test_111105_sol

# Now compare the effects of a decrease in government

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Now compare the effects of a decrease in government spending from 300 to 0 if there were fixed taxes to what would happen in Macronesia if there were variable taxes. Under fixed taxes: GDP Taxes Consumption (C) Gov. spending (G) Investment (I) Net exports (X-IM) 1000 200 900 0 200 -100 1200 200 1000 0 200 -100 1400 200 1100 0 200 -100 1600 200 1200 0 200 -100 1800 200 1300 0 200 -100 2000 200 1400 0 200 -100 Under variable taxes: GDP Taxes Consumption (C) Gov. spending (G) Investment (I) Net exports (X-IM) 1000 -100 1050 0 200 -100 1200 0 1100 0 200 -100 1400 100 1150 0 200 -100 1600 200 1200 0 200 -100 1800 300 1250 0 200 -100 2000 400 1300 0 200 -100 What would equilibrium output be under fixed taxes? (4 points) ___1000___ What would equilibrium output be under variable taxes? (4 points) ___1200___

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D) Using what you found about output changes in part C), what is the multiplier in the economy with fixed taxes? What is the multiplier in the economy with variable taxes? Show your work. (4 points each) Fixed taxes: GDP down by 600 when G down by 300, so the multiplier is 2 Variable taxes: GDP down by 400 when G down by 300, so the multiplier is 4/3 E) In which economy is the multiplier higher? Why? (4 points) The multiplier is higher in the economy with the fixed taxes. When there are variable taxes, taxes fall when income falls so that the negative effect of the decrease in government spending on output is partially offset by the fall in taxes.
Question 2 (30 points) The Macronesian government has two fiscal policy tools: government spending (G) and fixed taxes (T). The Central Bank of Macronesian has one monetary policy tool that it uses: control of the Macronesian money supply. A) Suppose that Macronesia is in a recession. The government and Central Bank want to help by pursuing an expansionary policy, but they don’t want investment to fall. Which policy is best suited to meeting these goals? (5 points) a) Increase the money supply b) Increase G c) Decrease T d) Increase G and decrease T B) Now analyze the effects of the policy that you chose in part A). Show how the money-market and goods market graphs look after the policy change by shifting any curves that need to be shifted. Be clear about which curves you have shifted.

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