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 Tn is net taxes] Keynesland then experiences a negative demand shock - aggregate demand (AD) fails unexpectedly Real ODP begins to fall and unemployment rises. The final result is that real GDP is $100 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 n 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 Prime back Prime 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 on 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).

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