Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

Chapter 1

The Demand Side –

Answers

1.1 Checklist questions

1. What is the IS curve? Why does it slope downwards?
ANSWER:
The IS is the curve that represents the demand side. It is called the
IS curve because it refers to planned investment and savings decisions. It
shows the combinations of the interest rate and output at which aggregate
spending in the economy is equal to output. This is a downward-sloping
relationship because a low interest rate generates high investment, which
will be associated with high output when aggregate spending is equal
to output. By contrast, when the interest rate is high, investment and
consequently equilibrium output is low.

2. Use the equation for the IS curve shown in Section 1.2.3 to answer the
following questions:

(a) If we assume that 0 < c1 , t < 1, then what can we say about the size
of multiplier?
(b) If there is a decrease in government spending of ∆G, by how much
does this decrease output?
(c) Describe the feedback process that means a decrease in government
spending can decrease output by more than 1 : 1.

ANSWER:
(a) The equilibrium output, for a given interest rate, is given by y =
1 1
1−c1 (1−t) (c0 + I + G). From this equation, the multiplier as 1−c1 (1−t) .
The multiplier is higher the higher the marginal propensity to consume c1

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Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

2 CHAPTER 1. THE DEMAND SIDE – ANSWERS

yD
y = yD

c0 + c1 (1 − t ) y + I + G
A

c0 + c1 (1 − t ) y + I '+G
C
∆I B

∆I Z

ϰϱΣ
y
EŽƚĞ͗ ∆I = I '− I

Figure 1.1: A decrease in autonomous investment

and the lower the tax rate t. This will translate into a flatter IS curve.
Under the assumptions of the question, the multiplier is strictly greater
than 1.
(b) Using the equilibrium output equation in (a), output will decrease by
1
1−c1 (1−t) ∆G.
(c) Consider a decrease in government spending by ∆G, that initially
depresses aggregate demand by the same amount. This dampens output,
and income, and so aggregate consumption decreases by c1 (1 − t) ∆G. The
decrease in aggregate consumption decreases aggregate demand by the
same amount, and, given that the goods market clears, decreases output
and income too. This feedback process will be repeated until the new
equilibrium is reached, implying a decrease in output greater than 1 : 1.
3. Use the Keynesian cross to show the effect of a decrease in autonomous
investment on the economy. Discuss the path of the economy as it adjusts
to the new medium-run equilibrium. Why does the economy not continue
to contract?
ANSWER:
The decrease in autonomous investment shifts the aggregate demand curve
downward. Output now exceeds aggregate demand (Point B). Production

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Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

1.1. CHECKLIST QUESTIONS 3

yD
y = yD

c0 + c1 (1 − t ) y + I + G
A

C B c0 + c1 ' (1 − t ) y + I + G

ϰϱΣ
y

Figure 1.2: The paradox of thrift

is therefore reduced and we move from point B to C. The lower produc-

tion reduces income (in the form of wages and profits) and this depresses
consumption and thus lowers further aggregate demand. The process con-
tinues until we reach point Z, where the new goods market equilibrium is
reached. The economy does not continue to contract because at this new
equilibrium, output and aggregate demand are equal.

4. Use the Keynesian cross to illustrate the paradox of thrift. Model the
change in savings behaviour as an increase in the marginal propensity to
save, s1 (remember that c1 + s1 = 1). Show how a rise in investment can
counteract the reduction in output associated with the rise in savings.
ANSWER:
See Fig.1.2
An increase in the marginal propensity to save, s1 , implies a fall in the
marginal propensity to consume, c1 . The latter has the effect of changing
the slope of the aggregate demand curve, which becomes flatter. The
paradox of thrift is therefore clear: if a policy that encourages savings is
introduced, with the aim of boosting investment, this will be counteracted
by the fact that consumption will fall, and thus aggregate demand will also
fall. After the change in savings behaviour, the economy moves to point

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Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

4 CHAPTER 1. THE DEMAND SIDE – ANSWERS

/ŶǀĞƐƚŵĞŶƚĨƵŶĐƚŝŽŶ

/ŶǀĞƐƚŵĞŶƚƉůƵƐĂƵƚŽŶŽŵŽƵƐĐŽŶƐƵŵƉƚŝŽŶ
ĂŶĚŐŽǀĞƌŶŵĞŶƚƐƉĞŶĚŝŶŐ

r
I 0 + c0 + G y0 =
1
( I 0 + c0 + G )
rH 1 − c1 (1 − t )

I1 + c0 + G y1 =
1
( I1 + c0 + G )
rL 1 − c1 (1 − t )

