Download Answers to Questions from Chapter 26 (1) and (2): The equilibrium

Answers to Questions from Chapter 26
(1) and (2): The equilibrium occurs where total expenditure (C+I+G+X-IM) equals total
production (GDP). In both questions this occurs at $3.8 trillion. These questions have different
consumption and investment schedules. The mpc in (1) is 0.90 and the mpc in (2) is 0.60.
Additionally, investment rises with GDP in (2) and remains constant in (1).
In (1), if I rises by $20 to $260, then equilibrium GDP will rise by $200B (= $20 x multiplier of
10). The expenditure schedule below will shift upward and the new equilibrium GDP (where the
45 degree line and the new expenditure schedule intersect) is $4.0T.
total
expenditures
45o
C+I+G+X-IM
E
$3.8 T
$3.8 T
GDP
(3) Consumption falls as the price level rises because the value of assets fixed in money terms is
lower. Since wealth is another source of financing purchases, at higher prices, consumption is
lower.
P level
110
105
100
95
90
AD
1.06
1.08
1.10
1.12 1.14
C+I+G+X-IM
Answers to Questions from Chapter 27
“Test Yourself”
(1) If full employment comes at $2,800 billion, then there is an inflationary gap of $200 billion.
(3) (a) In Chapter 26, question (1), we saw that the MPC = 0.90, 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 $3,770
to $3,970.
(b) The initial equilibrium is P = 100 and Y = $3,800. The equilibrium (after the rise in
investment spending) is P = 110 and Y = $3,940. The multiplier, taking into account the price
increases, is 140/20 = 7 (i.e., ∆Y/∆I). Thus, inflation has reduced the multiplier from 10 to 7.
“Discussion Questions”
(1) A decrease in the price of foreign oil reduces the costs of production, raising the profits of
firms and thereby encouraging them to raise their output levels. This is represented by an
outward shift of the aggregate supply curve, which reduces the price level and increases real
GDP.
(3) First, stagflation can arise in response to an inflationary gap. When aggregate demand
increases beyond full employment, prices and output initially rise. Eventually, however, wage
costs rise as the labor market tightens. This is shown as an inward shift of the aggregate supply
curve, which produces stagflation --rising prices and falling output. Second, stagflation can
result from any event that independently reduces aggregate supply, for example, an increase in
foreign oil prices.
Answers to Questions from Chapter 28
“Test Yourself”
(1) Equilibrium GDP is $1,720. The mpc is 0.75 and the multiplier is 4. If G falls by $60, and the
price level is unchanged, GDP would fall by 4 × $60 = $240, that is, to $1,480.
GDP
1,360
1,480
1,600
1,720
1,840
Taxes
400
400
400
400
400
DI
960
1,080
1,200
1,320
1,440
C
720
810
900
990
1080
I
200
200
200
200
200
G
500
500
500
500
500
X-IM
30
30
30
30
30
Total exp
1,450
1,540
1,630
1,720
1,810
(2) Compared to question 1, the expenditure line has a flatter slope, but it still crosses the 45degree line at a GDP of $1,720. The mpc 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 (note:
multiplier = ∆GDP/∆G). A reduction in G of $60 will lower equilibrium GDP by $120 (provided
prices do not change), to a new level of $1,600. Comparison of the two questions shows that the
introduction of a variable tax lowers the multiplier.
GDP
1,360
1,480
1,600
1,720
1,840
Taxes
320
360
400
440
480
DI
1,040
1,120
1,200
1,280
1,360
C
810
870
930
990
1,050
I
200
200
200
200
200
G
500
500
500
500
500
X-IM
30
30
30
30
30
Total exp
1,540
1,600
1,660
1,720
1,780
(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
1,360
1,480
1,600
1,720
1,840
Taxes
520
520
520
520
520
DI
840
960
1,080
1,200
1,320
C
630
720
810
900
990
I
200
200
200
200
200
G
620
620
620
620
620
X-IM
30
30
30
30
30
Total exp
1,480
1,570
1,660
1,750
1,840
Equilibrium GDP is now $1,840, which is $120 more than in question 1.
(4) Since you want to reduce GDP by $120, and since the multiplier is 4, you must take some
action that will have an initial impact of reducing expenditure on GDP by $30. You may cut G
by $30. Instead, you may raise taxes or reduce transfer payments by $40. Either of these latter
two policies will lower DI by $40 and, since the mpc is 0.75, lower C by $30.
“Discussion Questions”
(2) An increase in autonomous spending, whether C, I, or G, 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 DI. The initial
increase in GDP is less than this; it is equal to the reduction in taxes (increase in DI) times the
mpc. Note also the minus sign: GDP moves in the opposite direction from the tax change.
(3) To reduce AD, the government can reduce its spending, raise taxes, or reduce transfer
payments. To increase AD, it can do the opposite: increase its spending, reduce taxes, or increase
transfer payments.