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QUESTION
3. An economy is in long-run macroeconomic equilibrium when each of the following
aggregate demand shocks occurs. What kind of gap—inflationary or recessionary—will
the economy face after the shock, and what type of fiscal policies would help move the
economy back to potential output?
a. A stock market boom increases the value of stocks held by households.
b. Firms come to believe that a recession in the near future is likely.
c. Anticipating the possibility of war, the government increases its purchases of military
equipment.
d. The quantity of money in the economy declines and interest rates increase.
ANSWER
3)
a. As the stock market booms and the value of stocks held by households increases,
there will be an increase in consumer spending; this will shift the aggregate demand
curve to the right. The economy will face an inflationary gap. Policy makers could use
contractionary fiscal policies to move the economy back to potential output.
b. If firms become concerned about a recession in the near future, they will decrease
investment spending and aggregate demand will shift to the left. The economy will face a
recessionary gap. Policy makers could use expansionary fiscal policies to move the
economy back to potential output.
c. If the government increases its purchases of military equipment, the aggregate
demand curve will shift to the right. The economy will face an inflationary gap. Policy
makers could use contractionary fiscal policies to move the economy back to potential
output. The government would need to reduce its purchases of nondefense goods and
services, raise taxes or reduce transfers.
d. As interest rates rise, investment spending will decrease and the aggregate demand
curve will shift to the left. The economy will face a recessionary gap. Policy makers could
use expansionary fiscal policies to move the economy back to potential output.
QUESTION
5. In each of the following cases, either a recessionary or inflationary gap exists.
Assume that the aggregate supply curve is horizontal so that the change in real GDP
arising from a shift of the aggregate demand curve equals the size of the shift of the
curve. Calculate both the change in government purchases of goods and services and
the change in government transfers necessary to close the gap.
a. Real GDP equals $100 billion, potential output equals $160 billion, and the marginal
propensity to consume is 0.75.
b. Real GDP equals $250 billion, potential output equals $200 billion, and the marginal
propensity to consume is 0.5.
c. Real GDP equals $180 billion, potential output equals $100 billion, and the marginal
propensity to consume is 0.8.
ANSWER
5)
a. The economy is facing a recessionary gap; real GDP is less than potential output.
Since the multiplier for a change in government purchases of goods and services is 1/(1
− 0.75) = 4, an increase in government purchases of $15 billion will increase real GDP
by $60 billion and close the recessionary gap. Each dollar of a transfer increase will
increase real GDP by $MPC/(1 − MPC), or $0.75/(1 − 0.75) = $3. Since real GDP needs
to increase by $60 billion, the government should increase transfers by $20 billion to
close the recessionary gap.
b. The economy is facing an inflationary gap; real GDP is higher than potential output.
Since the multiplier for a change in government purchases of goods and services is 1/(1
− 0.5) = $2, a decrease in government purchases of $25 billion will reduce real GDP by
$50 billion and close the inflationary gap. Each dollar of a transfer reduction will
decrease real GDP by $MPC/(1 − MPC), or $0.5/ (1 − 0.5) = $1. Since real GDP needs
to decrease by $50 billion, the government should increase transfers by $50 billion to
close the inflationary gap.
c. The economy is facing an inflationary gap; real GDP is higher than potential output.
Since the multiplier for a change in government purchases of goods and services is
1/(1 − 0.8) = 5, a decrease in government purchases of $16 billion will reduce real GDP
by $80 billion and close the inflationary gap. Each dollar of a transfer reduction will
reduce real GDP by $MPC/(1 − MPC), or $0.8/(1 − 0.8) = $4. Since real GDP needs to
decrease by $80 billion, the government should reduce transfer payments by $20 billion
to close the inflationary gap.
QUESTION
6. Most macroeconomists believe it is a good thing that taxes act as automatic
stabilizers and lower the size of the multiplier. However, a smaller multiplier means that
the change in government purchases of goods and services, government transfers, or
taxes necessary to close an inflationary or recessionary gap is larger. How can you
explain this apparent inconsistency?
Ans.
Yes, it is true that Most macroeconomists believe it is a good thing that taxes act as
automatic stabilizers and lower the size of the multiplier. However, a smaller multiplier
means that the change in government purchases of goods and services, government
transfers, or taxes necessary to close an inflationary or recessionary gap is larger.
Reducing taxes act as automatic stabilizers affect the business cycle. When the
business cycle is in expansion stage then there are increases in tax rates and it leads to
contractionary policies.
But when, there is a decrease in demand and donfall in the business cycle, then there is
a decrease in the tax rate and expansioanry policies are followed by the government to
improve the economic condition.
13. In which of the following cases does the size of the government's debt and the size
of the budget deficit indicate potential problems for the economy?
a. The government's debt is relatively low, but the government is running a large budget
deficit as it builds a highspeed rail system to connect the major cities of the nation.
b. The government's debt is relatively high due to a recently ended deficit-financed war,
but the government is now running only a small budget deficit.
c. The government's debt is relatively low, but the government is running a budget
deficit to finance the interest payments on the debt.