Week 11, Day 1 - Midterm II Solutions

Week 11, Day 1 - Midterm II Solutions - MIDTERM II...

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MIDTERM II SOLUTIONS Part I: 1. Answer: Only policy B A temporary cut in income taxes for households will have a weak effect on the economy. Since the tax cut is temporary, households are unlikely to boost their consumer spending significantly in one period only to reverse their spending significantly in another period. A temporary tax cut on investment spending by businesses will have a significant effect on the economy. Since the tax cut is temporary, businesses that are planning to purchase physical capital will want to accelerate those plans in order to take advantage of the tax cut incentive. Businesses need to act quickly before the tax cut is eliminated. 2. Answer: negative supply shocks Stagflation is a phenomenon that involves a rising aggregate price level and a declining level of real GDP. This occurs when the SRAS curve shifts to the left (ie when a negative supply shock occurs). Fiscal and monetary policy (regardless of whether they are expansionary or contractionary) cause the AD curve to shift. 3. Answer: increased, less If actual investment is greater than desired investment, then businesses have more investment spending than was planned. This occurs because of unintentional increases in inventories, which are part of investment spending. The additions to inventories occurred because aggregate spending (ie demand) is less than aggregate output (ie supply) and a surplus of output. 4. Answer: increase, decrease As the baby boom generation retires, a large segment of the population will stop contributing to savings and will start withdrawing funds from savings. As a result, the supply of loanable funds will decrease (ie shifts to the left), the interest rate will increase, and the quantity of loanable funds will decrease. 5. Answer: a decrease in government purchases by $50 million To reduce the inflationary gap, the government must decrease government purchases (G), decrease transfers (TR), or increase lump-sum taxes (T 0 ). The other three policies would increase the inflationary gap. Equal changes in these three policies do not have the same impact on real GDP. Specifically, the decrease in G has the largest impact because real GDP falls initially by the full amount of the cut in G. The decrease in TR and the increase in T0 lead to lower disposable income and to lower consumption. But, the initial decrease in consumption is less than $50 million because households also cut their savings. Alternatively, the G multiplier, 1/(1-MPC), is larger than the TR multiplier, MPC/(1-MPC), and the T 0 multiplier, -MPC/(1-MPC). Therefore, the change in G has a bigger effect on the inflationary gap. 6.
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This note was uploaded on 10/13/2009 for the course ECON 1221 taught by Professor Whitaker during the Winter '09 term at Langara.

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Week 11, Day 1 - Midterm II Solutions - MIDTERM II...

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