IS

I0 I1 y0 y1 y
EŽƚĞƚŚĂƚ͗ I 0 = a0 − a1rH ĂŶĚ I1 = a0 − a1rL

Figure 1.3: Deriving the IS curve

B, where output exceeds aggregate demand. Production thus falls and

the economy moves to point C, with lower output. This contractionary
multiplier effect continues until the economy reaches the new steady state
Z, with lower equilibrium output. Given the assumptions of the model,
the increase in the marginal propensity to save has no effect on investment:
in the new equilibrium, the increase in the marginal propensity to save is
exactly offset by the effect of lower income on savings, leaving total savings
unchanged. A rise in investment shifts the flatter aggregate demand curve
up and the increase in income drives saving up to equal the new higher
level of investment in the equilibrium at A.

5. Use the equation for the IS curve shown in Section 1.2.3 and Fig. 1.3 to
discuss what happens to the IS curve in response to the following shocks.
In each case provide a real world example of what might cause the shock.

(a) An increase in autonomous consumption (i.e. ↑ c0 )

(b) A reduction in the interest sensitivity of investment (i.e. ↓ a1 )
(c) An increase in the marginal rate of taxation (i.e. ↑ t)

ANSWER:
See Fig. 1.3.(a) An increase in autonomous consumption shifts the IS to
the right, exactly by the change in autonomous consumption times the

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Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

1.1. CHECKLIST QUESTIONS 5

multiplier. This may model an increase in consumer confidence driven by

better prospects for the economy.
(b) A reduction in the interest sensitivity of investment affects the slope
of the IS curve. In particular, it implies a steeper curve. Indeed, when
investment is less responsive to interest rates it takes a larger change in
r to achieve the desired effect in terms of output. Investment may be
less sensitive when there are variables other than interest rates that affect
investment decisions. For instance, credit constraints, high costs of entry
and of adjustment of the capital stock. A tightening of credit constraints
reducing the access of firms to loans would have the effect of reducing the
interest-sensitivity of investment.
(c) An increase in the marginal rate of taxation decreases the size of the
multiplier, making the IS steeper. It makes interest rates less effective in
changing output or, in other words, output more interest-inelastic. Taxes
may be increased as part of a plan to improve the government’s finances
or as a means of reducing aggregate demand.
6. According to the permanent income hypothesis, how will the paths of
borrowing and consumption change in response to:

(a) A temporary decrease in income when it occurs.

(b) A permanent decrease in income when it occurs.
(c) Are the answers different if the changes in income are unanticipated,
i.e. if they are ‘news’ ? Comment on the size of the marginal propen-
sity to consume and the size of the multiplier.

ANSWER:
(a) Under the PIH, anticipated changes in income will have no effect on
consumption when they occur. The reason is that anticipated changes will
already have been incorporated into consumption through the recalcula-
tion of permanent income. If the decrease is unexpected, consumption
will fall by the extent to which this raises permanent income, namely just
r
by 1+r times the increase in lifetime wealth. The marginal propensity to
r
consume out of temporary income is 1+r . Borrowing will increase in order
to smooth out the transitory fall in income.
(b) The same considerations with respect to news apply here. If unex-
pected, a permanent decrease in income by one unit will imply a decrease
in consumption by the full one unit. Borrowing will then be unaffected.
(c) Under the PIH, anticipated changes in income will have no effect on
consumption when they occur. Hence, the marginal propensity to consume
out of an anticipated change in income will be 0.
7. Assuming the real interest rate is 4 per cent, calculate how, according to
the PIH, consumption and borrowing would change in each of the following
cases

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Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

6 CHAPTER 1. THE DEMAND SIDE – ANSWERS

(a) A stock market crash permanently reduces the value of an individ-

ual’s assets by 1,000.
(b) Households are told that in a year’s time, they will receive a one-off
bonus of 1000. Then in one year’s time, it is not paid.
(c) Comment briefly on your results.

