Intermediate
Macroeconomics
Tutorial 3
Chapter 3: Macroeconomic Dynamics I
- Adaptive Expectations
- Investment Theory
- Impact of Fiscal Stimulus
, T3 3.1, 3.2, 3.3, 3.10, 3.12
3.1 Short Ques.ons
What is the so-called “correspondence principle” and why is it so useful in principle?
The correspondence principle states that we only use stable models. Thys gives informa7on that is
typically useful in compara7ve sta7c and dynamic exercises. Unstable models are useless because
following a shock, the system does not return to a meaningful equilibrium.
What do we mean by “backward-looking stability”? And what is “forward-looking stability”?
Backward-looking stability; history determines where you are. No need to look at the future to know
how the system evolves to the equilibrium.
Forward-looking stability; both the past and the future determine the adjustment path. This typically
deals with expecta7ons.
Keynesians and monetarists engaged in a heated debate during the six?es and seven?es of the previous
century. The topic of the debate was the ques?on of whether or not government consump?on leads to
crowding out of the capital stock. Explain why this debate could not be seEled by simply appealing to
the correspondence principle.
The correspondence principle is needed to ensure that the model is stable. But stable models can s7ll
lead to crowding out or to crowding in. It all depends on the slopes of IS and LM.
𝐾̇ = Ω(𝐾, 𝐺)
𝑑𝐾 !" Ω#
) + =
𝑑𝐺 −Ω$
A typical monetarist would suggest a strong interest rate effect on investment and a large effect on the
interest rate but a small effect on output of a rise in government spending. Consequently, a monetarist
suggests that Ω# < 0 which would shiJ the 𝐾̇ line down and in the long-run crowd-out investment. A
typical Keynesian would suggest the reverse.
1
Macroeconomics
Tutorial 3
Chapter 3: Macroeconomic Dynamics I
- Adaptive Expectations
- Investment Theory
- Impact of Fiscal Stimulus
, T3 3.1, 3.2, 3.3, 3.10, 3.12
3.1 Short Ques.ons
What is the so-called “correspondence principle” and why is it so useful in principle?
The correspondence principle states that we only use stable models. Thys gives informa7on that is
typically useful in compara7ve sta7c and dynamic exercises. Unstable models are useless because
following a shock, the system does not return to a meaningful equilibrium.
What do we mean by “backward-looking stability”? And what is “forward-looking stability”?
Backward-looking stability; history determines where you are. No need to look at the future to know
how the system evolves to the equilibrium.
Forward-looking stability; both the past and the future determine the adjustment path. This typically
deals with expecta7ons.
Keynesians and monetarists engaged in a heated debate during the six?es and seven?es of the previous
century. The topic of the debate was the ques?on of whether or not government consump?on leads to
crowding out of the capital stock. Explain why this debate could not be seEled by simply appealing to
the correspondence principle.
The correspondence principle is needed to ensure that the model is stable. But stable models can s7ll
lead to crowding out or to crowding in. It all depends on the slopes of IS and LM.
𝐾̇ = Ω(𝐾, 𝐺)
𝑑𝐾 !" Ω#
) + =
𝑑𝐺 −Ω$
A typical monetarist would suggest a strong interest rate effect on investment and a large effect on the
interest rate but a small effect on output of a rise in government spending. Consequently, a monetarist
suggests that Ω# < 0 which would shiJ the 𝐾̇ line down and in the long-run crowd-out investment. A
typical Keynesian would suggest the reverse.
1
