09 - CHAPTER 9 INCOME AND SPENDING Solutions to the...

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CHAPTER 9 INCOME AND SPENDING Solutions to the Problems in the Textbook : Conceptual Problems: 1. In the Keynesian model, the price level is assumed to be fixed, that is, the AS-curve is horizontal and the level of output is determined solely by aggregate demand. The classical model, on the other hand, assumes that prices always fully adjust to maintain a full-employment level of output, that is, the AS- curve is vertical. Since the model of income determination in this chapter assumes that the price level is fixed, it is a Keynesian model. 2. An autonomous variable’s value is determined outside of a given model. In this chapter the following components of aggregate demand have been specified as being autonomous: autonomous consumption (C*) autonomous investment (I o ), government purchases (G o ), lump sum taxes (TA o ), transfer payments (TR o ), and net exports (NX o ). 3. Since it often takes a long time for policy makers to agree on a specific fiscal policy measure, it is quite possible that economic conditions may drastically change before a fiscal policy measure is implemented. In these circumstances a policy measure can actually be destabilizing. Maybe the economy has already begun to move out of a recession before policy makers have agreed to implement a tax cut. If the tax cut is enacted at a time when the economy is already beginning to experience strong growth, inflationary pressure can be created. While such internal lags are absent with automatic stabilizers (income taxes, unemployment benefits, welfare), these automatic stabilizers are not sufficient to replace active fiscal policy when the economy enters a deep recession. 4. Income taxes, unemployment benefits, and the welfare system are often called automatic stabilizers since they automatically reduce the amount by which output changes as a result of a change in aggregate demand. These stabilizers are a part of the economic mechanism and therefore work without any case-by-case government intervention. For example, when output declines and unemployment increases, there may be an increase in the number of people who fall below the poverty line. If we had no welfare system or unemployment benefits, then consumption would drop significantly. But since unemployed workers get unemployment compensation and people living in poverty are eligible for welfare payments, consumption will not decrease as much. Therefore, aggregate demand may not be reduced by as much as it would have without these automatic stabilizers. 5. The full-employment budget surplus is the budget surplus that would exist if the economy were at the full-employment level of output, given the current spending or tax structure. Since the size of the full- employment budget surplus does not depend on the position in the business cycle and only changes 121
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when the government implements a fiscal policy change, the full-employment budget surplus can be used as a measure of fiscal policy. Other names for the full-employment budget surplus are the
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09 - CHAPTER 9 INCOME AND SPENDING Solutions to the...

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