Download EC 132 Discussion Note PS5 CHIU P.1 Disclaimer:

EC 132 Discussion Note PS5 CHIU P.1 Disclaimer: All questions are adapted directly from the textbook and problem sets. Suggestions from Professor Tresch are used in preparation of this note. All solutions are just suggestive and tentative comments, not marking criteria actually adopted, subject to further changes and interpretations. Question 1 (Q3 Ch.11 P. 306)
Using the spending multiplier to calculate the change in national income that would
result from a $200 decrease in government spending. Assume that the MPC = 0.90.
MSpending = 1 / (1 – MPC) = 10
ΔY = ΔG × MSpending = (-$200) × 10 = -$2000
Question 2 (Q5 Ch. 11 P.306)
a) Calculate the change in national income if the government increases its transfer
payments by $500 and finances the transfers by issuing debt. Assume that the MPC =
0.75.
MTransfer = MPC / (1 – MPC) = 0.75 / 0.25 = 3
ΔY = ΔTransfer × MTransfer = (-$500) × 3 = -$1500
b) How would your answer change if the transfers were financed by a $500 increase in
taxes?
Balanced budget multiplier for equal change in government purchases and taxes is zero.
MΔTr=ΔTx = 0
ΔY = ΔG × MΔTr=ΔTx = (-$500) × 0 = 0
Definition: (Balanced budget multiplier) The ratio that relates the change in the
equilibrium level of national income to a balanced budget change in government
purchases and taxes.(P.296)
Question 3 (Q6 Ch.11 P.306)
Suppose that the economy is at the full-employment level of national income and the
federal government cuts defense spending by $100 billion. By how much must the
government change taxes, and in what direction, to keep the economy at the fullemployment level of national income? Assume that MPC = 2/3.
MSpending = 1 / (1 – MPC) = 3
ΔY = ΔG × MSpending = (-$100) × 3 = -$300
MTax = -MPC / (1 – MPC) = 2
Since ΔY = ΔTax × MTax and we need ΔY = 300 to cancel the effect, we have
300 = ΔTax × (-2) = -$150
Hence,, the tax reduction required is $150 billion.
Question 4 (Q7 Ch.11 P.307)
Suppose that the equilibrium level of national income is $1,000 and the full-employment
level of income is $1,500.
a) Is the economy experiencing an inflationary gap or a recessionary gap?
Definition: (Recession Gap) Exists when the equilibrium level of national income is
less than the full-employment level of national income; the size of the gap is the
amount that aggregate demand has to increase to bring the equilibrium level of
national income to the full-employment level of national income.
EC 132 Discussion Note PS5 CHIU P.2 Definition: (Inflationary Gap) Exists when the equilibrium level of national income is
greater than the full-employment level of national income; the size of the gap is the
amount that aggregate demand has to decrease to bring the
From definition, recessionary gap.
b) Represent this situation on ADE-45° line graph, and show the size of the gap on your
diagram.
Aggregate demand ADE ADE1 ADE2 Gap Y
Y YFE National Income
c) Calculate the size of the gap, assuming that the MPC = 0.80.
MSpending = 1 / ( 1 – MPC) = 5
Size of gap = (YFE – YE) / MSpending = (1500 – 1000) / 5 = $100
d) Describe two fiscal policies that would close the gap, and indicate why they would
work.
Increase in government purchase by debt financing by $100
Reduction of tax by debt financing by $125 (MTax = -4)
Increase government transfer by debt financing by $125 (MTransfer = 4)
Increase in government purchase and increase in tax by $500 (MΔTx=ΔTr = 4)
Question 5 (Appendix Ch.11 P.310)
a) Given the following information for an economy, find the equilibrium level of income,
YE.
Cd = 200 + 2/3 Yd
Id = 20
Gd = 70
T = 24
where Yd = disposable income, Y = national income, Cd = consumption demand, Id =
investment demand, Gd = government demand for goods and services and T = taxes –
transfer payments.
Equilibrium condition: Y = Cd + Id + Gd
Hence, Y = 200 + 2/3 (Y – 24) + 20 + 70.
Solving, we have Y = 822
b) What is the value of the spending multiplier for this economy? Of the tax multiplier? Of
the ΔGd = ΔTx balanced budget multiplier? (Hint: What is the MPC?)
