Download ECON366 - KONSTANTINOS KANELLOPOULOS

INSTRUCTOR: Mr. Konstantinos Kanellopoulos, MSc (L.S.E.), M.B.A.
COURSE: ECON-211-01-SUI13 Intermediate Macroeconomics
SEMESTER: Summer Session I, 2013
Tutorial 7 – for tutor
INSTRUCTIONS
Students are required to study the following questions and problems indicated and to be
able to solve them by themselves.
Although this is not a required part of a coursework, the purpose of the tutorial is
twofold: to help the student understand the methodology for solving the problems and to
help him/her prepare for the courseworks and/or exams. The utilisation of this resource
can be maximised depending on the time and effort each individual student devotes.
Konstantinos Kanellopoulos
12th June 2013
PART 1 SELF-TEST QUESTIONS
1.
Briefly explain in words the effect of an increase in the marginal propensity to save on
the size of the expenditure multiplier and the level of equilibrium income.
If the marginal propensity to save (s = 1 - c) rises, then the marginal propensity to consume (c) falls.
Therefore one extra dollar in income earned will now affect consumption by less than before this
reduction in c. But if the marginal propensity to save is larger, then the size of the expenditure
multiplier will be smaller, since the expenditure multiplier is defined as 1/(1 - c) = 1/s. We should
expect that when people start to save a larger portion of their income, spending on consumption goods
will decrease, leading to a decline in equilibrium income.
2.
Comment on the following statement:
“When aggregate demand falls below the current output level, an unintended inventory
accumulation occurs and the economy is no longer in an equilibrium.”
When aggregate demand falls below the equilibrium output level, actual production exceeds desired
spending. Therefore firms see an unwanted accumulation in their inventories, and they respond by
reducing their production level. This leads to a decrease in the level of output up to the point where
the new and lower level of desired spending is again equal to the level of actual output. In other
words, in the expenditure sector, the adjustment from one equilibrium to the next is based on
unintended inventory changes, until the economy eventually reaches a new equilibrium at another
output level.
PART 2 EXAM-TYPE PROBLEMS
Problem 1.
Assume you have the following model of the expenditure sector:
Sp = C + I + G + NX
C = 400 + (0.8)YD Io = 200
G = 300 + (0.1)(Y* - Y)
YD = Y - TA + TR
NXo = - 40
TA = (0.25)Y TRo = 50
a. What is the size of the output gap if potential output is at Y* = 3,000?
b. By how much would investment (Io) have to change to reach equilibrium at Y* = 3,000,
and how does this change affect the budget surplus?
c. From the model above you can see that government purchases (G) are counter-cyclical,
that is, G is increased as national income decreases. If you compare this specification of
G with one that has a constant level of government spending (for example, Go = 300),
how would the value of the expenditure multiplier differ?
d. Assume the equation for net exports changes from NXo = - 40 to NX1 = - 40 - mY. How
would this affect expenditure multiplier, if we assume that 0 < m < 1?
a. Sp = 400 + (0.8)YD + 200 + 300 + (0.1)(3,000 - Y) - 40
= 1,160 + (0.8)(Y - (0.25)Y + 50) - (0.1)Y
= 1,200 + [(0.8)(0.75) - (0.1)]Y = 1,200 + (0.5)Y
Y = Sp ==> Y = 1,200 + (0.5)Y ==> (0.5)Y = 1,200 ==>Y = 2*1,200 = 2,400
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The output gap is Y* - Y = 3,000 - 2,400 = 600.
b. From Y = (mult.)(A) ==> 600 = 2(I) ==> I = 300
BuS = TA - TR - G = (0.25)(2,400) - 50 - [300 + (0.1)(600)] = 600 - 50 - 300 - 60 = 190
BuS* = (0.25)(3,000) - 50 - 300 + 0 = 750 – 350 = 400.
Therefore, the budget surplus increases by BuS = 210.
c.
If government purchases are used as a stabilization tool, the size of the expenditure multiplier should
be lower than if the level of government spending is fixed. In the model of the expenditure sector
above, the slope of the [C+I+G+NX]-line is c1 = 0.5, and therefore the size of the expenditure
multiplier is α = 1/(0.5) = 2. However, if government purchases are defined as Go = 300 instead, the
slope of the [C+I+G+NX]-line changes to c2 = 0.6 and the size of the expenditure multiplier changes
to α2 = 1/(0.4) = 2.5.
d. With this change, net exports decrease as national income increases. This additional leakage implies
that the size of the multiplier will decrease. In the model above, the slope of the [C+I+G+NX]-line
decreases from c1 = (0.5) to c3 = (0.5) – m, and the expenditure multiplier decreases from 1/[1 - (0.5)]
to 1/[1 - (0.5) + m]. Therefore, if m = 0.14, then the expenditure multiplier decreases from α = 1/(0.5)
= 2 to α3 = 1/(0.64) = 1.5625.
Problem 2.
Assume you have the following model of the expenditure sector:
Sp = C + I + G + NX
C = Co + cYD
YD = Y - TA + TR
TA = TAo
TR = TRo
I = Io
G = Go
NX = NXo
a. If a change in income by ∆Y = - 800 leads to a change in savings by ∆S = - 160, what is
the size of the expenditure multiplier?
b. If a change in taxes by ∆TA = - 400 leads to an change in income by ∆Y = + 1,200, how
large is the marginal propensity to save?
c. If a change in exports by NX = - 200 is accompanied by a change in consumption by
∆C = - 800, what is the size of the expenditure multiplier?
The expenditure multiplier for such a simple model can be calculated as:  = 1/(1 - c)
a. (S)/(Y) = s = 1 - c = (-160)/(-800) = 02 ==> 1/(1 - c) = 1/(0.2) = 5
==> the multiplier is  = 5.
b. From (Y) = [-c(TAo)] ==> (Y)/(TAo) = (-c) = (-c)/(1 - c)
==> (1,200)/(-400) = - 3 = (-c)/(1 - c) ==> -3(1 - c) = -c ==> c = 3/4
==> mps = s = 1 - c = 1/4 = 0.25.
c.
Y = C + NX = - 800 + (- 200) = - 1,000
==> c = (C)/(Y) = (- 800)/(- 1,000) = 0.8 ==> multiplier =  = 1/(1 - c) = 1/(0.2) = 5
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