Introductory Macroeconomics, ECON10003

Semester 2, 2020

Solutions to Tutorial 5

1. (a) Our equilibrium condition is

P AE = C + I P + G + X − M
= 400 + 0.8(Y − (3000 + 0.05Y )) + 1000 + 3000

This is a numerical equation relating planned expenditure to output.

(b) In equilibrium, Y = P AE so

Y = P AE
= 400 + 0.8(Y − (3000 + 0.05Y )) + 1000 + 3000
= 2000 + 0.76Y

This allows us to solve for Y = 8333.3.

(c) At this level of output government spending is 3000. Tax revenue is 3000 + 0.05Y =
3416.65 so the budget is in surplus. Actually, it is easy to see for any positive Y that
tax exceeds government spending.
(d) We can rearrange our equilibrium condition as follows:

Y = C̄ + c(Y − (T̄ + tY )) + I P + G
→ (1 − c + ct)Y = C̄ − cT̄ + I P + G
C̄ − cT̄ + I P + G
→Y =
1 − c + ct
1
which implies the multiplier is 1−c+ct .
(e) If potential GDP = 10,500 we can find the level of T̄ to achieve this in the following
manner:

Y = C̄ + c(Y − (T̄ + tY )) + I P + G
→ (1 − c + ct)Y = C̄ − cT̄ + I P + G
C̄ − cT̄ + I P + G
→Y =
1 − c + ct
Now substituting in for Y = 10500 and leaving T̄ unknown, we find,

400 + 1000 + 3000 − 0.8T̄

10500 =
1 − 0.8 + 0.8(0.05)

We can rearrange to solve for T̄ = 2350.

(f) Under this tax scheme total government spending is still 3000. Total tax revenue is
2350 + 0.05(10500) = 2875 so government spending is less than tax revenue and the level
of public debt will be increasing.

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2. Assuming that households and governments can achieve their planned expenditures, then

P AE = C + I P + G + X − M

In this case if all imports are consumed by households or government, C + G = C d + Gd + M

and Gd represents the demand for domestic goods by the government and the other notation
is standard. Our key equation could be represented as

C + I P + G + X − M = C d + Gd + M + I P + X − M
= C d + Gd + I P + X.

So it is easy to extend our model to settings in which governments consume imports as well.
You may ask students if the same extension to investment is possible. Extending to a setting
in which some investment expenditure consists of imports is potentially more difficult since
we do not assume that firms necessarily achieve their planned expenditure.
3. (a) In lectures we discussed how an increase in the reserve to deposit ratio reduces the money
supply. The same is true if households increase the amount of currency they hold - the
money multiplier becomes smaller. The basic intuition behind the money multiplier is
that a bank may lend to a customer - the customer then makes a deposit in the bank,
and the bank is then able to lend out a portion of this deposit out to other customers.
This process repeats, generating a multiplier effect.
Now consider what happens if the bank makes a loan to a customer who holds the value
of the loan in currency rather than as a deposit in a bank account. In this case, the
bank does not receive a deposit after making a loan and is unable to lend out further
money. The multiplier process stops.
As consumers hold a larger portion of their financial wealth in currency then banks will
be receiving a lower level of bank deposits and this will reduce the multiplier. The effect
during the Depression is that households withdrew money from banks due to the risk of
bank failure. The greater currency holdings leads to a decrease in the money multiplier
and this lead to a reduction in money supply.
(b) The change in money supply would induce a large decline in price level. To give you
an idea, money supply during the Great Depression dropped by about 30 per cent
(depending upon specific measure). The price level dropped by a similar magnitude of
around 30 per cent. This is consistent with the quantity theory of money. The large
decline in prices occurred over a two or three year period, which meant that the annual
rate of inflation was between -7 to - 10 per cent for a couple of years.
(c) The level of nominal interest rates declined in the USA to low levels during the Great
Depression. This was, at the time, highlighted as evidence that monetary conditions
were supportive of domestic economic activity. The problem though was that with high
levels of deflation implied that real interest rates remained quite high.
Time permitting you may want to make the point that following the Great Depression in
the USA that the government introduced deposit insurance that increased the stability
of banks. This deposit insurance guaranteed individuals the value of the deposit against
bank failure. The main reason this policy was implemented was that bank runs were
a common cause of bank failure and this deposit insurance reduced the likelihood of a
bank run. A bank run is an event in which many people want to withdraw their money
from the bank at the same time.