Download Solutions to practice problems for 3/2/06:

Solutions to practice problems for 3/2/06:
Chapter 10
Test Yourself, Problem 3
(a) In Chapter 9, question 2, we saw that the marginal propensity to
consume was 0.9, and the (oversimplified) multiplier 10. The table in
this question confirms that when investment rises by 20, from 240 to
260, aggregate demand rises by 200, no matter what the price level, as
long as the price level is constant. For example, at a price level of 105
aggregate demand rises from 3770 to 3970.
(b) Initial equilibrium: P = 100, Y = 3800. Eventual equilibrium: P = 110, Y
= 3940. The multiplier, taking account of price increases, is 140/20 = 7.
Test Yourself, Problem 4
The steeper the aggregate supply curve, the smaller the multiplier effect of an
increase in aggregate demand, and the larger the inflationary effect. So, with an
identical increase in aggregate demand, Figure 27-3(a) shows a larger output
increase but a smaller price increase than Figure 27-3(b), because its aggregate
supply curve is flatter. In the limiting case of Figure 27-3(c), where the aggregate
supply curve is vertical, an increase in aggregate demand results only in
inflation, and the multiplier is zero. In the other limiting case of Figure 27-3(d),
where the aggregate supply curve is horizontal, inflation is absent and the
multiplier is equal to the “oversimplified” multiplier. See the graphs on the next
page.
Chapter 27/Supply-Side Equilibrium: Unemployment and Inflation? Y 375
FIGURE 27-3
QUESTIONS FOR DISCUSSION
1. A decrease in the price of foreign oil reduces the costs of production and thus
raises the profits of firms, inducing them to produce more output. This is
represented by a rightward shift of the aggregate supply curve, with a
consequent increase in output and reduction in the price level.
2. The statement is overly optimistic; gaps are worrisome. An inflationary gap will
eventually be eliminated, but only at a cost of the social disruption caused by
inflation. A recessionary gap may not be cured at all, because the cure requires
both prices and money wages to fall, and such falls are usually strenuously
resisted. Even if prices and wages do fall, and the recessionary gap is eventually
eliminated, the process is likely to take a long period, during which time the
country will suffer from unemployment and lost output.
3. (a) Stagflation follows naturally from an increase in aggregate demand above full
employment that causes an inflationary gap. Initially, prices and output rise.
But later, costs rise to catch up with prices. This is represented by a leftward
movement in the aggregate supply curve, which produces stagflation, that is
to say, rising prices coupled with falling output.
Discussion Question 1
A decrease in the price of foreign oil reduces the costs of production and thus
raises the profits of firms, inducing them to produce more output. This is
represented by a rightward shift of the aggregate supply curve, with a
consequent increase in output and reduction in the price level.
Discussion Question 2
The statement is overly optimistic; gaps are worrisome. An inflationary gap will
eventually be eliminated, but only at a cost of the social disruption caused by
inflation. A recessionary gap may not be cured at all, because the cure requires
both prices and money wages to fall, and such falls are usually strenuously
resisted. Even if prices and wages do fall, and the recessionary gap is eventually
eliminated, the process is likely to take a long period, during which time the
country will suffer from unemployment and lost output.
