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SP 2123 T4
SP 2123 T4
G 1 MPC
(2) Change in Tax (lump-sum tax)
Y
MPC
Multiplier
T
1 MPC
(3) Balanced budget multiplier
Suppose G and T increases by the same amount, the total effect on Y would be G
Y
Y
1
MPC
Multiplier
(
)
1
G
T
1 MPC 1 MPC
Y G 1
1
Automatic stabilizers are features of the tax and transfer systems that tend to offset
fluctuations in economic activity without direct intervention by government
Examples of automatic stabilizers: Why are these policies called automatic stabilizers?
Example 1
Y c0 c1 (1 )Y I G
1
Y
[ c0 I G ]
1 c1 (1 )
1
1
Multiplier:
1 c1 (1 ) 1 c1
Example 2
Y c0 c1 (Y t0 t1Y ) I G
Y c0 c1 (1 t1 )Y c1t0 I G
1
Y
[c0 I G c1t 0 ]
1 c1 (1 t1 )
1
1
Multiplier
1 c1 (1 t1 ) 1 c1
In equilibrium, Y c0 c1 (Y T ) I G
1
Y
[c0 I G c1T ]
1 c1
(2) Saving = Investment i.e. I = S + (T G)
Y=C+I+G
YTC=I+GT
S=I+GT
I = S + (T G)
In the equilibrium, I = S + (T G)
I = S = Y C T + (T G)
I = Y T c0 + c1 (Y T) + (T G)
1
Y
[c0 I G c1T ]
1 c1
-c0
Given
-c0
C = c0 + c1YD
S = c0 + (1 c1) YD
I I
1
[c0 I G c1T ]
1 c1
Suppose consumers decide to save more and increase their MPS (decrease in c1 and c0
remains unchanged). What will happen to output and saving? (P.52)
Y = c0 + c1(Y T) + I + G = Z
Y = c0 + c1Y c1t0 c1t1Y + I + G
Y = [1/ (1 c1 + c1t1)] [c0 c1t0 + I + G]
(d) Suppose that the government eliminates the surplus by reducing the fixed part of taxed
(t0). What effect will this have on Y? Does that cut in t0, which keeps that budget
balanced, counteract or reinforce that effect of the increase in c0 on output? (Dont do
the algebra. Use your intuition, and give the answer in words.)
It the government eliminates the surplus by reducing t0, consumption will be higher
which ends up in a higher Y. Therefore the cut in t0 reinforces the effect the effect of the
increase in c0 on output.
Question 5: Investment and income
This problem examines the implications of allowing investment to depend on output. Chapter
5 carries this analysis much further and introduces an essential relation the effect of the
interest rate on investment not examined in this problem.
(a) Suppose the economy is characterized by the following behavioral equation:
C =c0 + c1YD
YD = Y T
I = b0 + b1Y
Government spending is constant. Note that investment now increases with output. Chapter 5
will discuss the reasons for this relation. Solve for equilibrium output.
In the goods market equilibrium, Y = c0 + c1(Y T) + I + G = Z (equation 3.7),
Y = c0 + c1Y c1T + b0 + b1Y + G
Y = [1/ (1 c1 b1)] [c0 c1T + b0 + G]
(b) What is the value of the multiplier? Howe does the relation between investment and
output affect the value of the multiplier? For the multiplier to be positive, what condition
must c1 + b1 satisfy? Explain your answers.
The multiplier is 1/ (1 c1 b1) = 1/ [1 (c1 + b1)]. The value of the multiplier is
positively related to b1. The multiplier is larger when comparing to 1/ (1 c1). It is
because, in this case, an increase in autonomous spending now has a multiplier effect
through consumption as well as investment.
For the multiplier to be positive, c1 + b1 must be small than 1.
If c1 + b1 >1, then the economy would not have a well-defined equilibrium. One extra
unit of autonomous spending would lead to a greater than one unit increase in spending
(consumption plus investment) in every round of the multiplier, so the economy would
explode into infinite output.
(c) Suppose that the parameter b0, sometimes called business confidence, increases. How
will equilibrium output be affected? Will investment change by more or less than the
change in b0? Why? What will happen to national saving?
Equilibrium output increases by b0 times the multiplier. Investment increases by more
than the increase in business confidence, since the increase in output also leads
investment to increase (b1Y).
In equilibrium, national saving equals investment. If investment increases in equilibrium,
national saving increases as well.