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f07 ec51 exam 2 practice answers

# f07 ec51 exam 2 practice answers - Some Answers to Some...

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Economics 51D 20 October 2007 Some Answers to Some Practice Problems for Exam 2 1. When Ronald Reagan took office in 1981, he pushed through a massive increase in defense spending and a cut in tax rates. Suppose that the increase in defense spending was \$300 billion and that the aggregate tax rate was .3 to .22. Let the marginal propensity to consume be .9 and the marginal propensity to import be .08. A. Show and explain the effects of this policy on the medium-run and long-run equilibrium price level and GDP. Be as specific as you can about how much curves shift (if any) and what happens during the transition from the medium run to the long run. Answer: The increase in government spending will result in an increase in aggregate demand, of course—which will depend on two things. First, there are the parameters that govern the multiplier. The government spending multiplier will be 1/(1-.9*(1-.22)+.08) = 2.65, so that the total shift in the AD curve could be as much as 2.65*300 = 793.65. The second factor is whether there will be any crowding out. Since the problem does not specify, you are free to assume how much crowding out will take place. Let’s assume that there will be a mild amount, so that the total shift in the AD curve will actually be less than 794 billion, say 600 billion once we factor in the multiplier effect of the crowded-out investment. After the AD curve shifts to the right by 600 billion or so, this will raise output above potential (or full-employment) GDP as well as the price level. The medium-run equilibrium will be where the new aggregate demand curve AD 2 intersects the original MRAS curve, since the fiscal policy change doesn’t affect the MRAS curve. Since Y > Y P in the medium run, there will be labor- market shortages that will push the wage rate up. As the wage rate rises, the MRAS curve will shift up, and as long as output is above potential GDP, this process will continue. The long-run equilibrium is found where AD = LRAS, which is at the same output level Y P where we started, but at a higher price level. This is shown in the diagram. So, though Reagan billed himself as a “Supply-Sider,” his policies had a huge amount of fiscal stimulus built into them. So perhaps Reagan was the greatest Keynesian of them all! 1

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1B. Compare the impact of the above policy on the medium- and long-run equilibrium price level and GDP to an increase of spending of \$300 billion without the cut in taxes. Answer: If we ignore crowding out, the answer is clear: the multiplier rises because of the tax rate cut, so fiscal policy will be more effective because of the rate cut, which implies that the shift in the AD curve is larger than it would have been under a tax rate of .3. To see this, note that the government spending multiplier with the higher tax rate is 1 / (1-.9*(1-.3)+.08) = 2.22, which is smaller than the government spending multiplier we calculated under the lower tax rate.
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