CH4 solutions - P4.4 Budget Constraints . Holding all else...

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P4.4 Budget Constraints . Holding all else equal, indicate how each of the following changes would affect a budget constraint that limits consumption of goods (Y) and services (X). Explain your answer. A. Deflation that uniformly drops the price of all goods and services. B. Inflation that consistently increases the price of all goods and services. C. Technical change that reduces the price of goods, but leaves the price of services unchanged. D. Economic growth that boosts the level of disposable income. E. Government-mandated health care coverage for workers that boosts the price of goods by 3% and increases the price of services by 5%. P4.4 SOLUTION A. Deflation that drops the price of all goods and services results in a parallel rightward (outward) shift in the budget constraint. Holding income constant, lower prices make it possible for consumers to buy more goods and services with the same total amount of spending. This beneficial impact on consumption is similar to that following an increase in income. B. Inflation that increases the price of all goods and services results in a parallel leftward (inward) shift in the budget constraint. Holding income constant, higher prices reduce the amount of goods and services that consumers can buy with a fixed amount of spending. This harmful impact on consumption is similar to that following a decrease in income. C. Technical change that reduces the price of goods, but leaves the price of services unchanged results in an outward rotation of the budget constraint along the goods ( Y) axis. After such a change, the budget line intersects the Y axis at a higher point, indicating that a greater amount of goods can be purchased with a fixed budget. The amount of services that can be purchased for a fixed amount is unaffected by such a change, and the X intercept (services axis) of the budget constraint is unaffected by such a change. D. Economic growth that boosts the level of disposable income results in a parallel rightward (outward) shift in the budget constraint. Holding prices constant, growing income makes it possible for consumers to buy more goods and services with the same total amount of spending. This beneficial impact on consumption is similar to that following deflation that drops the price of all goods and services. E. Government-mandated health care coverage for workers that boosts the price of goods by 3% and increases the price of services by 5% will have a negative impact
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on consumption of both goods and services, but the negative impact will be worse in the case of services. Following such a change, the relative price of services will rise relative to the price of goods. The new budget line will move inward 3% along the X axis reflecting the fact that a fixed budget will only be able to buy 97% of the previously affordable goods. The new budget line will move inward 5% along the Y axis reflecting the fact that a fixed budget will only be able to buy 95% of the previously affordable services. The net effect is similar to a decrease in income
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