ANSWER:
(a) If assets are reduced by 1000, the impact on lifetime wealth is a re-
r
duction by (1 + r)1000. Consumption will decrease by 1+r (1 + r)1000 =
r1000 = 40. There is no change in borrowing.
(b) When the bonus is announced, lifetime wealth increases by the dis-
1
counted value of the bonus: 1+r 1000. Therefore consumption immediately
r 1
increases by 1+r 1+r 1000 = 36.98. Households need to borrow this amount
to finance consumption, since the bonus has only been announced and will
arrive in a year’s time. If the bonus does not arrive, household’s assets will
be permanently lower by the amount borrowed. Their lifetime wealth will
be lower by (1 + r)36.98 = 38.46. Therefore, consumption will be reduced
r
from the initial level by the interest on this amount: 1+r (1+r)36.98 = 1.48.
(c) Under the PIH, households smooth their consumption. For instance, as
soon as the bonus is announced, they smooth its impact over the whole of
the lifetime. The ability to borrow freely is a crucial assumption required
by the PIH.
8. Explain the concepts of excess sensitivity and excess smoothness that arise
from the empirical literature on the permanent income hypothesis. What
could explain these findings?
ANSWER:
Excess sensitivity means that consumption reacts more than predicted by
the PIH after a change in income. A typical example concerns retirement:
since the fall in income at retirement is largely predictable, the PIH theory
suggests that consumption should fall upon news and not react at all when
retirement actually happens. However, in the data it is observed that
when income falls in a predictable way on retirement, consumption falls.
Potential explanations, consistent with a refined PIH model, include the
possibility that consumption falls because spending was related to being
at work and that in the light of the increased leisure of the household,
home production substitutes for consumption spending. The response of
consumption to news about permanent income may be too smooth with
respect to the theoretical prediction (of a marginal propensity to consume
of one), a phenomenon called excess smoothness. This latter prediction
can be generally attributed to three main features: the presence of credit
constraints, which prevent borrowing by households who lack wealth or
collateral. Impatience, which prevents some households from saving as
would be indicated by a permanent income view. And uncertainty about

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Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

1.1. CHECKLIST QUESTIONS 7

future income, which explains precautionary saving over and above the
level predicted by the PIH.
9. What does Tobin’s q tell us firms’ investment decisions depend upon?
According to Tobin’s q, when should a firm invest?
ANSWER:
Tobin’s q theory of investment is forward looking: firms choose the amount
of investment to undertake with a view to maximising the expected dis-
counted profits over the lifetime of the project. A firm should invest if
q > 1, that is when the marginal benefit of investment exceeds the mar-
ginal cost. This will happen when one of the following occurs: an increase
in the price of output, an increase in the marginal productivity of capital,
a reduction in the rate of interest, a reduction in the rate of depreciation.
10. What is the key problem with measuring marginal q? Is there an alterna-
tive measurement that can be used instead? Is this alternative measure-
ment likely to be an accurate proxy for marginal q?
ANSWER:
Marginal q is difficult to measure because it depends on the marginal
product of capital, which cannot be observed. Average Q, defined as the
ratio between the market value of firm and the replacement cost of cap-
ital, can be used instead. This alternative measure captures the forward
looking nature of the investment decision. Evidence suggests that ana-
lysts’ forecasts of firms’ profits are a better guide to investment than the
stock market valuation of the firm, which is subject to bubbles and herd
behaviour.
11. Use Section 1.2.7 to discuss what is expected to happen to the IS curve
in response to the following shocks:

(a) A crash in the stock market.

(b) An increase in the retirement age.
(c) A decrease in the rate of depreciation.
(d) An increase in the cost of oil.
(e) An increase in the rate of technological progress.

ANSWER:
(a) According to the average Q equation, this should decrease fixed in-
vestment since it signals a fall in the value of companies relative to their
replacement cost. The IS curve is expected to shift to the left.
(b) An increase in the retirement age is likely to raise permanent income,
since agents will work longer and thus expect a higher discounted stream of
income. According to the PIH, they will immediately raise consumption,
smoothing the increase in permanent income over time. The IS curve is

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Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

8 CHAPTER 1. THE DEMAND SIDE – ANSWERS

expected to shift to the right. However, it is necessary to understand the

reasons for the increase in the retirement age to be confident about the
answer. A higher retirement age may be a signal that the government
is concerned about its ability to finance its long run expenditure plans,
including health and pensions. The household may foresee a longer work-
ing life but also the need for higher expenditures and the receipt of lower
pension income in the future. If this is the case, the increase in the retire-
ment age will not lead to a rise in consumption based on higher permanent
income.
(c) Tobin’s marginal q predicts that a decrease in the rate of depreciation
will boost investment and thus shift the IS curve to the right.
(d) Assuming the economy is a net oil importer, then the higher cost of
oil will depress expected future profits of firms, thus reducing Tobin’s Q
and shifting the IS curve to the left.
(e) According to Tobin’s marginal q, this should boost the marginal prod-
uct of capital, investment and, in turn, shift the IS to the right.

1.2 Problems and questions for discussion

1. This question involves collecting data from national statistics agencies (e.g.
the UK office for National Statistics) and/or international organisations
(e.g. the OECD or the IMF). First, select an emerging and a developed
economy.

