1 In Country X GDP is 400B below the fullemployment level of

1. In Country X, GDP is $400B below the full-employment level of output. Government officials have measured the marginal propensity to consume at 0.75.

A. The government wants to use fiscal policy to bring the economy back to full employment.

I. If the government wants to achieve this through a change in spending, what change would be necessary? (8 points)

II. If the government wants to achieve this through a change in taxes, what change would be necessary? (8 points)

III. If the government wants to achieve this without creating a budget deficit, what change would be necessary? (8 points)

B. Say that for a variety of reasons, the government shows that it is not up to the task of conducting fiscal policy. The central bank steps up and does something about it. If a 1% decrease in interest rates leads to an increase in investment of $50B, how should the central bank\'s interest rate targets change? (13 points)

Solution

A. The government wants to use fiscal policy to bring the economy back to full employment.

I. If the government wants to achieve this through a change in spending, what change would be necessary?

Government spending multipler = 1/1-MPC = 1/1-0.75 = 1/0.25 = 4

To increase national income by 400 billion, government spending needs ot be increased by 100 billion

Government spending multiplier = change in national income/change in government spending

4 = 400/change in government spending

change in government spedning = 400/4 = 100

II. If the government wants to achieve this through a change in taxes, what change would be necessary?

Tax multipler = -MPC/1-MPC = 0.75/1-0.75 = 0.75/0.25 = 3

To increase national income by 400 billion, tax needs ot be decreased by 133.33 billion

tax multiplier = change in national income/change in tax

3 = 400/change in tax

change in tax = 400/3 = 133.33

III. If the government wants to achieve this without creating a budget deficit, what change would be necessary?

Balanced busget multipler = government spending multipler + tax multipler = (1/1-MPC) + (-MPC/1-MPC)= 1

Hence we need to increase governmet budget by 400 billion

B. Say that for a variety of reasons, the government shows that it is not up to the task of conducting fiscal policy. The central bank steps up and does something about it. If a 1% decrease in interest rates leads to an increase in investment of $50B, how should the central bank\'s interest rate targets change?

We need to increase interest rate by 8% 400/50 =8