Ch15-HW

1) A closed economy is characterized by the following table:

C = 600 + .75*(Disposable Income)

I = 500

G = 400

T = 400

Potential GDP = 5100

A) What is the (short-run) equilibrium level of output?

B) By how much would government spending have to change to bring output to Potential GDP?

C) Draw two diagrams, one on top of the other. In the top diagram, illustrate your answer from Part B on an Aggregate Expenditure graph (with 45-degree line). In the bottom diagram, show how the effect on an Aggregate Supply and Demand graph.

D) Recently, many economics textbooks have dropped discussion of the Keynesian Cross and instead focused exclusively on AS and AD. What are the advantages of one diagram versus the other?

E) If instead the government would prefer to use tax policy to reach Potential GDP, by how much would taxes have to change?

2) Examples in class imposed “lump sum” taxes. That is, the government forces consumers to pay $T in taxes, regardless of income. In reality, taxes tend to equal a fraction of income earned (call it “t”). In this scenario, the consumption function becomes:

C = Ca + (1-t)*mpc*Y

A) Use an aggregate expenditure diagram to illustrate what happens if the tax rate falls. How might this relate to the book’s discussion of automatic stabilizers?

B) Though the tax multiplier is a bit complicated, the government spending multiplier is . Suppose the tax rate is 25% and that consumers save 20% of every dollar they earn. What is the government spending multiplier?

C) Suppose instead that the tax rate is 75% (It might sound shocking, but a 75% tax rate is not unrealistic. According to http://www.taxpolicycenter.org/TaxFacts/TFDB/Content/PDF/oecd_historical_toprate.pdf, Sweden’s top marginal tax rate in 1988 was 75%.). What is the government spending multiplier? Why is the result different from part B?

3) Argentina experienced a prolonged economic recession in the late 1990s (see “A Decline without Parallel” for possible explanations, if interested). Ultimately, the recession caused the government to default on many of the loans it had received to keep the economy alive. Countries in such dire straits often turn to the International Monetary Fund (IMF) for help. The IMF provides additional loans, but also imposes strict rules upon governments. Read “Scraping Through the Great Depression,” and discuss the appropriate role of fiscal policy to aid the economic recovery.

4) What is the best option for stabilizing the economy: enact fiscal policy, employ monetary policy, or do nothing at all? Discuss the advantages and disadvantages, with specific reference to inside and outside lags.