Suggested Solution to Problem Set 6

Macroeconomics (Fall 2023)

Professor: Wonmun Shin

1 Installation Cost
(a) TOTAL COST OF PURCHASING MACHINE

i. φPt
ii. Pt + φPt = (1 + φ) Pt
iii. (1 + i) (1 + φ) Pt

(b) TOTAL BENEFIT OF PURCHASING MACHINE

i. M PK,t+1 Pt+1
ii. (1 − δ) Pt+1
iii. [M PK,t+1 + (1 − δ)] Pt+1

(c) The optimality is achieved when the total cost of purchasing 1 unit of new machine is equal to the total

benet of purchasing it.

[M PK,t+1 + (1 − δ)] Pt+1 = (1 + i) (1 + φ) Pt

Pt
→ M PK,t+1 + (1 − δ) = (1 + i) (1 + φ)
Pt+1
(1 + i) (1 + φ) Pt+1
= ∵π= −1
1+π Pt
= (1 + r) (1 + φ) ∵ (1 + i) = (1 + r) (1 + π)
= 1 + r + φ (1 + r)
→ M PK,t+1 = r + δ + φ (1 + r)

(d) The previous equation gives the desired M PK,t+1 . Because of diminishing returns, M PK,t+1 is a decreasing

function of Kt . We can therefore use the previous equation to get the desired optimal level of capital K∗ as

seen on the following graph:

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(e) If r or φ goes up, the RHS of the optimal condition goes up which pushes up the black line (to the red line).

Hence, the desired level of capital goes down. That is, investment demand is negatively related to r and φ.

If M PK,t+1 goes up, the M PK curve shifts upward so the desired level of capital increases. That is,

investment demand is positively related to M PK .

(f ) If φ is a function of Kt , the optimality condition becomes:

M PK,t+1 = r + δ + (1 + r) φ (Kt )

where the only thing we know is that φis an increasing function of Kt . Three cases are possible, as seen on

the following graph:

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 As a result, we cannot tell what will be the eect on the desired level of capital.

2 Investment Tax Credits

(a)

i. (1 + i) (1 − b) Pt

ii. M PK,t+1 Pt+1

iii. (1 − δ) Pt+1

iv. The optimal condition equates the cost (part i) and gains (part ii and iii) of a rm:

[M PK,t+1 + (1 − δ)] Pt+1 = (1 + i) (1 − b) Pt

1 1+i
Note that Pt /Pt+1 = 1+π , and 1+π = 1 + r:

M PK,t+1 + 1 − δ = (1 + r) (1 − b)
→ M PK,t+1 + 1 − δ = 1 + r − b (1 + r)
→ M PK,t+1 = r + δ − b (1 + r) (1)

v. The LHS of the above resulting condition is a downward sloping curve (according to assumptions of

neoclassical production function), and the RHS is a horizontal line. The intersection of two curves represents

the optimal level of Kt . Since It = Kt − (1 − δ) Kt−1 and Kt−1 is predetermined, the change in investment (It )

is the same as the change in Kt .

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 vi. If b goes up, the horizontal line shifts down, so the optimal Kt increases. Therefore, investment also

increases.

Since rms are willing to tolerate a lower return on the marginal machine (i.e. lower M PK ) thanks to higher
subsidy. This means a higher desired capital stock and hence higher investment.

(b) If b goes up, it shifts the investment demand to the right. As a result, aggregate demand Yd = C +I
shifts by the same amount. Nothing happens on the supply side, and there is no other indirect eect. Both

the equilibrium levels of output and the real interest rate go up. The eect on the money demand schedule is

ambiguous (∵ higher i, higher Y ), so we cannot tell what happens to the price level.

(c) The cost rm faces is same as before: (1 + i) (1 − b) Pt . However, the gains become dierent; the rm

that resells capital must return a fraction of b of the proceeds of the resale, so the rm is going to earn

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(1 − δ) (1 − b) Pt+1 . As a result, the nal gains of purchasing one unit of machine is [M PK,t+1 + (1 − δ) (1 − b)] Pt+1 .
The optimal investment condition is:

[M PK,t+1 + (1 − δ) (1 − b)] Pt+1 = (1 + i) (1 − b) Pt

Using the Fisher equation, we obtain:

M PK,t+1 + (1 − δ) (1 − b) = (1 + r) (1 − b)
→ M PK,t+1 + 1 − δ − b (1 − δ) = 1 + r − b (1 + r)
→ M PK,t+1 = r + δ − b (1 + r − 1 + δ)
→ M PK,t+1 = r + δ − b (r + δ) (2)

Let us compare the RHS of equation (1) and that of equation (2). Since 0 < δ < 1, we know that r +δ < 1+r
(so, −b (r + δ) > −b (1 + r)). This means that, the horizontal line with return (RHS of equation (2)) is above

the line without return (RHS of equation (1)).

Therefore, if a rm must return a fraction b of the proceed of resale, the desired capital stock becomes lower

and hence investment becomes lower, than those without the return (part (a)).

(d) Similarly to what we had before, if b goes up, the RHS goes down so the horizontal line shifts down.

As a result, investment increases as b increases. Note that r + δ < 1 + r, which means that the impact of

an increase in b is smaller in this case than in part (a). What is intuition here? An increase in b decreases

the cost of borrowing money from the bank, (1 + i) (1 − b) Pt . But it also reduces the return on the machine

[M PK,t+1 + (1 − δ) (1 − b)] Pt+1 at the same time. The eect on the gain was absent in part (a). Therefore,

the eect of increase in b is smaller here.

