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# ECMA06_Tutorial_7_Solution.doc

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University of Toronto Scarborough

Economics for Management Studies

MGEA06H3

Iris Au

Summer

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ECMA06 Tutorial #7 Answer Key
If r is held fixed at 0.06 & E is held fixed at 0.85 US$ per C$, then
I = 130 – 10(0.06 – 0.06) = 130
X = 330 – 4(0.85 – 0.85) = 330
IM = 0.23Y + 3.5(0.85 – 0.85) = 0.23Y
Question 1
Suppose the general wage rate is 20, i.e., w = 20:
• Disposable income, DI:
DI = Y – T + TR
DI = Y – 0.25Y + [140 – 0.05Y] = 140 + 0.7Y
• C = C(Y):
C = 14 + 0.9(140 + 0.7Y) + (100 – P)
C = 240 + 0.63Y – P
• The AE function:
AE = C + I + G + X – IM
AE = [240 + 0.63Y – P] + 130 + 300 + 330 – 0.23Y
AE = 1000 + 0.4Y – P
• The AD function
To derive the AD function, we make use of Y = AE.
Y = 1000 + 0.4Y – P
0.6Y = 1000 – P
Y = 1666⅔ – 1⅔ P or P = 1000 – 0.6Y
• Equilibrium output & price:
In equilibrium, AS = AD:
(–200 + 0.2Y)(20/20) = 1000 – 0.6Y
Y* = 1500
P* = 1000 – 0.6(1500) = 100 or P* = [–200 + 0.2(1500)](20/20) = 100
• Government (budget) deficit:
GBB = T – TR – G
GBB = 0.25Y – [140 – 0.05Y] – 300 = 0.3Y – 440
GBB = 0.3(1500) – 440 = 10
⇒ The government runs a budget surplus of 10.
• Since the economy is in its long-run equilibrium (i.e., its full-employment), the level of Y at
full employment, Y , is 1500.
FE
Question 2
Suppose the government increases its spending by 32, i.e, G = 332:
Part (a)
In the short run, the general wage rate is held fixed at 20 (i.e., w = 20):
• The new AE function:
AE = [240 + 0.63Y – P] + 130 + 332 + 330 – 0.23Y
AE = 1032 + 0.4Y – P
ECMA06 Tutorial #7 Answer Key 1 • The new AD function
To derive the AD function, we make use of Y = AE.
Y = 1032 + 0.4Y – P
Y = 1720 – 1⅔ P or P = 1032 – 0.6Y
• Equilibrium output & price:
In equilibrium, AS = AD:
(–200 + 0.2Y)(20/20) = 1032 – 0.6Y
Y* = 1540
P* = 1032 – 0.6(1540) = 108 or P* = [–200 + 0.2(1540)](20/20) = 108
• Government (budget) deficit:
GBB = 0.25(1540) – [140 – 0.05(1540)] – 332
GBB = – 10
⇒ The government has a budget deficit of 10.
Compare the multiplier on G with the multiplier that would have been used if there is no change
in price:
• The multiplier that would have been used if we has assumed no change in price = 1 =
1 - Y
1
= 1⅔.
1 - 0.4
• The multiplier =dY * = ΔY * = 1540 -1500 = 1.25
dG ΔG 32
• The difference in the multipliers is due to the increase in P leads to a movement along the
1
AD curve (AD of the diagram on page 3) and reduces the effect of an increase in G on Y.
• Note: Make sure you can explain the theoretical adjustment mechanism from the initial
equilibrium to the short-run equilibrium.
Part (b)
• In the long run, Y must equal toFE :
Y = Y FE1500
• The new long run price level:
Sub Y = 1500 into the new AD curve:
P = 1032 – 0.6(1500)
P* = 132
• Government (budget) deficit:
GBB = 0.25(1500) – [140 – 0.05(1500)] – 332
GBB = – 22
⇒ The government budget deficit has increased from 10 (in the SR) to 22 (in the LR).
• The new general wage rate:
Sub Y = 1500 & P = 132 into the AS curve:
132 = [–200 + 0.2(1500)](w/20)
w* = 26.4 (wage has increased from 20 to 26.4 in the long run).
• The adjustment mechanism (from the short run to the long run):
ECMA06 Tutorial #7 Answer Key 2 ⇒ The short-run level of output exceeds the long-run level; this means that unemployment
is below the full-employment level.
⇒ This would create shortage of workers and put an upward pressure on the wage rate.
⇒ In the lon1 run, when wages are flexible, wages begin to rise and shift the AS curve to the
left to AS (of the diagram).
⇒ The process continues until the AS curve intersects the new AD curve aFEthe Y (point C
of the diagram), i.e., when Y falls bacFEto Y & the level of unemployment returns to its
full-employment level.
Part (c)
AE AE = Y AE(P = 100, G = 332)
AE(P = 108, G = 332)
AE(P = 100, G = 300) =
AE(P = 132, G = 332)
SR
LR
SR
45°
Y
1500 1540 1553⅓
P AS 1
0
C AS
132
Pt A = initial LR equilibrium
108 B

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