Econ 204: Intermediate Macroeconomics, Fall 2019, Dr.

Duggan
Exercise 1.4: Paradox of Thrift and Policy

Y = a + bY + I+G

Where a, b and I are given, so that this reduces to a bivariate equation:

Y = (a+ I+G) + bY

Or aggregate demand depends on a constant term and then increases with output supplied.

Let a = 200 and I = 200. Assume that G = 0. Assume that b = 0.8 [this last means that people spend 80%
of any windfall income that they receive.] Assume we are in equilibrium.

Use the second equation above to solve for Y. This is about moving numbers around so that both terms
with a Y in them are on the same side of the equation, then factoring out, and dividing both sides by that
necessary to get Y all by itself on one side. Show all of your work.

A. Now let b= 0.6. [this means people are afraid they will lose their jobs soon, and so are saving
more, meaning they only spend 60% of windfall income, and save the rest]. When b falls, people
are saving more and spending less. Because people are spending less, some unsold inventories
will rise in stores. What is new equilibrium Y? Show your work in detail.

B. What is the moral of the story from this exercise which illustrates the impact of a change in the
marginal propensity to consume? Please write at least three sentences.

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2. Savings is equal to the following:
S=sY
Note that s = 1-b The marginal propensity to save is 1 minus the marginal propensity to
consume. Or in other words, when you get new income, you save a percentage of it, and you
consume the rest. [Note: in this context, money you might use to pay down debt would count
as saving].

A. When the marginal propensity to consume was b = 0.8 in the exercise above, what was the
dollar amount of income y that was actually saved, the amount saved?

B. When b = 0.6 in the exercise above, what was y and the total dollar amount saved?

C. What is the moral of the story in terms of how saving a larger proportion of aggregate
income affects the total amount saved? Again, please use at least three sentences.

3. During a recession, would you advise a policy maker to encourage households to save? Please
explain your answer with reference to the equations and analyze earlier on the page.

4. Now let us add the tax rate to the model.

Y = a + b(1-t) Y + I + G

Assume that as before a= $200.and I $200, and that G is $200 as well. Now b is 0.8 and t is 0.25 (people
pay 25% of their income as taxes).

A. Assume macroeconomic equilibrium. What is the equilibrium level of income? Show your work.

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B. Now, let us assume that people fear a recession, and the marginal rate of savings s increases to
0.4, so that the marginal propensity to consume b decreases to 0.6. What will the new level of
equilibrium income be?

C. Explain how increasing saving affected national income.

D. Now, change the question: if people are panicking about the future and increasing their rate of
savings to 0.4 during a recession, what could the policy maker due to the rate of taxation such
that equilibrium y would remain at 1500? Tell us the specific rate of taxation you would
recommend. This means that you use the same tax equation, but now you solve for t. (Plug in
all the numbers you have first, including Y = 1500).