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Fdocuments - in Dornbusch Chapter 3 Solutiondocx
Fdocuments - in Dornbusch Chapter 3 Solutiondocx
A COMMERCE HUB
CHAPTER – 3
PROBLEMS
1. Here we investigate a particular example of the model studied in Sections 3-2 and 3-3
with no government. Suppose the consumption function is given by C = 100 + 0.8Y,
while investment is given by I = 50.
(a) What is the equilibrium level of income in this case?
(b) What is the level of saving in equilibrium?
(c) If, for some reason, output were at the level of 800, what would the level of
involuntary inventory accumulation be?
(d) If I were to rise to 100 (we discuss what determines / in later chapters), what
would the effect be on equilibrium income?
(e) What is the value of the multiplier, , here?
(a) y AD
Y CI
Y 100 0.8 50
0.2y 150
y 750
(b) S YC
Y 100 0.8Y
0.2Y 100
150 100
50
(d) I 50()
I
y
Ic
dy 1 1
5
(e) Value of multiplier da I C 1 0.8
2. Suppose consumption behavior were to change in problem 1 so that C = 100 + 0.9Y,
while I remained at 50.
(a) Would you expect the equilibrium level of income to be higher or lower than in
la? Calculate the new equilibrium level, Y’, to verify this.
(b) Now suppose investment increases to I = 100, just as in Id. What is the new
equilibrium income?
(c) Does this change in investment spending have more or less of an effect on Y than
in problem 1? Why ?
(d) Draw a diagram indicating the change in equilibrium income in this case.
(b) I = 100
I 50
A I
y
1 C 1 C
50
500
1 0.9
3. This problem relates to the so-called paradox of thrift. Suppose that I = I0 and that
C C cY
.
Ans. I I 0 , C C CY
(b) S yC
y (C Cyd)
y (C C(y TA Ty TR)
y C Cy CTA CTy CTR
S A (1 C Ct)y
A (1 C(1 t))y
C+I=C+S
(c)
When AD = AS
C+I=C+S
I=S
Thus, intersection of the saving and investment function gives us the equilibrium
level of output.
(d) When individuals want to save more at every level of income, the saving income
shifts upwards.
(e)
Equilibrium, savings equal autonomous investment which is constant, the level of saving
in the economy remains the same in this case but the level of income decreases.
Induced investment:
As the saving increase, the saving curve shifts upward to s’.
At s1curve, for equilibrium I = S’. Equilibrium is attained at E 1, where the amount of
equilibrium, saving and the national income both have decreased.
4. Now let us look at a model that is an example of the one presented in Sections 3-4 and 3-
5: that is, it includes government purchases, taxes, and transfers. It has the same features
as the one in problems 1 and 2 except that it also has a government. Thus, suppose
consumption is given by C = 100 + 0.8yd and that I = 50, while fiscal policy is
summarized by G = 200, TR = 62.5, and t = 0.25.
(a) What is the equilibrium level of income in this more complete model?
(b) What is the value of the new multiplier, a c? Why is this less than the multiplier in
problem 1(e)?
(a) y = AD
y C CYd I G
y = 100 + 0.8 (y - 0.25y + 62.5) + 50 + 200
y = 350 + 0.6y + 50
0.4y = 400
y = 1000
A
y
(b) 1 C(1 t)
dy 1
dA 1 C(1 t)
1 1
1 0.8(1 0.25) 0.4
2.5
Ans. I = 50
(a) BS TA ty G TR
BS 0.25y 200 62.5
0.25 1000 262.5
250 262.5
12.5
Budget Deficit
(b) When I 50
y 50 2.5 125
New y1 = 1125
BS = 0.25 1125 - 262.5
= 18.75 Budget surplus
(e)
(f) We use full employment budget surplus rather than the simple budget surplus
because the simple budget suffers a serious defect as a measure of the direction of
fiscal policy. The defect is that the surplus can change because of a change in
autonomous private spending.
