Questions & Answers Ex. 5-6 - Exercise 5 Q I dont...

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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 end-result 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 3000-2500=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/(1-MPC-MPI)=1/(1-0.6- 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/(1-MPC-MPI)=0.6/(1-0.6-0.2)=3. Thus, the desired tax cut is 500/3=167. 2B3 In 2B3 (an increase in public consumption financed with a fixed-sum tax) you use the balanced-budget 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 (1-MPC)/(1-MPC-MPI)=2. Thus, the desired
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Questions & Answers Ex. 5-6 - Exercise 5 Q I dont...

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