Exercise 5
Q
I don’t understand the solution to Question 2B. How did you proceed? Why do we
have to equal the borrowing and the taxes? Why on question 2B2 did we calculate
two times the effect of the multiplier?
A
In this question you are asked to start with the desired endresult and work your way
back to the start of the multiplier process. In other words, start by finding the output
gap (between full employment and the current equilibrium) that you want to
eliminate. This is 30002500=500.
All you need to do next in order to find the right policy in each case, is to divide 500
by the relevant multiplier. What complicates the answer is that we assume that
investment is not autonomous to output (or at least not fully autonomous), which
means that it has a Marginal Propensity to Invest (MPI), in this case 0.2. Thus, the
slope of the AD curve is MPC+MPI=0.6+0.2=0.8.
2B1
In 2B1 (an increase in public consumption financed by selling bonds to the public) the
multiplier is the regular one (adjusted for MPI), which is 1/(1MPCMPI)=1/(10.6
0.2)=5. Thus, the desired increase in public consumption is 500/5=100.
2B2
In 2B2 (a tax cut coupled with an increase in bond sales to the public to the same
amount) the multiplier is the regular one (adjusted for MPI) multiplied by the MPC.
We multiply the regular multiplier by the MPC because assuming that the tax being
cut is not an income tax, the tax cut represents an autonomous rise in disposable
income, of which only a fraction (determined by the MPC) will be spent on private
consumption. Thus, the rise in AD is MPC*(tax cut). So the multiplier in this case is
MPC/(1MPCMPI)=0.6/(10.60.2)=3. Thus, the desired tax cut is 500/3=167.
2B3
In 2B3 (an increase in public consumption financed with a fixedsum tax) you use the
balancedbudget multiplier (adjusted for MPI), which is the sum of two effects on
AD: A rise in AD due to the increase in public consumption, for which the multiplier
is 5; and a decline in Ad due to the tax rise, for which the multiplier is 3.
Mathematically, the multiplier is (1MPC)/(1MPCMPI)=2. Thus, the desired
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 Spring '07
 sadeh
 Taxes, Keynesian economics, Fractionalreserve banking, negative external infusion

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