Question

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 Mo = ām 7x + xm 7,7 Assume investment and consumption are described by equations in the previous exercise 11 =ā- b(Rt-r). C =ācPx + x 7497 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 F = 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?

Answer 1