Thus an increase in the budget deficit does not necessary mean that the govt. has
changed its policy.
y = AD
y=C+I+G
y c cyd I G
y c c(y TA ty TR by)
y c cy cTA c y cTR cby
y cy cty cby A
y[1 c(1 t b)] A
A
y
1 c(1 t b)
1
(b) New multiplier , 1 c(1 t b)
(c) The multiplier is less than the standard one because of the presence of b in the
denominator.
1 1
,
The standard 1 c(1 t) , which is always greater than 1 c(1 t b)
(d) An automatic stabilizer is any mechanism in the economy that reduces the amount
by which output changes in response to a change in autonomous demand.
If the multiplier is small, it means that the income is changing less than it
would have changed when the multiplier was large.
1
The use of the new multiplier , 1 c(1 t b) reduces the amount by which the
income changes due to a change in the autonomous components of demand.
C = 50 + 0.8YD
I 70
G = 200
TR 100
t = 0.20
(a) Calculate the equilibrium level of income and the multiplier in this model.
(b) Calculate also the budget surplus, BS.
(c) Suppose that t increases to 0.25. What is the new equilibrium income? The new
multiplier?
(d) Calculate the change in the budget surplus. Would you expect the change in the
surplus to be more or less if c = 0.9 rather than 0.8?
(e) Can you explain why the multiplier is 1 when t = 1?
Ans. C = 50 + 0.8yd
I 70 , G 200 , TR 100 , t = 0.20
(a) At equilibrium, y = AD
y=C+I+G
y c cyd I G
0.36y = 400
y =1111.11
1 1 1
1 c(1 t) 1 0.8(1 0.20) 1 0.8 0.8
1
2.77
0.36
(b) BS TA ty G TR
1
New multiplier = 1 0.8(1 0.25
A 420
New equilibrium income = 1 c(1 t) 1 0.8(1 0.25) =1050
1 c
BS y0 t
(d) 1 c(1 t1 )
1 0.8
1111.11 0.05
1 0.8(1 0.25)
(e) When t = 1,
1 1
1
1 c(1 t) 1 0.8(1 1)
Ans. y0 =1,000
t increases by 0.05, t 0.05
G 5%of 40
Thus, the increase in tax (5% of y1) is more than the increase in G (5% of 40)
9. Suppose Congress decides to reduce transfer payments (such as welfare) but to increase
government purchases of goods and services by an equal amount. That is, it undertakes a
change in fiscal policy such that G TR .
dA
dy
(a) 1 c(1 t)
TR(c 1)
dy
1 c(1 t)
G 10 , TR 10
10(0.8 1)
dy
1 0.8(1 0.25)
2
dy 5
0.4
(b)
TR(c 1)
BS t
(c) 1 c(1 t)
(10)(0.8 1)
0.25
= 1 0.8(1 0.25)
= 0.25 5
= 1.25
ADDITIONAL PROBLEMS
1. Briefly explain in words the effect of an increase in the marginal propensity to save
on the size of the expenditure multiplier and the level of equilibrium income.
When aggregate demand falls below the equilibrium output level, actual production
exceeds desired spending. Therefore firms see an unwanted accumulation in their
inventories, and they respond by reducing their production level. This leads to a decrease
in the level of output up to the point where the new and lower level of desired spending is
again equal to the level of actual output. In other words, in the expenditure sector, the
adjustment from one equilibrium to the next is based on unintended inventory changes,
until the economy eventually reaches a new equilibrium at another output level.
We can derive the equilibrium value of output by setting actual output equal to intended
spending, that is, Y = C + I
- C0 + (1 - c)Y = I0 (1 - c)Y = C0 + I0
4. For a simple model of the expenditure sector without any government involvement,
derive the multiplier in terms of the marginal propensity to save (s) rather than the
marginal propensity to consume (c). Does this formula still hold when the
government enters the picture and levies an income tax?
The expenditure multiplier for a model without any government involvement was derived
as = 1/(1 - c).
