Mankiw_Text_Chapter_11_Prob_1_d - increase in government...

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Mankiw_Text_Chapter_11_Prob_1_d First let’s examine the effect of increasing government purchases and taxes by equal amounts. The effect on income (Y) is determined by the effect of each variable times its respective multiplier. Δ Y = [Gov’t Purchases Multiplier] Δ G - [Tax Multiplier] Δ T Δ Y = [1 / (1 – MPC)] Δ G - [MPC / (1 – MPC)] Δ T Since the increase in taxes and government purchases are equal, we can say that Δ G = Δ T. The above equation can be rewritten as: Δ Y = [1 / (1 – MPC)] Δ G - [MPC / (1 – MPC)] Δ G Δ Y = [[1 / (1 – MPC)] - [MPC / (1 – MPC)]] Δ G Δ Y = [(1 – MPC)] / (1 – MPC)] Δ G = Δ G According to the Keynesian model, this means that equal increases in government purchases and taxes, ceteris paribus , leads to an increase in income that is equal to the
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Unformatted text preview: increase in government spending. This increase in government spending leads to a rightward shift of the IS curve by the amount Δ G. However, output Δ Y increases by some amount less than Δ G because of the upward sloping LM curve. In essence, this increase in government spending leads to an increase in interest rate and output. Now let’s look at the consumption curve. The consumption function is of the form: C = C + c (Y – T), where c = MPC. Since output Δ Y increases less than Δ T, then disposable income ( Δ Y- Δ T) decreases, which leads to a decrease in consumption. Finally, since interest rate increases, this will cause investment (I) to decrease. I recommend that you look at Figure 11-1 and 11-2 for the graphical representation of the above....
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This note was uploaded on 11/17/2009 for the course ECO 121212 taught by Professor Smith during the Spring '09 term at Culver-Stockton.

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