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07f101ps6solutions

07f101ps6solutions - Princeton University Professor E Bogan...

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Unformatted text preview: Princeton University Professor E. Bogan Economics 101 Fall 2007 Problem Set 6 Solutions 1. I A. if P=I = C ,ooa+I+G+X-M. ={100+. 8(Y-. 2Y)+. 05( /1)} +200+ 300+ 150- (100+.14Y) Y=700+. SY Y*=1400 Budget Deficit=Expenditures—Revenue=G-T =300-.2(1400)=20 Trade Deficit: Imports-Exports , =100+.14(1400)-150=146 I. B. P=I, but taxes fall to T=.075Y Y: C + I + G + X — M. Y: {100+. 8(Y—. O75Y)+. OS(50/1_)} +200 + 300 + 150- (100+. MY) =700+. 6Y Y*=1750 , so tax cut increased GDP by stimulating consumption Budget Deficit=G-T =300-.O75(1750)=168.75, but tax cut increased budget deficit because . while the economy grew, it does not grow enough to offset the lower tax rate Trade Deficit: Imports-Exports =100+.14(1750)-150=195, and trade deficit grows because Y grows. II. A. T=.2Y., but supply is no longer horizontal You are given AS: Y=2100-’(500/P) Must derive AD: Y=C+I+G+X~M Y=650+(5.0/P) +.5Y Y=1300 + (lOO/P) Now set AS=AD 2 1 00-(500/P)=1300+( IOO/P) 800:600/P P*=3/4 or .75, and Y* =1433.33 II. B. T=.O75Y, but supply-is same as II A New AD: 650+(50/P)+.6Y=Y Y: 1625 + (125/P) Set AD=AS ' 1625+(125/P)= 2100-(500/P) _ P*=(25/19) =l.3l6, and Y* =1720 So upward sloping supply means that the tax cut causes some inflation and a smaller increase in GDP. Budget Deficit=300-.O75( 1720)=171 Trade Deficit=100+.14(1720)-150=190.80 III. Put taxes in the AS function AS=2200-500(.075)~(500/P) AS=AD 2200- 500(. O75)- (500/P)=1625+(125/P) 537. 5: 625/P P*=I .163 . Y*=1732 If taxes can shift the supply curve, then one gets a bigger kick to GDP out of a tax cut and less inflation. I 2A. Because of the large number of baby boomers relative to current retirees, the social security system is currently running a surplus (taxes going into the system exceed payments going out). According to current projections, when the baby boomers retire, tax receipts will fall short of payouts. This situation will necessitate running down the social security surplus that is accumulating now. By 2042 the surplus will be spent and‘the government will have to find some other way to meet its payout obligations to the retired baby boomers. 2B. The government could change the benefits promised by indexing only to inflation and not to wages, which include payments for increased real output. But since this means less benefits than now projected, this idea is politically difficult. (One variant is to exempt low income recipients from the change so that they would get the higher real social security payments.) The age of retirement with full benefits could be raised. The government could increase the revenues by raising the income limit on social security taxes. But supply—siders worry about the increase of the marginal tax rate of 12 4% on all those people with income between the old and the new limits. We could keep the limit and raise the tax rate, but that would make higher marginal tax rates for everyone with 1ncome under the limit. Some argue for partial privatization. This is forced saving placed intoa privately managed retirement fund of stocks and bonds. The proponents emphasize the possible increase in real investment from the new saving raising economic growth and thus partially paying for the borrowing necessary to give payments to retirees who were previously promised benefits. Critics doubt that growth can be raised enough to offset the huge financing cost of changing from a pay—as—you-go system to a funded system. That is, current workers’ social security payments are already promised to retirees. If we divert the current taxes into private saving plans, then we must borrow to pay all those who are retired or retire between now and when those that build up their private saving accounts retire. Also those who oppose private plans point out that how much you receive at retirement will vary depending on choosing better plans. In addition, private accounts would be more expensive to administer than the current system. 3. Crowding out refers to the reductiOn of private investment that results when increased government spending with given tax revenues increases the deficit (or reduces the surplus), thereby putting upward pressure on interest rates and discouraging interest- sensitive investment. Crowding-in refers instead to the increased private investment that results when increased public spending raises aggregate demand and thus encourages businesses to expand their productive capacity. 4. In 1993-1994, long—term interest rates Were high because of high government borrowing, and thus there was substantial crowding—out. The introduction of the l993 Budget Act, was contractionary from a traditional Keynesian perspective because it ‘ reduced the deficit (raising taxes and restraining the growth of spending). However, long— term interest rates came down with the passage of the act, encouraging investment. The key to the 1993 Budget Act was credible, moderate deficit reduction over a period of years. If the budget had been substantially more aggressive in reducing the deficit, then the economy probably would have contracted. Another key was Clinton’s coordination of deficit reduction with the Federal Reserve. Because the Fed knew that the US. structural budget deficit was being reduced, it was more comfortable keeping interest rates low. 5. Barro and others dislike any emphasis on the deficit. They care only about the level of G+TR, and they don’t care whether government outlays are financed by taxes or by borrowing.) They model the economy as generally in the vicinity of full employment and thus view the opportunity cost of government outlays as the foregone private output. Thus they believe the discussion of government outlays should be in terms of what functions are clearly superior to private alternatives and then those should be done 6. Many business people were overly confident that growth in technology would continue. The growth rate in technology (including internet businesses) and telecommunications in the later 19905 was unsustainable. Other businesses reduced their purchases in these areas so their investment fell. Telecommunications and technology realized they were over expanded and stopped their investment in plant and equipment. Falling real investment meant aggregate demand fell and the US had a brief recession, which hit technology and internet industries the hardest. Even with the unprecedented disaster of September 11‘“, it still took Congress until March 2002 to pass a stimulus bill. By now the economy is already recovering and probably doesn’t need the stimulus package. It is very difficult to get the timing right on counter cyclical fiscal policies. Each faction fights over what ought to be done. (However this package is small and probably won’t overheat the economy during the upturn.) 7.A 10. D 8.A 11. C 9.B ...
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