Problem Set 1 Solutions

# Problem Set 1 Solutions - ECON 202 MACROECONOMIC THEORY...

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ECON 202 MACROECONOMIC THEORY Problem Set 1-Answer Key MULTIPLE CHOICE 1) E 2) E 3) C 4) E 5) B 6) E 7) D 8) E 9) C 10)E 11)D 12)D 13)E 14)E 15)D 16)D 17)C 18)C 19)B 20)D 21)D 22)C 23)C 24)B ESSAY 1-a) 0 * ( ) 500 0.5( 600) 300 2000 2500 0.5 5000 D Y Y Z C I G X IM Y Y Y Y Y = = + + + - = + - + + = - = dhDh± dhDh± 1-b) 1-c) 0 0 0 1 400 500 100 1 . . 1 1 100. 1 0.5 100.2 200 200 new old old c Y c multiplier c c Y Y Y Y = - = - = ∆ = ∆ - = - - = - = - = + ∆ = - 5000 200 4800 = - = 1-d) When demand falls by 100, firms cut their production by 100. As the production falls by 100, income falls which causes a subsequent reduction in consumption and demand. This Y-induced fall in demand causes further reduction in production. This continues and we observe a final change in Y that exceeds the initial change in autonomous demand. 45° Z’=2400+0.5 Z=2500+0.5Y Y=Z 4800 5000 Y (income) Demand Slope=0.5 Z=2500+0.5Y Y=Z Y (income) Demand 5000

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2) The change in taxes will be larger because part of any tax increase will cause saving to fall. So, to cause the same reduction in demand, the size of the tax increase will be higher than the size of any reduction in government spending. To solve this analytically, you need to derive the tax multiplier and the government spending multiplier (as shown below) then compare these two given the desired amount of change in the output. 0 1 ( ) D Y Y c c Y T I G = + - + + dD± 0 1 1 1 c c T I G Y c - + + = - 1 1 / 1 1 c MPC MPC Y T c MPC MPS - - - = = = - - ; Tax multiplier 1 1 1 1 / 1 1 Y G c MPC MPS = = = - - ; Government Spending Multiplier Given MPC = 0.5, the tax multiplier is -1 whereas the government spending multiplier is 2. This means in order to decrease the output by 500 ( 500 Y = - ) government can either increase the taxes by 500 ( 500 T = ) or decrease the government spending by 250 ( 250 G = - ) . You can see whether it works by plugging T=1100 or G=1750 into the Y=AE equation. Important: Make sure that you don’t memorize but learn how to derive the multiplier under different circumstances (open economy, existence of income tax. ..etc). 3) This is a suggestive answer. You will receive full credit even if you have outlined just the basics or emphasized different points. The Global Economic Crises in 2008-2009 was mainly triggered by the burst of the “US Housing Bubble” which had expanded from 2003 onwards due to easy borrowing conditions and low interest rates prevalent in the country. The housing bubble peaked around mid-2006 with banks extending credits to low profile customers who typically have bad credit histories and high risk of default. Once the interest rates began to rise in 2007, the (adjustable) mortgage payments increased and the borrowers started to default their loan, leaving investment banks with houses that worth way too less than the original value of the loans. Foreclosures in the real sector affected the secondary markets through the mortgage backed securities
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Problem Set 1 Solutions - ECON 202 MACROECONOMIC THEORY...

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