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Macro2 Problem #3 Answers (
(1)
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points)
Note: In doing this problem do not set inflationary expectations to
“constant” at any time. Choose the recession option and record the initial
conditions. Continue to the policy options and then select “Calculate.”
Observe these results and choose “Next Year.” Retain the initial policy
values for the new year and again record the results.
Year 2 real GDP = 2111.03
(2)
Now select “New Term in Office” and again select the “Recession” option.
Calculate the results for the initial year and then choose “Next Year.” Enter
a new value for government spending, making it different from the initial
value by at least $10 and observe the results. Retain the initial values of the
other two policy tools.
(Cut in government spending = $10) Year 2 real GDP = 2107.17
(3)
Use the results from (1) and (2) to calculate the spending multiplier (the
change in real GDP divided by the change in government spending).
Compare the result you get with the spending multiplier you get using the
formula:
$2,111.03 - $2114.89 = -$3.86 = 0.386
$600 - $610
-$10.00
1__ = 1__ = 10
1 – 0.9
0.10
Spending Multiplier = 1/(1-Marginal Propensity to Consume) The MPC is
0.9 in this module. Explain why the two results are different.
The two results are different because crowding out. The increase in government spending
started to increase real GDP. However, as real income rose so did the demand for money,
and with a constant real money supply interest rates, real and nominal, rose. The increase
in the real interest rate discouraged private consumption and investment spending, and
that partly offset the impact of the increase in government spending. The overall effect of
government spending on real GDP (and on inflation and unemployment) was therefore
smaller. The fact that inflationary expectations were varying between years 1 and 2 did
not matter because the comparison made is between two year 2 results—and inflationary
expectations were the same for each because inflationary expectations in this module are
determined by past actual inflation and that was the same for both.
(4)
Repeat your procedures in part 2 but this time change the amount of taxes
(with no change in other policy values) by at least $10.
Year 2 Taxes = $2114.49
(5)
Using the results from (4), calculate the effective tax multiplier (the change in
real GDP divided by the change in government spending). Compare the
result you get with the tax multiplier you get using the formula:
Tax Multiplier = MPC / (1-Marginal Propensity to Consume) The MPC is
0.9 in this module. Explain why the two results are different.
$2,111.03 - $2114.49 = -$3.46 = -0.346
$600 - $590
$10.00
0.9_ = 0.90 = 10
1 – 0.9
0.10
The two results are different for the same reason as the one given in part 3, the tax cut
raised income, increased money demand, which increased interest rates and therefore
discouraged private spending. The only difference is that with the rise in government
spending there was less of an increase in consumption, here consumers got the tax cut
and there was more of a positive impact on them.
(6)
Repeat your procedures in part 2 but this time change the amount of the
money supply (with no change in other policy values) by at least $1 (but no
more than $5).
Year 2 real GDP = $2149.51 Money supply = $61
(7)
Using the results from (6), calculate the effectiveness of a $1 change in money
supply on real GDP. Explain why the money supply has this kind of effect.
(Hint: Check out the changes in consumer and investment spending, but
remember that consumer spending also depends on the level of real GDP.)
$2,111.03 - $2149.51 = -$38.48 = 38.48
$62 - $60
-$ 1.00
An increase in the money supply will tend to lower the real interest rate. This is because
holders of the excess money compete with each other for financial assets, the increase in
prices of such assets represents a decrease in (nominal) interest rates. With the same
inflationary expectations, due to having the same past inflation, that means a decrease in
real interest rates. The reduction in the real interest rate will stimulate private investment
spending and consumer spending, particularly on consumer durables. This is because the
reduced interest rate will lower the cost of borrowing that is needed for business
investment spending and consumer purchases. This increased spending will have a
multiplier effect as the increased spending creates income. Thus, an increase in the
money supply will have a positive multiplier effect on real GDP.
Note that the above situation occurs only when there is substantial unemployment as in
this recession. If the economy is near or at full employment, the additional money supply
will just spin around the economy faster and faster, causing inflation. Since the economy
would already be very close to full employment, very little increase in real GDP will be
possible.
(8)
Click on “New Term in Office”, and select the “Inflation” option. Calculate
the results for the initial year and record them. Now select “Next Year,”
and use the initial values for all of the policy tools and record the results. Do
the same again for another two years and record the results. (This would be
a good time to look at the “Performance Over Time” graph by clicking on
that on the tool bar. Explain the reason for the changes you observe despite
the unchanged policy values.
The changes observed over time with the same (real) policy values are the result of
changes in inflationary expectations. This economy was already above full employment
output in year 1 and the actual inflation rate was 8.12%, while the expected rate of
inflation (measured as the gap between the nominal and real interest rates) was 7.9%.
With inflation exceeding expectations, since in the module expectations depend on past
actual inflation, expectation increase. Higher inflationary expectations lower the real rate
of interest, which encourages even more private spending. The increase in private
demand increases the actual inflation rate and that in turn increases inflationary
expectations next time around. That means income, demand, and inflation will keep
rising (and unemployment will keep falling) as long as the same policies are maintained
in real terms. This would not be the result if the money supply were kept constant in
nominal terms, if it were fixed in nominal terms the rising price level would have reduced
the real supply of money and that would have increased real interest rates, reducing
demand for goods and services and eventually stabilizing the economy and reducing the
inflation rate.
(9)
Use the information gained in all the previous steps, to come up with a
combination of policy values that will prevent the rapid rise in the inflation
rate without raising the unemployment rate above 7%. Explain why you
chose your policies.
Judging from the calculation of the multipliers in the previous steps, in this module
changes in the money supply have a stronger impact on real GDP than changes in
government spending or taxes. That would make it easier to control inflation through
monetary policies than through fiscal policies (very large changes in government
spending and taxes would be needed to have much impact).
Along this line of thought, I decided to maintain a balanced budget with $690 for both
government spending and taxes and to decrease the money supply from $58.2 to $56.2
for two years. This resulted in an inflation rate of 1.7% and an unemployment rate of
6.85% by year 3. This is acceptable according to the confines of this question. An
inspection of the performance over time graph shows that the trend line for inflation has
bent downward, indicating that inflationary expectations have been brought under
control. However, since decreasing inflationary expectation (at 13.69 – 7.71 = 5.98% by
year 3) have been increasing real interest rates, and since actual inflation is now far lower
than expected inflation, continuing this set of policies for another year would cause
unemployment to rise past the limit set by the question.