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f07 ec51 exam 2 ver 2 answers

# f07 ec51 exam 2 ver 2 answers - Economics 51D 24 October...

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Economics 51D 24 October 2007 EXAM TWO ANSWERS Annoying Version PART ONE: Problems. Work each of the problems in the space provided. Make sure that you do everything the question asks. 1. Suppose that the Congress reaches a compromise to cut taxes by \$225 billion but government spending must also be cut by \$150 billion. Taxes are all lump-sum taxes. Suppose that the autonomous level of consumption is \$60 billion, and the marginal propensity to consume is .89. The autonomous level of imports is \$50 billion and the marginal propensity to import is .07. Before the above bill passed, the economy was in short-run, medium-run and long-run equilibrium with G = T = \$600 billion , I = \$900 billion, and X = \$400 billion. A. (10 points) What is the level of GDP before the changes in taxes and spending? Write down the formulas you use and show your calculations. Answer: Since we only have lump-sum taxes of \$600 billion, let a T = 600 and b T = 0 in the expression Y = Y E = a C + b C *(Y- a T - b T *Y) + I + G + X – a M - b M *Y = a C + b C *(Y- a T ) + I + G + X – a M - b M *Y . Now we can collect the Y’s and we get Y*(1 - b C + b M ) = a C - b C *a T + I + G + X – a M . Using the above numbers gives Y*(1 - .89 + .07) = 60 - .89*600 + 900 + 600 + 400 – 50 or Y*.18 = 1376, so Y = 1376 / .18 = 7,644.44 billion. 1

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B. (20 points) Ignoring any crowding-out effects, show and explain the effects of the above change in spending and taxes on medium-run and long-run equilibrium prices and GDP. Be as specific as you can about the magnitudes of curve shifts and other changes. Answer: With lump-sum taxes, the government spending multiplier is 1 / (1 - b C + b M ) = 1 / (1 - .89 + .07) = 1 / .18 = 5.5556, while the lump-sum tax multiplier is - b C / (1 - b C + b M ) = -.89 / (1 - .89 + .07) = -.89 / .18 = -4.9444. Thus, the decrease in spending of \$150 billion will shift the AD curve by -150*5.5556 = -833.3333 billion, which is a shift to the left (decreasing AD), while the decrease in taxes of \$225 billion will shift the AD curve by -225*(-4.9444) = 1112.5 billion, which is a shift to the right (increasing AD). The net effect will be to shift the AD curve to the right by \$1112.5 – 833.3333 = \$279.1667 billion. This will have the usual effects, increasing GDP in the short and medium runs and pushing Y above Y P , potential GDP, which puts upward pressure on wages since unemployment falls. The rise in wages shifts MRAS up, which causes P to rise but Y to fall over time, until we get to the new long-run equilibrium given by the intersection of the new AD curve with the original long run aggregate supply curve. Therefore we get back to the original equilibrium output level, but we have a higher price level, in the long run. 2
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C. (20 points) Now include crowding-out type effects in your answer, if there are any, and compare the equilibrium you find to your answer in Part B. Again, be as specific as you can. Answer: Since T falls more than G, we have an increase in the government budget deficit, or a decrease in the budget surplus T – G, of 225 – 150 = 75. Recall that we call the budget surplus government saving, while we call Y – C – T – X + M private saving. So government saving falls, but it appears at first that private saving rises, since T falls. But note that consumption, C, is thought to depend on after-tax income, Y – T.
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f07 ec51 exam 2 ver 2 answers - Economics 51D 24 October...

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