But since the marginal propensity to save is s = (1 - c), the multiplier now becomes
= 1/(1 - c) = 1/s.
In the text, we have also seen that, if the government enters the picture and levies an
income tax, then the simple expenditure multiplier changes to
S + TA = I + G - C0 + sYD + TA = I0 + G0
- C0 + s(Y - TA) + TA = I0 + G0
[s + (l - s)t]Y = C0 + I0 + G0 - (1 - s)TA0
The paradox of thrift occurs because a higher level of saving can only be achieved if the
level of consumption is lowered. But a lower level of spending sends the economy into a
recession and a new equilibrium is reached at a lower level of output. In the end, the
increase in autonomous saving is exactly offset by the decrease in induced saving due to
the lower income level. In other words, the economy originally is in equilibrium when
S = I0. Since the level of autonomous investment (I 0) has not changed, the level of private
saving at the new equilibrium income level must again equal I0, and can therefore not
change.
6. The balanced budget theorem states that the government can stimulate the economy
without increasing the budget deficit if an increase in government purchases (G) is
financed by an equivalent increase in taxes (TA). Show that this is true for a simple
model of the expenditure sector without any income taxes.
If taxes and government purchases are increased by the same amount, then the change in
the budget surplus can be calculated as
Y = c( Y) + (1 - c) ( G) since TA0 = G.
(1 - c) ( Y) = (1 - c) ( G) Y = G.
In this case, the increase in output (Y) is exactly of the same magnitude as the increase in
government purchases (G). This occurs since the decrease in the level of consumption
due to the lump sum tax has exactly been offset by the increase in the level of
consumption caused by the increase in income.
7. In an effort to stimulate the economy in 1976, President Ford asked Congress for a
$20 billion tax cut in combination with a $20 billion cut in government purchases.
Do you consider this a good policy proposal? Why or why not?
This was not a good policy proposal. According to the balanced budget theorem, a
decrease in government purchases and taxes of equal magnitude will decrease rather than
increase national income. Therefore the intended result, that is, an increase in economic
activity, will not be achieved.
8. “An increase in government purchases always pays for itself, as it raises national
income and hence the government's tax revenues.” Comment on this statement.
Therefore, if government purchases are increased, the budget surplus will decrease.
9. In a simple model of the expenditure sector with a positive income tax rate (t), does
a decrease in autonomous investment (I0) affect the budget surplus? Why or why
not?
A decrease in autonomous investment (I0) has a multiplier effect so national income will
decrease. As a result, income tax revenues will decrease, and the budget surplus will
decrease as shown below:
(a) If the government would like to increase the equilibrium level of output (Y) to the
full-employment level Y* = 2,700, by how much should government purchases (G)
be changed?
(b) Assume we want to reach Y = 2,700 by changing government transfer payments
(TR) instead. By how much should TR be changed?
(c) Assume you increase both government purchases (G) and taxes (TA) by the same
lump sum of G = TA0 = + 300. Would this sufficient to reach the full-
employment level of output at Y* = 2,700? Why or why not?
(d) Briefly explain in words how a decrease in the marginal propensity to save would
affect the size of the expenditure multiplier.
(b) Since A0 = 100 and A0 = c( TR0) 100 = (4/5)( TR0) TR0 - 125.
(c) This is a model with income taxes, so the balanced budget theorem does not apply in its
strictest form, which states that an increase in government purchases and taxes by a given
lump-sum amount increases national income by that same amount, leaving the budget
surplus unchanged. In this model, total tax revenues actually increase by more than 300,
since taxes are initially increased by a lump sum of 300. However, income taxes then also
change due to the change in the income level. Therefore income does not increase by
Y - 300, as we can see below.
This change in fiscal policy will increase income by only Y = 180, that is, from Y0 =
2,400 to Y1 = 2,580, and we therefore will be unable to reach Y* = 2,700.
