EC202 PS6solution

# EC202 PS6solution - Fall 2015 EC202 Section D Problem Set 6...

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Fall 2015 - EC202 Section D - Problem Set 6 Textbook Questions Chapter 3 Question 4 For both political and macroeconomic reasons, governments are often reluctant to run budget deficits. Here, we examine whether policy changes in G and T that maintain a balanced budget are macroeconomically neutral. Put another way, we examine whether it is possible to affect output through changes in G and T so that the government budget remains balanced. Start from the following equation: Y * = 1 1 - c 1 c 0 - c 1 T + ¯ I + G a. By how much does Y increase when G increases by one unit? Solution: Let’s start with equation 3.8 from the textbook: Y = 1 1 - c 1 c 0 + ¯ I + G - c 1 T If G increases by one unit, then output will increase by the multiplier 1 1 - c 1 . b. By how much does Y decrease when T increases by one unit? Solution: If taxes increase by one unit, then output will fall by c 1 1 - c 1 . c. Why are your answers to (a) and (b) different? Suppose that the economy starts with a balanced budget: G = T . If the increase in G is equal to the increase in T , then the budget remains in balance. Let us now compute the balanced budget multiplier. Solution: 1

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A change in G affects demand and thus output directly, since it is added to total demand. However, a change in T affects demand and thus output only indirectly through consumption. If taxes go up by one unit, consumption will fall by only c 1 units since the remaining fraction is reduced savings. d. Suppose that G and T increase by one unit each. Using your answers to (a) and (b), what is the change in equilibrium GDP? Are balanced budget changes in G and T macroeconomically neutral (that is, is there a zero effect?)? Solution: To get the combined effect, we need to add up the two individual effects (remember that the tax effect on output is negative!). Thus the balanced budget multiplier is: 1 1 - c 1 + - c 1 1 - c 1 = 1 - c 1 1 - c 1 = 1
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