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 mediumrun and longrun 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 crowdedout investment.
After the AD curve shifts to the right by 600 billion or so, this will raise output above potential
(or fullemployment) GDP as well as the price level. The mediumrun 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 longrun
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 “SupplySider,” his policies had a huge amount of fiscal
stimulus built into them.
So perhaps Reagan was the greatest Keynesian of them all!
1
This preview has intentionally blurred sections. Sign up to view the full version.
View Full Document
1B.
Compare the impact of the above policy on the medium and longrun 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.
This is the end of the preview.
Sign up
to
access the rest of the document.
 Fall '07
 Fullenkampf

Click to edit the document details