Problem Set 10 Solutions

Problem Set 10 Solutions - Economics 3213 Answers to...

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Economics 3213 Answers to Problem Set 10: 101 Dalmatians Prof. Xavier Sala-i-Martin 1. Cruella DeVil a. A permanent reduction in public spending and lump sum taxes is just the reverse of a permanent increase analyzed in class. As a direct effect, aggregate demand decreases because G decreases. Indirect effects include an increase in C d by the same amount as a permanent decrease in taxes. Hence, Y d shifts back to its initial position. Another indirect effect is a decrease in labor supply because of the wealth effect of a tax reduction. Y s shifts to the left a little, and consequently Y d shifts to the left by the same amount. In equilibrium, interest rate stays the same; output is lower; quantity consumed is higher; quantity invested is the same. Money demand is lower because output goes down. Therefore, price level is higher. In this model people will like the policy of reduced government spending. Although the price level is higher and output is lower, private real consumption is higher. Private investment stays the same. Governments do not reduce spending in the real world for two broad sets of reasons. First, this model assumes that all public spending is useless , while at least a part of government spending is definitely useful in the real world. Part of government spending increases the productivity. By providing the infrastructure, law and contract enforcement, financing research and development, etc., the government increases marginal returns to private capital and labor. Another part of public spending directly increases consumers' utility: national parks, police protection, using the infrastructure for consumption (roads, public utilities), etc. Another set of reasons why public spending is not reduced concerns how governments make decisions. Unlike this model, governments in the real world are not impersonal entities. They make decisions based on political considerations. Some groups may weigh more in the political process than consumers: the military industrial complex, big firms and wealthy individuals who contribute to election campaigns, etc. Finally, bureaucrats and elected officials who actually constitute the government can make decisions that benefit themselves or their friends and relatives. Even if the government spending is useless or harmful to an average consumer , it can benefit certain special interest groups who will oppose the reduction of spending. b .A temporary reduction in public spending and lump sum taxes
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temporary increase analyzed in class. As a direct effect, aggregate demand decreases because G decreases. As an indirect effect, C d increases by a smaller amount than taxes decrease because the tax break is temporary. Y d shifts to the right but short of its initial position. Another indirect effect is a decrease in labor supply because of the wealth effect of a tax reduction. Y s shifts to the left a little, and consequently Y d shifts to the left by the same amount. In equilibrium, interest rate goes down; output is lower; quantities consumed and
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This homework help was uploaded on 04/07/2008 for the course ECON W3213 taught by Professor Xavier during the Fall '06 term at Columbia.

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Problem Set 10 Solutions - Economics 3213 Answers to...

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