ECMA06_Tutorial_4_Solution.doc

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Department
Economics for Management Studies
Course
MGEA06H3
Professor
Iris Au
Semester
Summer

Description
ECMA06 Tutorial #4 Answer Key If r is held fixed at 0.05 & E is held fixed at 0.85 US$ per C$, then I = 50 – 5(0.05 – 0.05) = 50 X = 220 – 3(0.85 – 0.85) = 220 IM = (3/11)Y + 2.5(0.85 – 0.85) = (3/11)Y Question 1 • Disposable income, DI: DI = Y – T + TR DI = Y – (44 + 0.3Y) + (110 – 0.1Y) = 0.6Y + 66 • C = C(Y): C = 10 + (10/11)(0.6Y + 66) C = 70 + (6/11)Y • The AE function: AE = C + I + G + X – IM AE = [70 + (6/11)Y] + 50 + 300 + 220 – (3/11)Y AE = 640 + (3/11)Y • Equilibrium output: In equilibrium, Y = AE: Y = 640 + (3/11)Y (8/11)Y = 640 Y* = 880 Question 2 Suppose government spending increases by 40 to 340, i.e., G = 340: • The new AE function: AE = C + I + G + X – IM AE = [70 + (6/11)Y] + 50 + 340 + 220 – (3/11)Y AE = 680 + (3/11)Y • New equilibrium output: In equilibrium, Y = AE: Y = 680 + (3/11)Y Y* = 935 G = 300 G = 340 Change Equilibrium output, Y* 880 935 935 – 880 = 55 GBB = T – TR – G – 14 – 32 – 32 – (– 14) = – 18 Trade balance = X – IM – 20 – 35 – 35 – (– 20) = – 15 • When government spending increases by 40, the government budget deficit increases by 18 (GBB falls by 18). In addition, the country’s trade deficit also widens when government spending rises. • Indeed, the simultaneous occurrences of budget and trade deficits are called the twin deficits. ECMA06 Tutorial #4 Answer Key 1 dY * ΔY * 55 • The (government expenditure) multiplier: dG = ΔG = 40 = 1.375 Question 3 Suppose there is a tax cut such that government tax revenue falls by 44 at each level of Y, i.e., T = 0.3Y: • Disposable income, DI: DI = Y – 0.3Y + (110 – 0.1Y) = 0.6Y + 110 • C = C(Y): C = 10 + (10/11)(0.6Y + 110) = C = 110 + (6/11)Y • The new AE function: AE = [110 + (6/11)Y] + 50 + 300 + 220 – (3/11)Y AE = 680 + (3/11)Y • New equilibrium output: In equilibrium, Y = AE: Y = 680 + (3/11)Y Y* = 935 T = 44 + 0.3Y T = .03Y Change Equilibrium output, Y* 880 935 935 – 880 = 55 GBB = T – TR – G – 14 – 36 – 36 – (– 14) = – 22 • When there is a tax cut of 40, the budget deficit increases by 18 (GBB falls by 22). • The (tax) multiplier: dY * = ΔY * = 55 = 1.25, which shows that when tax falls by 1, dT ΔT − 44 output will increase by 1.25. • The tax multiplier is smaller than the government expenditure multiplier because the effect of a change in tax enters the AE function indirectly (through a change in consumption) but the effect of a change in government spending enters the AE function directly. • Besides, as shown in the consumption function, when there is a tax cut only 10/11 of the initial tax cut is consumed. Thus, the tax multiplier is only 10/11 of the government expenditure multiplier. Question 4 • Using parameters to express our model (let IM =00, hold r and E constant): C = C 0 c 1I T = T + t Y 0 1 TR = TR –0tr 1 I = 0 G X = X 0 I
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