(d) If the marginal propensity to save s = (1 - c) decreases, people spend a larger portion of
their additional disposable income, that is, the marginal propensity to consume (c) and
11. Assume a model with income taxes similar to the model in Problem 10 above. This
time, however, you have only limited information about the model, that is, you only
know that the marginal propensity to consume out of disposable income is c = 0.75,
and that total autonomous spending is A 0 = 900, such that Sp = A0 + c'Y = 900 + c'Y.
You also know that you can reach the full-employment level of output at Y = 3,150
by increasing government transfers by a lump sum of TR = 200.
(a). If transfer payments are changed by a lump sum TR = 200, then total autonomous
spending is changed by
A = c( TR) = (0.75) 200 = 150.
Therefore the intended spending line, that is, the [C + I + G + NX] line changes to
For each model of the expenditure sector we can derive the equilibrium level of income
by using the following equation:
Y* = A0 = [1/1 – c’)]A0
In this case, we have
3,150 = (1,050) the expenditure multiplier is = 3.
Y = a( A) Y = 3*150 = 450.
Therefore the old equilibrium level of income before this change must have been
(b) From our work above we can see that the size of the expenditure multiplier is = 3.
(c) I f w e c h a n g e t h e t a
NX] line is of the form Sp2 = 900 + c2Y. This new intended spending line intersects the
45-degree line at the desired equilibrium income level of Y = 3,150. This allows us to
derive the slope of the new intended spending line from the graph below as follows:
12. Assume you have the following model of the expenditure sector:
Sp = C + I + G + NX C = 400 + (0.8)YD I0 = 200 G = 300 + (0.1)(Y* - Y)
YD = Y - TA + TR NX0 = - 40 TA = (0.25) Y TR0 = 50
(a) What is the size of the output gap if potential output is at Y* = 3,000?
(b) By how much would investment (I 0) have to change to reach equilibrium at Y* =
3,000, and how does this change affect the budget surplus?
(c) From the model above you can see that government purchases (G) are counter-
cyclical, that is, G is increased as national income decreases. If you compare this
specification of G with one that has a constant level of government spending (for
example, G0 = 300), how would the value of the expenditure multiplier differ?
(d) Assume the equation for net exports changes from NX 0 = - 40 to NX1 = - 40 - mY.
How would this affect expenditure multiplier, if we assume that 0 < m < 1?
(c) If government purchases are used as a stabilization tool, the size of the expenditure
multiplier should be lower than if the level of government spending is fixed. In the model
of the expenditure sector above, the slope of the [C + I + G + NX] line is c 1 = 0.5, and
therefore the size of the expenditure multiplier is = 1/(0.5) = 2. However, if
government purchases are defined as G0 = 300 instead, the slope of the [C + I + G + NX]
line changes to c2 = 0.6 and the size of the expenditure multiplier changes to 2 = 1/(0.4)
= 2.5.
(d) With this change, net exports decrease as national income increases. This additional
leakage implies that the size of the multiplier will decrease. In the model above, the slope
of the [C + I + G + NX] line decreases from c1 = (0.5) to c3 = (0.5) - m, and the
expenditure multiplier decreases from 1/[1 - (0.5)] to 1/[1 - (0.5) + m]. Therefore, if m =
0.14, then the expenditure multiplier decreases from = 1/(0.5) = 2 to 3 = 1/(0.64) =
1.5625.
13. Assume you have the following model of the expenditure sector:
Sp = C + I + G + NX C = Co + cYD YD = Y - TA + TR TA = TA0
TR = TR* I = I0 G = G0 NX = NX0
The expenditure multiplier for such a simple model can be calculated as: = 1/(1 - c)
14. Explain why the income tax system, the Social Security system, and unemployment
insurance are considered automatic stabilizers.
