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Macro2 Problem #1 Answers (
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Open the Macro2 module in SimEcon®. Begin by selecting the inflation scenario
and be sure to make inflationary expectations constant. After seeing the initial
conditions, change government spending by $10 billion in Year 2, keep the original
values for taxes and the money supply. Compare the new GDP with the level of real
GDP in Year 1. That is, divide the change in real GDP by the change in government
spending. Compare the value you get with the multiplier of 10. (Remember that the
MPC (and the marginal propensity to spend) in this module is 0.90.)
(a)
Explain why the value you got is less than 10. (Hint: Check what
happened to the real rate of interest and to the types of spending
affected by the real interest rate.)
The original policy values give a real GDP of 2315.03 and a real interest rate of 7.55.
Cutting government spending (other policies constant) from 690 to 680 reduces real GDP
to 2311.17 with a real interest rate of 7.45. The ratio of the change in real GDP to the
change in government spending is (2315.03-2311.17)/(690-680) = 0.386
The ratio is less than 10, in fact it’s less than 1. When government spending was cut that
started a drop in real GDP and the decline in real GDP reduced the demand for money
(for transactions). The reduction in money demand caused interest rates to drop, both
nominal and real interest rates. This reduction in real interest rates causes increases in
consumer spending and in investment spending that partly offset the drop in government
spending. Note that despite the reduction in income of 3.86 consumer spending only
declined from 1283.71 to 1282.77, a drop of 0.94, even though an MPC of 0.9 should
mean a drop in consumer spending of 3.47. Something -- real interest rates -- has
prevented part of the decline in consumer spending. In addition the value of investment
spending has actually increased from 341.32 to 348.4. The rise in business investment,
encouraged by the lower cost of investing, has eliminated most of the drop in real GDP
that would otherwise have been caused by the decline in Government demand for goods
and services. This is “crowding in.”
(b)
Find a way to get the real interest rate back to its original value
without putting government spending back to its original value.
Explain how you accomplished this objective. (Hint: There are two
ways of accomplishing this.)
I got the real interest rate back to its original value by reducing the money supply to 55.8.
The same real interest rate could be restored by increasing taxes by about $11 billion.
(c)
Explain why your actions got the real interest rate back to its original
value.
A smaller money supply raises interest rates, offsetting the impact of a smaller demand
for money. If the money supply is reduced to 55.8 the real interest rate is back to its
original value of 7.55. A tax increase reduces income and therefore the demand for
goods and services, and the demand for money—which gets interest rates down again.
The tax change must be larger than the government spending change because the tax
multiplier is about 10% smaller than the spending multiplier.
(d)
Note the value of real GDP that you got when the real interest rate
was back at its original level. Explain why you got this value for real
GDP, and the impact of the change in government spending in this
case compared to the multiplier value of 10.
With government spending at 680, taxes still at 690, and the money supply at 55.8, real
GDP is 2218.83. If the change in real GDP is compared to the change in government
spending the calculation (2315.03 -2218.83)/(690-680) = 9.62. The only reason it isn’t
exactly 10 (the spending multiplier) is that real interest rates are only given to two digits
past the decimal point. The real interest rates with the original policy values and with the
new values are different, but the difference is so small it didn’t show up. The value of
investment is back to its original value of 341.32 and consumer spending has dropped by
about ninety percent of the change in income.
Now choose the recession scenario with constant inflationary expectations.
(a)
If the “full employment” level of real GDP is $2,211 billion, how much
of a change in government spending will it take to get to that real
GDP with a multiplier of 10? (Use the results from the inflation
scenario to help you figure out how to get to a real GDP of $2,211
billion with the same change in government spending that you would
need if the spending multiplier were actually 10. Hint: this will
require you to use your results from (b) above.)
The necessary change in GDP to reach 2211 is 70.14, with a government spending
multiplier of 10, which would mean raising government spending from 600 to 607.14.
(b)
Explain your results
Just raising government spending by 7.014 would raise real GDP by 7.014* 0.386 or 2.7
(to the nearest decimal place). The larger government spending causes real interest rates
to rise, “crowding out” consumer and business investment spending. The larger change
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in real GDP can be achieved by increasing the money supply, driving the real interest rate
down to its original value. If government spending is raised by 7 (values of less than 1
billion cannot be entered) and the money supply is raised to 61.8 the value of real GDP
2212.76, a bit over the target (real interest rate is at to 7.64). If the money supply is set
at 61.7 real GDP is 2208.96, a little below the target (real interest rate still at 7.64). The
tools cannot be set precisely enough to hit 2211 (using just these two tools) but it is
possible to get really close.
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