University of the Philippines

SCHOOL OF ECONOMICS

Economics 100.1
1st Semester, AY 2021-2022
HOMEWORK 3

Prof. MS Gochoco-Bautista J. Abong/L. Garces/P. Benedicto

Instructions: Fill in the blanks with the most appropriate word or phrase. For multiple choice items,
encircle the letter that best corresponds to your answer. Correct answers will be provided during the
discussion class.

1. Macroeconomic theory says that in the short run, shifts in aggregate demand produce the frequent
and unpredictable fluctuations in output, prices, and employment known as business cycles.

2. The components of aggregate demand are consumption, investment, government spending, and
net exports.

3. The aggregate demand slopes downward which means that holding other things constant, the
level of real spending declines as the overall level of prices in the economy rises. This corresponds
to a movement along the aggregate demand curve.

4. Key determinants of changes or shifts in aggregate demand include policy variables which are
under government control such as fiscal and monetary policies; and exogenous variables which
are determined outside the AD-AS framework.

5. Refer to the table below that shows the investment demand schedules of two countries, country
A and country B, at different interest rates. Answer the questions that follow.

Investment Demand
Interest Rate
Country A Country B
10% $10 $70
8% $50 $75
6% $90 $80
4% $130 $85
2% $170 $90

A. Plot the respective investment demand curves of Country A and Country B. How is
investment related to interest rate? How does this manifest in the graph?
 University of the Philippines
SCHOOL OF ECONOMICS

Economics 100.1
1st Semester, AY 2021-2022
HOMEWORK 3

Prof. MS Gochoco-Bautista J. Abong/L. Garces/P. Benedicto

Investment is inversely related to the interest rate – that is, the higher the interest rate, the lower is
investment and vice versa, ceteris paribus. This manifests in a downward-sloping investment demand
curve.

B. By inspection, how will you characterize the responsiveness of investment spending to the
interest rates in Country A compared with Country B?

The investment demand curve of Country A is flatter than that of Country B, implying that its
investment spending is more responsive to changes in interest rates.

C. How will you interpret the difference between movement along an existing investment
demand curve and a shift in the entire investment demand curve?

Changes in investment spending brought about by changes in the interest rate manifest in movements
along the investment demand curve whereas changes in investment spending due to changes in factors
other than the interest rate (such as output, taxes and expectations) shift the entire investment
demand curve.

6. How does the multiplier model explain the impact of aggregate demand on the level of output?

The multiplier model is a macroeconomic theory used to explain how output is determined in the short run.
It states that each peso change in exogenous expenditures (components of aggregate demand) leads to more
than a peso change or a multiplied change in GDP (output).

A. Mathematically, how is the multiplier derived?

The multiplier is derived by taking the ratio of the change in output to the change in
exogenous/autonomous expenditure.

B. On what variable does the size of the multiplier depend upon?

The size of the multiplier depends upon how large the marginal propensity to consume (MPC) is.

C. What will happen to the size of the expenditure multiplier when the marginal propensity to
save (MPS) increases?

The simple expenditure multiplier, denoted by EM, is given by:

𝟏
⟹ 𝑬𝑴 =
𝟏 − 𝑴𝑷𝑪
Since 𝑴𝑷𝑪 + 𝑴𝑷𝑺 = 𝟏, we can express the expenditure multiplier as:
𝟏
⟹ 𝑬𝑴 =
𝑴𝑷𝑺
Hence, an increase in MPS decreases the expenditure multiplier.
 University of the Philippines
SCHOOL OF ECONOMICS

Economics 100.1
1st Semester, AY 2021-2022
HOMEWORK 3

Prof. MS Gochoco-Bautista J. Abong/L. Garces/P. Benedicto

7. Consider an economy described by the following equations:

Y=C+I+G

C = 100 + 0.75YD

I = 500

G = 125

T = 100

where Y is GDP, C is consumption, YD is disposable income, I is autonomous investment, G is

government purchases, and T is the head tax.

A. Solve for the equilibrium income Y* in this economy.

In equilibrium, Y = AD:
⟹𝑌 =𝐶+𝐼+𝐺
⟹ 𝑌 = 100 + 0.75(𝑌 − 100) + 500 + 125
⟹ 𝑌(1 − 0.75) = 100 + 500 + 125 − 75
⟹ 0.25𝑌 = 650
⟹ 𝒀∗ = 𝟐, 𝟔𝟎𝟎

B. What is the new equilibrium income Y* if autonomous investment increases by ₱ 10?

The impact of a ₱ 10-increase in autonomous investment on equilibrium income can be measured either
by:

➢ Solving for the new equilibrium income Y* with the new value of autonomous investment :
⟹𝑌 =𝐶+𝐼+𝐺
⟹ 𝑌 = 100 + 0.75(𝑌 − 100) + 510 + 125
⟹ 𝑌(1 − 0.75) = 100 + 510 + 125 − 75
⟹ 0.25𝑌 = 660
⟹ 𝒀∗ = 𝟐, 𝟔𝟒𝟎

The ₱ 10-increase in autonomous investment yields an increase in equilibrium income by ₱ 40

➢ Using the investment expenditure multiplier :

1 1
⟹ Δ𝑌 ∗ = Δ𝐼 ( ) = (10) ( )
1 − 𝑀𝑃𝐶 1 − 0.75
10
⟹ Δ𝑌 ∗ =
0.25
⟹ 𝚫𝒀∗ = 𝟒𝟎

We still arrive at the same answer that equilibrium income will increase by ₱ 40 if autonomous
investment increases by ₱ 10.
 University of the Philippines
SCHOOL OF ECONOMICS

Economics 100.1
1st Semester, AY 2021-2022
HOMEWORK 3

Prof. MS Gochoco-Bautista J. Abong/L. Garces/P. Benedicto

C. Suppose the government of this economy aims to increase output. It chooses between raising
its expenditure by ₱ 1 or decreasing the head tax by ₱ 1. Will the two policies yield the same
result? Why or why not?

➢ The impact of a ₱ 1-increase in government purchases on equilibrium income can be measured either
by:

• Solving for the new equilibrium income Y* with the new value of government purchases :
⟹𝑌 =𝐶+𝐼+𝐺
⟹ 𝑌 = 100 + 0.75(𝑌 − 100) + 500 + 126
⟹ 𝑌(1 − 0.75) = 100 + 500 + 126 − 75
⟹ 0.25𝑌 = 651
⟹ 𝒀∗ = 𝟐, 𝟔𝟎𝟒

Hence, a ₱ 1-increase in government purchases yields a ₱ 4-increase in equilibrium income

from the initial level of ₱ 2,600.

• Using the government expenditure multiplier:

1 1
⟹ Δ𝑌 ∗ = Δ𝐺 ( ) = (1) ( )
1 − 𝑀𝑃𝐶 1 − 0.75
1
⟹ Δ𝑌 ∗ =
0.25
⟹ 𝚫𝒀∗ = 𝟒

Similarly, this means that the new equilibrium increases by ₱ 4, which implies that Y* now
becomes ₱ 2,604 from the initial equilibrium level of ₱ 2,600.

➢ Meanwhile, the impact of a ₱ 1-decrease in the head tax on equilibrium income can be measured
either by:

• Solving for the new equilibrium income Y* with the new value of the head tax:
⟹𝑌 =𝐶+𝐼+𝐺
⟹ 𝑌 = 100 + 0.75(𝑌 − 99) + 500 + 125
⟹ 𝑌(1 − 0.75) = 100 + 500 + 125 − 74.25
⟹ 0.25𝑌 = 650.75
⟹ 𝒀∗ = 𝟐, 𝟔𝟎𝟑

Hence, a ₱ 1-decrease in the head tax yields a ₱ 3-increase in equilibrium income from the
initial equilibrium income of ₱ 2,600.

• Using the tax multiplier:

𝑀𝑃𝐶 0.75
⟹ Δ𝑌 ∗ = −(Δ𝑇) ( ) = −(−1) ( )
1 − 𝑀𝑃𝐶 1 − 0.75
 University of the Philippines
SCHOOL OF ECONOMICS

Economics 100.1
1st Semester, AY 2021-2022
HOMEWORK 3

Prof. MS Gochoco-Bautista J. Abong/L. Garces/P. Benedicto

0.75
⟹ Δ𝑌 ∗ =
0.25
⟹ 𝚫𝒀∗ = 𝟑

Similarly, this means that the new equilibrium increases by ₱ 3, which implies that Y* now
becomes ₱ 2,603 from the initial equilibrium level of ₱ 2,600.

➢ As shown in the calculations, the impact on output caused by the increase in government purchases
is greater than the impact on output induced by the slashing of the head tax, even if both policy
changes were of the same amount (₱ 1-change):

• Mathematically, this is because, by definition, the tax multiplier (TM) is smaller in

magnitude than the government expenditure multiplier (EMG):
𝟏 𝑴𝑷𝑪
⟹ 𝑬𝑴𝑮 = > 𝑻𝑴 =
𝟏 − 𝑴𝑷𝑪 𝟏 − 𝑴𝑷𝑪
since comparing the two numerators, 𝑴𝑷𝑪 ≤ 𝟏.