MPC = 2/3
EC 132 Discussion Note PS5 CHIU P.3 Mspending= 1/ (1 – MPC) = 3
MTax = -MPC / (1 – MPC) = -2
MΔGd=ΔTx = 1
c) If government spending on goods and services, Gd, decreases by 10, what will be the
change in YE be?
ΔYE = MSpending × ΔGd = 3 × -10 = -30
d) If the government matches the decrease in Gd by a cut in taxes of 10, how will your
answer to part c change?
ΔYE = MΔGd=ΔTx × ΔGd = 1 × -10 = -10
e) If the economy is at the full-employment level of income and the government increases
Gd by 10, how can it change taxes to keep the economy at full employment?
ΔGd × Mspending + ΔTx × MTax = 0
Hence, ΔTx = - ΔGd × Mspending / MTax = 10 × 3 / (-2) = 15
Increase tax by 15
f) If government transfer payment increase by 12, by how much will the equilibrium level
of income change? If the government increases taxes 12 to finance the transfer
payments, what will the net effect on YE be?
Transfer: ΔYE = ΔGd × MTransfer = 12 × 2 = 24
Tax: ΔYE = ΔGd × MTax = 12 × (-2) = -24
Net effect is zero.
g) Suppose that the government decides that the target level of income is 900. Relative to
the equilibrium computed in part a, is the economy experiencing a recessionary or an
inflationary gap? What is the size of the gap? Design two government policies that will
eliminate the gap.
Recessionary gap (Here we assume the target level is full-employment level.)
Size of gap = (YTarget – YE) / MSpending = (900 – 832) / 3 = $200 > 0
1) Increase in government purchase by debt financing :
ΔYE = ΔGd × MTransfer implies ΔGd = ΔYE / MTransfer = 200 / 2 = 100
2) Reduction of tax by debt financing
ΔYE = ΔGd × MTax implies ΔGd = ΔYE / MTax = 200 / (-2) = -100
3) Increase in government purchase and increase in tax.
ΔYE = ΔGd × MΔGd=ΔTx implies ΔGd = ΔYE / MΔGd=ΔTx = 200 / 1 = 200
Question 6 (Q1 Ch. 12 P.341)
Taxes are a drain on aggregate demand, and government transfer payments are a
contributor to aggregate demand. Yet, they both act as automatic stabilizers. How can
this be?
Definition: (Automatic Stabilizer) Any component of the economy that is related to
the level of national income and lowers the value of the spending multiplier;
automatic stabilizers make the economy less responsive to aggregate demand
shock.
Income taxes increase when economy is good and reduces when economy is bad. Opposite
role is for transfer payment.
EC 132 Discussion Note PS5 CHIU P.4 Question 7 (Q3 Ch. 12 P.341)
Show the effect of a depreciation of the dollar on the import demand and export demand
functions. Explain how the depreciation of the dollar affects net export demand and the
equilibrium level of national income.
Depreciation means dollar worth less.
Hence, less import demand and more export demand.
Net export = export – import. Hence, net export rises.
Increases aggregate demand and hence national income.
Imd Exd Imd
Exd
Export demand Import demand New Imd New Exd Y National Income Y National Income Question 8 (Q7 Ch. 12 P.341)
Assume that a country has a balanced budget initially. The country’s economic structure
has automatic, built-in stabilizers in the form of taxes and government transfers.
Suppose that national income increases in consumption demand.
a) What is the effect of the increase in consumption demand on the actual budget
surplus or deficit? On the structural budget deficit?
Definition: (Actual budget surplus) The difference between government revenues
and government expenditure(P.328)
Definition: (Actual budget deficit) The difference between government expenditure
and government surplus (P.328)
Definition: (Structural Budget Deficit) An estimate of what the government’s budget
deficit would be if the economy were at full employment (the natural rate of
unemployment), regardless of where the economy actually is; it increases and
decreases with discretionary changes in government goods and services, transfer
payments, or taxes; formerly referred to as the high-employment budget deficit.
Increase budget surplus.
No change in structural budget deficit.
b) If the government is required by law to maintain a balanced (actual) budget, what
further impact would this law have on aggregate demand as the government tries to
rebalance the budget.
Aggregate demand would further increase as government would spend the extra tax income.