(a) Collect annual data on real GDP as far back as it is available for
both countries. Convert the data to the log scale and plot on a
graph. Comment on your findings. Calculate the growth rates of
GDP for the two countries over the period and plot them on a graph.
How do the business cycles of the two countries compare? To what
extent do they appear synchronized?
(b) Collect current price data on GDP and its components for the two
countries. Calculate the percentage of GDP according to each of the
four main types of expenditure – i.e. household consumption, gov-
ernment consumption, gross fixed capital formation and net exports
(i.e. exports minus imports) and plot the series. How does the com-
position of GDP and changes over time in the two countries compare?
Discuss possible reasons for the differences.

ANSWER:
Left as an activity for students

2. We start this question with a simple version of the aggregate demand func-
tion, where to keep the maths simple, we omit taxation and government
spending:

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Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

1.2. PROBLEMS AND QUESTIONS FOR DISCUSSION 9

y D = c0 + c1 y + I (1.1)

Now, assume that c0 = 200 and I = 200. In addition, assume that c1 = 0.8,
such that:

yD = 200 + 0.8y + 200 (1.2)

(a) What is the level of output in goods market equilibrium?

(b) Assume there is a fall in the marginal propensity to consume, c1 , to
0.6 – i.e. there is a rise in the savings rate, as s1 + c1 = 1. If we
assume that the rise in planned savings leads to the accumulation
of unplanned inventories of goods and does not increase planned in-
¯ then what is the level of output that satisfies the new
vestment (I),
goods market equilibrium?
(c) Compare the level of savings in the new and old goods market equi-
libria. Note that in goods market equilibrium; S = s1 y − c0 and
I = I¯ .
(d) Comment on your findings in (c) in response to the question of
whether it is advisable for the policy maker to encourage households
to increase their savings to help escape a recession. Describe in
words a mechanism, which is not included in this model, that could
provide a connection from a policy encouraging households to save
more and exit from a recession.
ANSWER:
1
(a) y = 1−0.8 (200 + 200) = 2000.
1
(b) y = 1−0.6 (200 + 200) = 1000
(c) The autonomous component of consumption is unchanged in the two
goods market equilibria, thus any change in savings will be driven by a
different marginal propensity to save. However, since this implies also a
different equilibrium output, the level of savings will be the same in the two
market equilibria. S1 = 0.2(2000)−200 = 200. S2 = 0.4(1000)−200 = 200
(d) The answer to the question of whether saving should be encouraged in
a recession depends on the model of the economy the economist is using.
Using this model, encouraging more saving will not help the economy to
exit recession. The reason is that there is no mechanism in this model
through which higher saving is translated into higher investment. Invest-
ment remains at I¯ throughout. Hence the result of a higher propensity
to save is that aggregate demand falls, output falls and the recession is
deepened. If the model included a central bank, then the recession could
be averted by the central bank cutting the interest rate and boosting in-
vestment to offset the effect of the rise in savings on aggregate demand.

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Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

10 CHAPTER 1. THE DEMAND SIDE – ANSWERS

3. Use Section 1.2.4 and appropriate readings from beyond this book to de-
cide whether the following statements (S1 and S2) are both true or whether
one of them is false. Justify your answer.
S1: According to Tobin’s q theory, the path of investment is independent
of current cash flow (and profits).
S2: The empirical evidence shows that current cash flow is an important
determinant of investment.
ANSWER:
Both statements are true. S1 is true because forward-looking firms should
take into account any credit constraints that they face: these should al-
ready be incorporated into the stock market valuation, Q. However, the
role of cash flow in empirical studies of investment suggests that capital
market imperfections are important. This is likely to be justified by the
presence of credit constraints. Firms that are limited in equity issuance
or that are borrowing constrained will have to rely on their internal funds
in order to finance investment. This, in turn, will show up as an excess
cash-flow sensitivity of investment decisions.
4. Aggregate consumption varies less than GDP and aggregate investment
varies more. Can you reconcile these observations with the assumption
that consumption and investment decisions are taken by rational, forward-
looking agents?
ANSWER:
As Tobin’s Q theory suggests, investment depends on expected after-tax
profits and is very dependent on how optimistic firms are, so it tends to
flourish in boom periods and collapse in recessions, making it more volatile
than the other components of GDP, or GDP itself. Moreover, investment
can be delayed during recessions more easily than other components of
GDP, such as consumption. The fact that consumption is less volatile
than GDP is in line with the predictions of the PIH. Consumers will
borrow and save in order to smooth consumption over the economic cycle.
The government contributes to consumption smoothing through provision
of unemployment benefits.

© Wendy Carlin and David Soskice 2015. All rights reserved.