Download Solutions for Homework Assignment 4

Solutions for Homework Assignment 4
ECON 202 –005, Winter 2009
Drexel University
Instructor: Yuan Yuan
Question 1 (40 points, 2 pts each)
1) A
2) C
3) A
4) A
5) A
6) C
7) B
8) D
9) D
10) C
11) B 12) C 13) B 14) C 15) C 16) B 17) E 18) D 19) D 20) C
Question 2 (10 points)
What is “crowding out” effect? Use both static AD-AS model and money supply and money demand
model to verbally and graphically explain crowding out effect.
Answer:
Crowding out is a decline in private expenditures as a result of an increase in government
purchases. In the static AD-AS model, an increase in government purchases shifts the AD to the
right. The price level increases. In money market, an increase in the price level shifts the money
demand to the right because of an increase in need of money to complete transactions. The
equilibrium interest rate increases, pulling down C, I and NX. Then the AD curve shifts to the left
but still above the original position because in the short run the crowding out effect cannot
completely offset the effect of an increase in government purchases.
Question 3 (15 points)
1) If real GDP is $300 billion below potential GDP and the tax multiplier equals -1.5, then how much
would the government need to change taxes to bring the economy to equilibrium at potential? Show
your work. (5 pts)
Answer:
A real GDP/ A tax=tax multiplier
$300b/ A tax = -1.5
A tax = $300b/-1.5= -$200b.
The government needs to cut tax by $200 billion.
2) Suppose real GDP is currently $12.5 trillion and potential real GDP is $13 trillion. Use basic AD-AS
model to verbally and graphically show what the result on the economy would be if the president and
the Congress increased government purchases by $500 billion. Assuming the government purchase
multiplier is greater than unity. (10 pts)
Answer:
The economy would go from a short-run equilibrium below potential GDP to a short-run
equilibrium above potential GDP. The increase in government purchases, which equals the
shortfall in real GDP from potential real GDP, is too large. The increase in government purchases
needs to be less than the shortfall in real GDP, because of the multiplier effect.
Before the fiscal policy, the AD intersects SRAS at a point on left side of the potential real GDP.
An increase in government purchases by $500 b would shift the AD curve to the right. SRAS is
constant. Because the government purchase multiplier is greater than unity, the new short-run
equilibrium real GDP will be higher than potential GDP. The difference between the potential real
GDP and the new real GDP is determined by the magnitude of the government purchase
multiplier.
(If you consider the crowding-out effect at the same time and argue that the new real GDP could be
lower than the potential real GDP, you also get full credits.)
Question 4 (10 points)
If the federal budget goes from a budget deficit in Year 1 to a budget surplus in Year 2, does it
necessarily follow that the federal government acted to raise taxes or cut government spending in Year 2?
Explain.
Answer:
No, the economy could have had been in an expansion in Year 2 with GDP growing faster than
anticipated. The faster growth in GDP would raise tax revenues and decrease government
spending on transfer payments, decreasing the budget deficit (in this case, moving it to a budget
surplus).
Question 5 (10 points)
Is it a good idea that the federal government always runs a balanced budget? Explain.
Answer:
No. It is not a good idea. Because as an automatic stabilizer, a budget surplus or a budget deficit
can stabilize the economic growth automatically. Running a budget balance usually needs to
implement an expansionary fiscal policy when the economy is overheated and a contractionary
fiscal policy when economic growth slowdowns. These policies are pro-cyclical and will make the
economy more volatile instead of more stable.
Question 6 (15 points)
What is the Philips curve? Verbally and graphically show the consistence between the Philips curve and
basic AD-AS model.
Answer:
Phillips curve is a curve showing the short-run relationship between the unemployment rate and
the inflation rate. This short-run relationship is usually negative. When business cycles are driven
by the movements of AD, the negative slope of Philips curve is caused by the positive slope of
SRAS. As AD curve shifts to the right, at equilibrium both the price level and real GDP increase.
An increase in real GDP indicates lower unemployment. Similarly, as AD shifts to the left, the
price level decreases and unemployment increases. Therefore the Philips curve is consistent with
AD-AS model.
Question 7 (Extra 5 points)
Why would a higher tax rate lower the government purchases multiplier? What does the tax rate have to
do with the government purchases multiplier?
Answer:
The tax rate affects how much of the additional income that results from the initial increase in
government purchases is available to be consumed. A higher tax rate decreases the amount of
disposable income that can be consumed at each round of the multiplier process.