ANSWERS TO Tutorial 7

Q1: Attempt this on your own when/after doing the readings

Q2
a. i) The supply of labour will decrease. As
shown in Figure 27.1, the supply of labour
curve shifts leftward from LS0 to LS1. The
supply of labour decreases because at
each real wage rate, the hike in the tax
rate on labour income lowers the after-tax
wage rate received by workers.
ii) The demand for labour will remain the
same so in Figure 27.1 the demand for
labour curve remains LD. The demand for
labour depends on the productivity of
labour, which does not change after the
increase in the tax rate on labour income.
iii) As Figure 27.1 shows, the equilibrium
before-tax wage rate increases from $29
per hour to $30 per hour. The before-tax
wage rate rises because the leftward shift of the supply of labour curve leads to
a movement up along the demand for labour curve.
iv) The equilibrium after-tax wage rate decreases. The tax wedge in the figure is $2 per
hour, so the after-tax wage rate falls from $29 per hour to $28 per hour. The increase in
the tax rate on labour income increases the wedge between the before-tax wage rate and
the after-tax wage rate. The before-tax wage rate
increases but not by as much as the increase
in tax. So the after-tax wage rate decreases.
b i) As Figure 27.1 shows, the equilibrium level
of employment decreases. In the figure,
employment decreases from 310 billion hours
per year to 300 billion hours per year.
ii) Potential GDP decreases. The equilibrium
level of employment is full employment. So
as full employment decreases, potential GDP
decreases along the aggregate production
function. Figure 27.2 shows this change as
the movement along the aggregate
production function, PF, from point A, with
 310 billion hours of employment and potential GDP of $12.2 trillion, to point B, with 300
billion hours of employment and potential GDP $12.1 trillion.

Question 3
a. Fiscal policy that increases government expenditure or decreases taxes would boost
aggregate demand and move the economy back towards full employment. In terms of
automatic fiscal policy, welfare spending increases automatically in recessions and tax
revenue falls. The government can also use discretionary policy by passing a new spending
bill or a money bill to cut tax rates.
b. An increase in government expenditure with an offsetting increase in tax rates to boost tax
revenue would not bring a budget deficit and would increase aggregate demand because
the increase in government expenditure increases aggregate demand by more than the
increase in taxes decreases aggregate demand.
c. The risk of discretionary policy is that, because of time lags, it takes effect too late
and ends up moving the economy away from potential GDP.

Question 4
1. a) Aggregate Demand/Aggregate Expenditure AE = C + I + G + (X-M)
AE = 250 + 0.64Y + 40 + 230 + 270 + 220 – 120 – 0.15Y
AE = 890 + 0.49Y
Equilibrium condition in the Expenditure sector: Y =AE
Y = 890 + 0.49Y
b) Y = 890 + 0.49Y
0.51Y = 890
Yo = 1/0.51 [890]
 4

Or

Yo = 1/1-b(1-t)+m x Ao [α = 1/1-0.8(1-0.2)+ 0.15= 1/0.51], multiplier formula with inclusion

of Govt sector and overseas sector: [α = 1/1-c(1-t)+m]; t is the marginal propensity to tax or
simply the tax rate; m is the marginal propensity to import
Ao = Co + Io + Go + cTRo –cTAo + Xo – IMo = 250 + 230 + 270 + 0.8(100) – 0.8(50) + 220
– 120 = 890
Yo= 1/0.51 x 890

b.) 1.96078 x 890 = $1745.10m

c) 1/0.51 = 1.96 is the autonomous expenditure multiplier
d) An inflationary gap since Yo > Yf. The magnitude of the inflationary gap: $1 745.10 -
1200 = $545.10m
e) The fiscal policies to eliminate inflationary gap would be contractionary so that AD is
reduced to reduce economic activity and put downward pressure on prices, therefore reduce or
even eliminate the inflationary gap.
Contractionary fiscal policies would be reducing G, raising T
So by how much should G be reduced, by how much should T be raised and by how
much should TR be reduced to eliminate the inflationary gap. Use appropriate fiscal
multiplier formulas on
αG (government exp multiplier) = 1/1-b(1-t) + m = 1/0.51 = 1.96

∆Y = α x ∆G
-$545.10m = 1.96 x ∆G
∆G = -$278.11.
Therefore, Government spending should be reduced by $278.11m

Aut. Taxes multiplier [αTA = -b/1-b (1-t) +m] = -0.8/0.51 = -1.5686

∆Y = α x ∆T
-$545.10m = -1.5686 x ∆T
∆T = $347.51m
Therefore, autonomous taxes should be increased by $347.51m
 f) If the government decides to use a strictly balanced budget to eliminate the gap above,
calculate the magnitude of the BB required by using the BB multiplier formula:
1-b/1-b (1-t)+m
= 0.2/0.51 = 0.39
∆Y = α x ∆BB
-$545.10m = 0.39 x ∆BB
∆BB = -$1 397.7m.
Government should reduce G and increase TA (autonomous Tax) i.e balanced the budget by
$1 397.7m