i*), with i* going up by 2,
Af goes up by (x2e12) = (500.052) = 252 = 50. New Af = 1050. New IS: Y = 2100 –
100i.
Step 1: Y = 21050 = 2100 – 100(.02Y – 10) = 3100 – 2Y  3Y = 3100  YC = 1033.
Step 2: Substitute YC into LM: iC = .021033 – 10 = 20.7 – 10 = 10.7.
Step 3: EC = 1.20 – .05(10.7 – 12) = 1.20 + 0.07 = 1.27; IC = 400 – 2510.7 = 400 – 267.5 =
132.5.
Step 4: NXC = -600 +.0110,000 – .11033 + 5001.27 = -600 + 100 – 103.3 + 635 = +31.7.
Step 5: DC = –31.7.
ACTION: In the Foreign Sector, the increase in the US interest rate increases E, which
reduces the price of Canadian Exports to USers and increases the price of Canadian Imports
to Canadians. Both increase NX, which increases Output, Y, in the Real Sector, including
the multiplier process.
REACTION: This is ONLY in the Financial Sector – Financial Markets. Increased Output
increases Transactions Demand. Speculators have less Money in their portfolios; they
attempt to increase Money by selling Bonds. Supply of Bonds increases, Price of Bonds
falls, i increases.
There are TWO FEEDBACK effects:
FEEDBACK1: The increased interest rate reduces private Investment, I, reducing Y.
FEEDBACK2: The increased interest rate reduces E, which increases the price of Canadian
Exports to USers and reduces the price of Canadian Imports to Canadians. Both reduce NX,
reducing Y.
Both the first and second feedback effects reduce Y. But the reduction in Y during
FEEDBACK must be less than the increase in Y during ACTION because the model is
stable, and we know this from the IS and LM curves before and after. And the reduction in
E during FEEDBACK must ALSO be less than the increase in E during ACTION, which is
true also because the model is stable.
D. New Af : Since Af = (c0 – c1 T + b0 + G + x0 + x1 Y* + x2 Ēe + x2 e1 i*), with Ēe going down by
0.1, Af goes down by (x20.1) = 5000.1 = 50. New Af = 950. New IS: Y = 2950 = 1900 –
100i.
Step 1: Y = 1900 – 100(.02Y – 10) = 2900 – 2Y  3Y = 2900  YD = 967.
Step 2: Substitute YD into LM: iD = .02967 – 10 = 19.3 – 10 = 9.3.
Step 3: ED = 1.10 – .05(9.3 – 10) = 1.10 + 0.035 = 1.135; ID = 400 – 259.3 = 400 – 232.5 =
167.5.
Step 4: NXD = -600 +.0110,000 – .1967 + 5001.135 = -600 + 100 – 96.7 + 567.5 = –29.2 .
Step 5: DD = +29.2.
ACTION, REACTION, FEEDBACK here are nearly identical to C.
yourselves anyway.
Work them out for
For each of the last four changes, work out in detail what is going on in each sector. One
sector has the initial change, the action.. Then there is a reaction in two other sectors.
These feedback to the first sector. Describe these for yourself to study for the final exam.