Income taxation, unemployment benefits, and the Social Security system are often called
automatic stabilizers because they reduce the magnitude by which the level of
equilibrium output changes as a result of a change in aggregate demand. These stabilizers
are a part of the structure of the economy and therefore work even though no explicit
government action is undertaken. For example, when the economy enters a recession, the
level of output declines and the unemployment rate increases. If there was no
unemployment insurance program in place, people out of work would no longer have any
disposable income and consumption would drop significantly. However, since
unemployed workers receive unemployment compensation, consumption and aggregate
demand do not decrease as much. Similarly, as people retire, their income from work
drops, but then they receive Social Security benefits, which means that their disposable
income does not decline by as much and therefore they do not have to reduce
consumption by as much.
15. “A tax cut will increase national income and will therefore always decrease the
budget deficit.” Comment on this statement.
While a tax cut serves to simulate national income, not all of the increase in income is
spent, nor is it completely taxed away. The budget deficit will increase since overall tax
revenue will fall. This can be shown with the help of a simple model of the expenditure
sector that has income taxation:
= [(1 - c)/(1 – c + ct)]( TA0) < 0, since c < 1 and TA0 < 0.
16. Assume a model of the expenditure sector with income taxes, in which people who
pay taxes, have a higher marginal propensity to consume than people who receive
government transfer payments. The consumption function is thus of the following
form: C = C0 + c(Y - TA) + dTR, with c < d.
(a) What will happen to the equilibrium level of income and the budget surplus if
government purchases and taxes are both reduced by the same lump sum amount?
(b) What will happen to the equilibrium level of income and the budget surplus if
government transfers are reduced by the same lump sum amount as taxes?
The budget surplus will decrease by the loss in income tax revenue.
Y = [(- c)/(1 - c')]( TA0) + [d/(1 - c')][ TR0) = [(d - c)/(l - c')](-100) < 0, that is,
national income will increase since c < d and c' = c(1 - t).
17. Assume a simple model of the expenditure sector with a positive income tax rate (t).
Show mathematically how an increase in lump sum taxes (TA 0) would affect the budget
surplus.
Sp = C + I + G + NX I = I0
C = C0 + cYD G = G0
YD = Y - TA + TR NX = NX0
TA = TA0 + tY BS = TA - G - TR
TR = TR0
From BS = TA - G - TR = tY + TA0 - G - TR
= t[1/(1 - c + ct)](- c)( TA0) + TA0 = ([- ct/(1 - c + ct)] + 1)( TA0)
= ([- ct + 1 - c + ct]/[1 - c + ct])( TA0) = [(1 - c) /(1 - c + ct)]( TA0) > 0, since c < 1
In other words, a lump sum tax increase would increase the budget surplus.
18. Is the size of the actual budget surplus always a good measure for determining fiscal
policy? What about the size of the full-employment budget surplus?
The actual budget surplus has a cyclical and a structural component. The cyclical
component of the budget surplus changes with changes in the level of income whether or
not any fiscal policy measure is implemented. This implies that the actual budget surplus
also changes with changes in income and is therefore not a very good measure for
assessing fiscal policy. The structural (full-employment) budget surplus is calculated
under the assumption that the economy is at full-employment. It changes only with a
change in fiscal policy and' is therefore a much better measure for fiscal policy than the
actual budget surplus. One should keep in mind, however, that the balanced budget
theorem implies that the government can stimulate national income by an equivalent and
simultaneous increase in taxes and government purchases without affecting the actual or
the full-employment budget surplus. In addition, estimates of the true value of the full-
employment budget surplus largely depend on the assumptions that lead to the calculation
of the full-employment output level.
True. Imports represent a leakage out of the income flow. An increase in autonomous
spending will raise income and we will see the usual multiplier effect. However, if
imports are positively related to income, this effect is reduced since higher imports
reduce the level of domestic demand. (Assume for simplicity that TA = TR = 0 in both
cases below.)
Y = A0 + cY Y = A0 + (c - m)Y
Clearly the open economy multiplier is smaller than the closed economy multiplier. This
is because leakages reduce demand. If income taxes were included in these models, they
too would reduce the multipliers, as income taxes represent another leakage from the
income flow.