BONUS: For a MAXIMUM of 10 additional points. For any credit you must complete a

Question

BONUS: For a MAXIMUM of 10 additional points. For any credit you must complete all parts the economy of Keynesland has achieved their potential output/full employment level of real GDP and has a zero budget balance.[G = Tn. where G is government purchases and T_n is net taxes] Keynesland then experiences a negative demand shock - aggregate demand (AD) falls unexpectedly Real GDP begins to fall and unemployment rises. The final result is that real GDP is SICK) billion below the full employment level of real GDP by the end of the year. Questions: Assume that the mpc for this economy is 0.5 and that the short run aggregate supply is horizontal in the relevant range of output so the price level does not change.[As aggregate demand shifts the full multiplier effect occurs.] Your answers should give the size and direction of the changes/effects when required. Show sufficient work to "back" your answer and to receive any partial credit; however, the final conclusion should be clearly indicated. Show the effect of the negative demand shock on the macroeconomic equilibrium using the AD-AS model/graph. label clearly. Use the back of this paper. If the government decides to pursue expansionary fiscal policy, What change in G would be required to shift AD by the $100 billion and achieve the potential output. What change in Tn-either through a change in taxes or change in transfers- could be used instead?] size and direction of the change required] Indicate the effect of each of the above options on the federal budget balance. [the budget balance for option a and the budget balance for option b. if each occurs independently.] What is the effect of the equilibrium level of real GDP and the budget balance if both G and tn are increased by $100 billion? [Both changes made at the same time.] Show sufficient work and clearly indicate the final result.

Explanation / Answer

(2) MPC = 0.5

(a) Spending multiplier = 1 / (1 - MPC) = 1 / (1 - 0.5) = 1 / 0.5 = 2

So, if government spending rises by $1, real GDP (AD) rises by $2.

For AD to rise by $100 billion, government spending has to rise by $100 billion / 2 = $50 billion

(b) Tax multiplier = - MPC / (1 - MPC) = - 0.5 / 0.5 = -1

If tax falls by $1, AD rises by $1.

For AD to rise by $100 billion, tax has tofall by $100 billion / 1 = $100 billion.

(3) Budget balance = Tn - G = 0 (Initially)

In case (a), G rises by $50 billion, so Budget balance is - $50 billion (deficit).

In case (b), Tn falls by $100 billion, so budget balance is - $100 billion (deficit).

Note: First 2 questions are answered.

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