1. The Multiplier
Suppose C = A + 0.7*DI, and that the tax rate is 0.2, so that DI = 0.8Y + TR. Suppose autonomous consumption rises by 300 due to a stock market boom, and at the same time suppose investment rises by 100 due to lower real interest rates.
(a) How much will equilibrium output change? (Use the multiplier formula)
(b) In equilibrium, the change in output you solved for in part (a) must equal the change in aggregate demand. Which components of aggregate demand (C, I, G or NX) change in this example, and by how much?
(c) Intuitively, why does Y change by more than the change in autonomous expenditure? Don’t use formulas to answer this question–tell a story.
(d) Intuitively, why doesn’t Y change by infinity in this example?
2. Fiscal Policy in the Keynesian Model:
Assume the following parameters: C = 100 + 0.85*DI; t = 0.15; I = 200;
G = 120; NX = 30; TR = 100
(a) Calculate equilibrium output. Calculate the budget deficit (or surplus), where the budget deficit is given by G + TR – tY. Calculate the multiplier.
(b) Suppose that full employment output for this economy is 500 more than the equilibrium level you solved for in (a). Suppose the government wants to increase output by 500, by using an increase in government purchases. How much does G have to rise in order to increase output by 500? What is the new level of the budget deficit? (For this part, use the multiplier formula, which says that ΔY = Multiplier * Δ(Autonomous Expenditure). Note that in this case, the only category of autonomous expenditure that is changing is G.)
(c) Now suppose that G is once again 120 (as in part (a)) and that output is at its level from part (a). Suppose the government wants to increase output by 500, by using an increase in transfer payments (TR) rather than an increase in government purchases. How much does TR need to rise in order to increase output by 500? What is the new level of the budget deficit? (Hint: how does a change in TR affect autonomous expenditure? Remember that only part of an increase in TR is spent while the rest of it is saved).
3. More on the multiplier
Suppose that the government hires additional teachers and pays them 300. Shortly thereafter, we observe that teachers’ disposable income rises by 255, while tax revenues increase by 45. Next we see that teachers’ spending on consumer goods rises by 229.5 while their saving rises by 25.5.
Calculate the eventual total increase in output in this example. [Hint: think of the steps of the multiplier process that I went through in class. What is the tax rate implied by the numbers I gave you above? What is the MPC? What is the implied multiplier?]
4. For each of the following, first indicate whether this is a change to fiscal or monetary policy; then explain in words and show using the 45 degree line diagram how this change will affect Keynesian equilibrium output. Does the expenditure schedule experience a rotation or a parallel shift? If the latter, what components of autonomous expenditure change and why? Also, explain in one sentence why the government or Fed would undertake such a policy.
(a) The government increases transfer payments
(b) The government increases the income tax rate
(c) The Federal Reserve increases the federal funds rate from 0 percent to 2 percent
(d) The Federal Reserve buys long term bonds, reducing long-term interest rates (this is an example of quantitative easing)
5. Describe the short-run effects of each of the following shocks on output and inflation in the Aggregate Demand-Aggregate Supply model, using pictures to illustrate your answers. Explain which curves shift and why. Also describe what happens in the medium-to-long run to output and inflation, again using pictures to illustrate your answers. Explain which curves shift and why.
(a) An earthquake in the Middle East destroys oil fields and permanently reduces the supply of energy.
(b) The Fed tightens monetary policy drastically (more than the Taylor Rule would imply) to fight inflation