(e) Since I shifts to the right, implications are the same as in (b). Output and interest rate go up, and the eect

on the price level is ambiguous. Notice, however, that as we explained in (d), the investment is less sensitive to

changes in the tax credit if the rm should return some portion of the resale earning (compared to without the

return).

3 Credit Crunch
(a) The credit crunch shifts the investment curve to the left. The IS curve (or aggregate demand curve) also

shifts to the left because it is simply the sum of investment demand and consumption demand: Yd = C +I

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(arrow #1). In the Keynesian model, the short-run equilibrium is found at the intersection of the IS and LM

curves (point A). Thus both output and real interest rate go down (point E to point A).

s
Aggregate supply (Y ) is greater than Y d at the new short-run equilibrium (point A). Therefore, prices begin
to fall. The LM curve shifts downward until it reaches the intersection of Yd and Y s as P goes down (arrow

#2). The interest rate drops further, while output increases a little (point A to point B). In the long run, the

overall eect is the reduction of output, interest rate, and prices compared to the initial equilibrium (point E

to point B).

(b) To prevent output from declining, the BOK may want to increase money supply. Without the intervention

by the BOK, the credit crunch may result in point A according to a fall in investment (arrow #1). Expansionary

monetary policy can shift the LM curve to the right (arrow #2) to achieve the initial level of output. So the

short-run equilibrium with the intervention of the BOK is point B.

d s
The demand (Y ) is greater than supply (Y ) at point B, and prices will rise. The LM curve will shift back

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to the blue line (arrow #3). Output will fall, and the interest rate will rise in the meantime (point B to point

C). The long-run equilibrium is the same as that in part (a) (but price level will increase here). That is, money

is neutral in the long run in the Keynesian model.

(c) Since prices adjust instantaneously in the Classical model, the goods market always clear. The credit crunch

shifts Yd curve to the left. The new equilibrium is found at the intersection of Ys and Y d , where output and the
interest rate are lower. This classical equilibrium is identical with the long-run equilibrium in part (a) and part

(b). In the money market, due to lower interest rate and lower output, the eect on price level is ambiguous.

Expansionary monetary policy has no real eect. In the money market, the eect on money demand is

unclear, and money supply curve shifts to the right. As a result, the overall eect on price level is still unclear.

4 New Oil Field

[Scenario 1 ] Classical Model
(a) This question requires an analysis in the classical general equilibrium model when there exists a temporary

productivity shock. (Please refer to the lecture notes!)

1. Direct eect: Ys ↑ (real market), no eect on money market

2. Indirect eect: small shift in C ↑ (less than Y s , i.e. 4C < 4Y s ), no shift in I (∵ temporary change in

technology)

3. Real market: Y ↑, r ↓, C ↑ and I↑ (due to reduction in r)

4. Money market: lower r (→ lower i) and higher Y → M d↑ → P ↓

As a result, Y increases, r decreases, and P falls. As a Goldilocks economy means the economy with

economic boom and low ination, the above result from a positive productivity shock explains the Goldilocks

economy.

(b) According to (a), the price level will fall without any intervention of a central bank. In order to avoid a fall
s
in the price level, The BOK should increase the money supply (M ).

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(c) This question requires an analysis in the classical general equilibrium model when there exists a permanent

productivity shock. (Please refer to the lecture notes!)

1. Direct eect: Ys ↑ (real market), no eect on money market

2. Indirect eect: C ↑ (4C = 4Y s ), I↑ by large amount (∵ At+1 ↑) → Y d ↑

3. Real market: Y ↑, r↑, C ↑ and I↑

4. Money market: higher Y and higher i→ ambiguous for Md → So, ambiguous for P (P will fall if Md
increases and will rise if Md decreases.)

As a result, Y increases, r decreases, and the change in P is ambiguous. Since we are not certain that

the price level decreases, the case of the permanent productivity shock cannot explain the Goldilocks economy.

Only when the force from higher Y is greater than that from higher i (so money demand increases), we can

explain the Goldilocks economy with the permanent productivity shock.

[Scenario 2 ] Keynesian Model

(d) Since i = r + πe , the LM curve should be modied to:

ψY
r= − πe
M 2


2 P

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 e
which has an additional component (−π is a constant), compared with the original LM equation we used in the

class.

(e) According to the above modied LM curve (which considers the expected ination), r = −π e when Y = 0.
ψY
Note that the LM curve we used in the class is r= 2 so r = 0 when Y = 0, which means the upward-sloping
2( M
P )
LM curve passes through the origin (0, 0) on the Y − r plane. In contrast, the modied LM curve passes through
e
(0, −π ):

(f ) π e declines, so the vertical intercept of the modied LM curve −π e moves up. Thus, the modied LM curve

shifts upward, which leads to a decrease in Y and an increase in r in the short run.

(g) In order to prevent the recession, the BOK should increase the money supply. The LM curve will shift to

the rightward, and Y and r will go back to the initial level. But, I would like to comment regarding one more

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thing; the LM curve will not go back to the initial LM curve unless the expected ination recovers the initial

level. This is why the blue-colored line (after the monetary expansion) is dierent from the black-colored LM

curve.

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