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The consumption multiplier tries to capture the idea that individuals increase their consumption expenditures when their income increases, even when it is only a short-term increase and their life time income didn't change. However, individuals not only consume domestic products but also, they import part of their consumption. Therefore, if domestic consumption reacts to changes in current income, then it is natural to think that consumption of foreign goods should increase as well. For example, when the economy is booming, imports usually rise. To incorporate this channel into the model, suppose the import equation is given by Mt = āmỸt + xm Ỹt Yt Assume investment and consumption are described by equations in the previous exercise It = āƒŸµ — b(R₁ — Ñ) Ÿt, Ct = ācỸt + x Ỹt Ÿt. The other categories of expenditures follow the same rules as in class. a) Derive the IS curve for this new specification. b) What is the economic explanation for why the parameter xm shows up in the denominator of the new IS curve? Assume r = 0.02, b = 0.5, x = 0.4, xm = 0.2, and that there are no short-term demand shocks ā= 0. c) How does output respond when the real interest rate increases by 0.01. Why is the response smaller than in the previous exercise?

The consumption multiplier tries to capture the idea that individuals increase their consumption expenditures when their income increases, even when it is only a short-term increase and their life time income didn't change. However, individuals not only consume domestic products but also, they import part of their consumption. Therefore, if domestic consumption reacts to changes in current income, then it is natural to think that consumption of foreign goods should increase as well. For example, when the economy is booming, imports usually rise. To incorporate this channel into the model, suppose the import equation is given by Mt = āmỸt + xm Ỹt Yt Assume investment and consumption are described by equations in the previous exercise It = āƒŸµ — b(R₁ — Ñ) Ÿt, Ct = ācỸt + x Ỹt Ÿt. The other categories of expenditures follow the same rules as in class. a) Derive the IS curve for this new specification. b) What is the economic explanation for why the parameter xm shows up in the denominator of the new IS curve? Assume r = 0.02, b = 0.5, x = 0.4, xm = 0.2, and that there are no short-term demand shocks ā= 0. c) How does output respond when the real interest rate increases by 0.01. Why is the response smaller than in the previous exercise?

Brief Principles of Macroeconomics (MindTap Course List)
Brief Principles of Macroeconomics (MindTap Course List)
8th Edition
ISBN:9781337091985
Author:N. Gregory Mankiw
Publisher:N. Gregory Mankiw
Chapter7: Production And Growth
Section: Chapter Questions
Problem 5CQQ
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Exercise 4. Imports and the multiplier. The consumption multiplier tries to capture the idea that individuals increase their consumption expenditures when their income increases, even when it is only a short-term increase and their life time income didn't change. However, individuals not only consume domestic products but also, they import part of their consumption. Therefore, if domestic consumption reacts to changes in current income, then it is natural to think that consumption of foreign goods should increase as well. For example, when the economy is booming, imports usually rise. To incorporate this channel into the model, suppose the import equation is given by Mt =āmīt + xm Ỹt Ỹt are described by equations in the previous exercise It = āƒŸt — b(R₁ − ñ) Yt, Ct =ācīt + x Ỹt Ỹt. The other categories of expenditures follow the same rules as in class. a) Derive the IS curve for this new specification. b) What is the economic explanation for why the parameter xm shows up in the denominator of the new IS curve? Assume investment and consumption Assume r = 0.02, b = 0.5, x = 0.4, xm = 0.2, and that there are no short-term demand shocks ā = 0. c) How does output respond when the real interest rate increases by 0.01. Why is the response smaller than in the previous exercise?
Transcribed Image Text:Exercise 4. Imports and the multiplier. The consumption multiplier tries to capture the idea that individuals increase their consumption expenditures when their income increases, even when it is only a short-term increase and their life time income didn't change. However, individuals not only consume domestic products but also, they import part of their consumption. Therefore, if domestic consumption reacts to changes in current income, then it is natural to think that consumption of foreign goods should increase as well. For example, when the economy is booming, imports usually rise. To incorporate this channel into the model, suppose the import equation is given by Mt =āmīt + xm Ỹt Ỹt are described by equations in the previous exercise It = āƒŸt — b(R₁ − ñ) Yt, Ct =ācīt + x Ỹt Ỹt. The other categories of expenditures follow the same rules as in class. a) Derive the IS curve for this new specification. b) What is the economic explanation for why the parameter xm shows up in the denominator of the new IS curve? Assume investment and consumption Assume r = 0.02, b = 0.5, x = 0.4, xm = 0.2, and that there are no short-term demand shocks ā = 0. c) How does output respond when the real interest rate increases by 0.01. Why is the response smaller than in the previous exercise?
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