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

More
Less