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EC 102 – Spring 2015
Problem Session 5 (Chapter 13):
Krugman and Wells, Ch 13,
Q3.
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. This would shift the aggregate demand curve to the
left.
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. This would shift the aggregate demand curve to the right.
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. This would shift the aggregate demand curve to the left.
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. This would shift the aggregate
demand curve to the right.
Q6: 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 government transfer increase will increase real GDP by MPC/(1 − MPC) × $1, or 0.75/(1 − 0.75) × $1 = $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 government transfer reduction will decrease real GDP by MPC/(1 − MPC) × $1, or 0.5/(1 − 0.5) × $1 = $1. Since real GDP needs to decrease by $50 billion, the government should decrease 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 government transfer reduction will reduce real GDP by MPC/(1 − MPC) × $1, or 0.8/(1 − 0.8) × $1 = $4. Since real GDP needs to decrease by $80 billion, the government should reduce transfer payments by $20 billion to close the inflationary gap. Q9: It’s impossible to determine which policy maker is correct given the information available. Other things equal, the government’s budget surplus will rise either if real GDP is growing or if Macroland is using contractionary fiscal policy. When the economy grows, tax revenue rises and government transfers fall, leading to an increase in the government’s budget surplus. However, if the government uses contractionary fiscal policy, then the government purchases fewer goods and services, increases taxes, or reduces government transfers. Any of those three changes will result in a temporary increase in the government’s budget surplus, although the reduction in real GDP will eventually cause tax revenue to fall and government transfers to rise, which will partly reduce the budget surplus. Q13: Your study partner is correct that the distinction between the government’s budget deficit and debt is similar to the distinction between consumer savings and wealth. Savings and deficits refer to actions that take place over time. When the government spends more than it receives in tax revenue in a particular time period, it is running a budget deficit. When consumers spend less than their disposable income in a particular time period, they are saving. However, both debt and wealth are measured at one point in time. When the government runs a budget deficit, the deficit is almost always financed by borrowing, which adds to its debt. Similarly, consumers accumulate wealth by saving. Your study partner is wrong in that the government can run a large budget deficit and have a small debt if it hasn’t run large deficits in the past. Q14: a. If the government has relatively little debt but is running a large budget deficit as it builds a high‐ speed rail system, this should not indicate potential problems for the economy. Like funding a war effort, it is difficult, if not impossible, to finance major improvements in a nation’s infrastructure without borrowing. As long as the budget deficit ends with the building project, this should not create long‐ term problems. b. If the government’s debt is relatively high but the government has reduced its budget deficit, this should not indicate potential problems for the economy. However, the government needs to be careful that the deficits do not become persistent. c. Even if the government’s debt is relatively low, if it is running a budget deficit to finance the interest payments on that debt, this portends potential problems for the future. Without any changes, the government’s debt will grow over time and with it the size of the government’s budget deficit because of increasing interest payments. If GDP growth does not keep up with the growth in the government’s debt, the debt–GDP ratio will rise.