• Intuitively, changes in government spending have the same macroeconomic impacts as

changes in private investment spending or private consumption expenditures since these
are direct components of total expenditure/aggregate demand. Hence, when the
government spends an additional ₱ 1, that ₱ 1 gets spent directly on GDP. On the other
hand, changes in taxes are reflected in part on consumption through the disposable income.
When the government cuts taxes by ₱ 1, only a part of that deduction is spent on
consumption while the remaining portion is saved.

D. Suppose instead of a head tax, the government imposes a proportional income tax, t = 0.25. What
will equilibrium income Y* be?

In equilibrium, Y = AD:
⟹𝑌 =𝐶+𝐼+𝐺
⟹ 𝑌 = 100 + 0.75[𝑌 − (0.25)𝑌] + 500 + 125
⟹ 𝑌 = 100 + 0.75𝑌 − 0.1875𝑌 + 500 + 125
⟹ 𝑌(1 − 0.75 + 0.1875) = 100 + 500 + 125
⟹ 0.4375𝑌 = 725
⟹ 𝒀∗ = 𝟏, 𝟔𝟓𝟕. 𝟏

E. With a proportional income tax, what will the new expenditure multiplier be?

➢ We first derive what the new marginal propensity to consume (MPC) will be from the modified
consumption function with a proportional income tax:
⟹ 𝐶 = 100 + 0.75𝑌𝐷 = 100 + 75(𝑌 − 0.25𝑌)
⟹ 𝐶 = 100 + 0.75𝑌 − 0.1875𝑌
⟹ 𝐶 = 100 + 0.5625𝑌
 University of the Philippines
SCHOOL OF ECONOMICS

Economics 100.1
1st Semester, AY 2021-2022
HOMEWORK 3

Prof. MS Gochoco-Bautista J. Abong/L. Garces/P. Benedicto

• From this modified consumption function with a proportional tax, MPC = 0.5625 (the
coefficient of Y).

➢ We plug in this new MPC to the formula for the expenditure multiplier (EM):
1
⟹ 𝐸𝑀 =
1 − 𝑀𝑃𝐶
1 1
⟹ 𝐸𝑀 = =
1 − 0.5625 0.4375
⟹ 𝑬𝑴 ≈ 𝟐. 𝟐𝟗
• Hence, the new expenditure multiplier indicates that any increase in autonomous
expenditures will increase the equilibrium income by a factor of approximately 2.29.

8. Consider an economy given by the following equations:

Y = C + I + G + NX

Y = 10,000

C = 500 + 0.8(Y − T)

I = 1,500

G = 2,100

T = 2,000

X = 500

M = 1,000

where Y is GDP, C is consumption, I is autonomous investment, G is government purchases, and

T is taxes net of transfer payments, X is exports and M is imports.

A. What is the government’s budget balance in this economy?

The budget balance of the government is equal to its tax revenues less its expenditures:
T − G = 2,000 – 2,100 = −100. Hence, the government faces a budget deficit.

B. What is the trade balance in this economy?

The trade balance is equal to exports less imports: X − M = 500 – 1,000 = −500. Hence, the economy
faces a trade deficit.

C. How much are private savings in this economy?

Private savings are given by:

⟹ 𝑆 = 𝑌 − 𝑇 − 𝐶 = 𝑌 − 𝑇 − [500 + 0.8(𝑌 − 𝑇)]
⟹ 𝑆 = 𝑌 − 𝑇 − 500 − 0.8𝑌 + 0.8𝑇 = 0.2𝑌 − 0.2𝑇 − 500
 University of the Philippines
SCHOOL OF ECONOMICS

Economics 100.1
1st Semester, AY 2021-2022
HOMEWORK 3

Prof. MS Gochoco-Bautista J. Abong/L. Garces/P. Benedicto

⟹ 𝑆 = 0.2(10,000) − 0.2(2,000) − 500

⟹ 𝑆 = 2,000 − 400 − 500
⟹ 𝑺 = 𝟏, 𝟏𝟎𝟎

D. Show that the current account balance of this economy is equal to the excess of private savings
over investment and the government’s budget balance.

On the left-hand side, the absence of net international transfer receipts reduces the current account
balance to just the trade balance. Hence:

⟹ 𝐶𝐴 = 𝑋 − 𝑀 = 500 − 1,000
⟹ 𝑪𝑨 = −𝟓𝟎𝟎

On the right-hand side, this current account balance must be equal to the excess of private savings over
investment and the government’s budget deficit:
⟹ 𝐶𝐴 ≡ (𝑆 − 𝐼) + (𝑇 − 𝐺) = (1,100 − 1,500) + (2,000 − 2,100)
⟹ 𝐶𝐴 ≡ −400 − 100
⟹ 𝑪𝑨 ≡ −𝟓𝟎𝟎

Hence, the current account balance of the economy is −500. The economy faces a current account deficit
(𝑪𝑨 < 𝟎).