Chapter 11
Test Yourself, Problem 1
GDP
Taxes
1360
1480
1600
1720
1840
DI
400
400
400
400
400
C
960
1080
1200
1320
1440
I
720
810
900
990
1080
G
200
200
200
200
200
X-IM
500
500
500
500
500
Total
expenditure
30
1450
30
1540
30
1630
30
1720
30
1810
Equilibrium GDP is 1720. The marginal propensity to consume is 0.75 and
the multiplier is 4. If government purchases fell by 60, and the price level
were unchanged, GDP would fall by 240, to 1480. After G falls, the new
chart is:
GDP
Taxes
1360
1480
1600
1720
1840
DI
400
400
400
400
400
C
960
1080
1200
1320
1440
I
720
810
900
990
1080
G
200
200
200
200
200
X-IM
440
440
440
440
440
Total
expenditure
30
1390
30
1480
30
1570
30
1660
30
1750
Test Yourself, Problem 2
GDP
Taxes
1360
1480
1600
1720
1840
DI
320
360
400
440
480
C
1040
1120
1200
1280
1360
I
810
870
930
990
1050
G
200
200
200
200
200
X-IM
500
500
500
500
500
Total
expenditure
30
1540
30
1600
30
1660
30
1720
30
1780
Compared to Question 2, the expenditure line has a flatter slope, but it still
crosses the 45-degree line at a GDP of 1720. The marginal propensity to
consume is still 0.75. Now, however, the marginal tax rate is 1/3 (that is,
when income rises by 3, taxes rise by 1). Consequently the multiplier falls
to 2. A reduction in G of 60 will lower equilibrium GDP by 120 (provided
prices do not change), to a new level of 1600. Comparison of the two
questions shows that the introduction of a variable tax lowers the
multiplier. After G falls, the new chart is:
GDP
Taxes
1360
1480
1600
1720
1840
DI
320
360
400
440
480
C
1040
1120
1200
1280
1360
I
810
870
930
990
1050
G
200
200
200
200
200
X-IM
440
440
440
440
440
Total
expenditure
30
1480
30
1540
30
1600
30
1660
30
1720
Test Yourself, Problem 3
At each level of GDP, G rises by 120, while C falls by three quarters of 120, or
90. Therefore there is a net increase in expenditures of 30, as follows:
GDP
Taxes
DI
C
I
G
X-IM
Total
expenditure
1360
1480
1600
1720
1840
520
520
520
520
520
840
960
1080
1200
1320
630
720
810
900
990
200
200
200
200
200
620
620
620
620
620
30
30
30
30
30
1480
1570
1660
1750
1840
Equilibrium GDP has risen by 120, to 1840. (This is an example of what is
sometimes called “the balanced budget multiplier.” When government
spending and autonomous taxes are raised by the same amount, in this
case GDP rises by that amount.)
Test Yourself, Problem 5
Because the marginal propensity to consume is 0.75, and the marginal tax rate is
1/3, the multiplier is 2. Therefore, you must take some action that will
have the initial effect of raising expenditure by 60. You may raise
government spending on GDP by 60, or you may lower taxes or raise
transfer payments by 80.
Discussion Question 2
An increase in autonomous spending, whether it be consumption, investment or
government spending, increases GDP in the initial round by exactly the
amount of the increase in spending: there is no difference between C, I
and G in this respect. A tax reduction, however, does not initially increase
GDP, but only disposable income. The initial increase in GDP is less than
this; it is equal to the reduction in taxes (increase in disposable income)
times the marginal propensity to consume.
Discussion Question 3
To reduce aggregate demand, the government can reduce its spending on goods
and services, raise taxes or reduce transfer payments. To increase
aggregate demand, it can do the opposite: increase government spending,
reduce taxes or increase transfer payments.
Discussion Question 5
A capital gains tax cut will increase aggregate supply only insofar as it persuades
people to increase their capital investments. Whether or not this happens,
the tax cuts will lead to an increase in aggregate demand and a reduction
in tax revenue.
a. A tax cut on the gains from all investments will result in the largest
loss in tax revenue and the largest increase in aggregate demand. In
terms of its effects on investment, it will influence only new
investment, not investments already made.
b. If the tax cut is applied only to gains on investments made since the
tax cut, the revenue loss and impact on aggregate demand will be less
than in part (a). The impact on aggregate supply should be exactly the
same as in (a), since only new investments can be affected by a change
in policy.
c. A tax cut only on certain strategic types of investments would have
the least effect of the three policies on tax revenue and aggregate
demand. It would probably have a somewhat smaller effect on
aggregate supply, but not much smaller if the tax cuts are carefully
targeted. If the goal is to increase aggregate supply, without having too
much effect on aggregate demand, in order to increase production
while at the same time easing inflationary pressures, then policy (c) is
the most desirable.