Problem Set 6 Solution - California State University, Sacramento

Name: ______Solutions_________
Department of Economics
Professor Dowell
California State University, Sacramento Spring 2013
Problem Set #6
Due in hard copy at beginning of lecture on Friday, April 19, 2013
Important: Place all answers in the indicated spaces. Only your work and answers in the indicated
spaces will be graded. All pages must be in order and stapled together.
1. Fill in the blanks in the table below:
To answer this question, use the formula
information.
1
Y
G
1
MPC
to solve for the missing
MPC
Spending
Multiplier
Change in
Government
Spending
Change in
Income
0 10 100 100
0.833 6 -50 -300
0.75 4 200 800
0.5 2 500 1,000
2. Fill in the blanks in the table below:
To answer this question, use the formula
information.
Y
1
MPC
MPC
T
to solve for the missing
MPC
Spending
Multiplier
Change in Taxes
Change in
Income
0.9091 -10 -100 1,000
0.857 -6 50 -300
0.75 -3 200 -600
0.5 -1 -1,000 1,000

3. a. Use a pair of AS-AD diagrams to show that the multiplier effects are smaller when the AS curve
is steeper. (Hint: Each diagram should have one AS curve, one steeper than the other and two
AD curves, the same distance apart in each diagram.)
AS
P
P
AS
AD 1
AD 1
AD 2
AD 2
Y
∆Y 1 ∆Y 2
Note that the horizontal shift of the AD curve is approximately the same in both panels above.
Clearly though the change in income is less on the right hand side with the steeper AS curve.
This is because as prices rise, so does money demand. This increases interest rates and reduces
investment causing a movement up AD 2 to the point of equilibrium.
b. Why is the multiplier reduced as the price level increase? (Hint: Think about what is happening
in the money market.)
The price level increases more along the steeper AS curve. As a result we move further up
the new AD curve due to the real wealth effect, the interest rate effect and the foreign trade
effect. The steeper the AS curve is, the more we move up the demand curve and the smaller
the multiplier is.
Y
c. What is the value of the multiplier when the AS curve is vertical?
Zero. If AS is vertical, output isn’t changing and as a result the multiplier is zero.
4. On a separate sheet of paper, complete Study Problems 1, 2 and 3 on pages 516-517 of the text.
Staple these pages to the back of your problem set,
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Text Book Problems
Question 1:
In general, demand side policies are focused on shifting aggregate demand while supply side policies
are focused on shifting aggregate supply.
a. A $1,000 per person tax cut is primarily a demand side policy in that it increases disposable
income and hence spending. To the extent it increases after tax wages though, it may also
increase labor supply resulting in a small supply side effect.
b. Still predominantly a demand side effect though any reduction in taxes on income from
innovation and investment will also have a supply side effect.
c. Pell grants will have a demand side effect in the short run as they increase demand for education
services. To the extent they increase human capital though, the grants will have a long-run
supply side effect.
d. Government prizes for new scientific discoveries will primarily have a supply side effect as they
encourage technological innovation.
e. Increasing unemployment compensation will primarily have a demand side effect as it offsets lost
income. Some would argue though that it also has a negative supply side effect as it reduces the
incentive to work.
Question 2
A.
Interest
Rate
100
S
6%
4%
D 1
D 2
800
860
Savings, Investment and
Gov’t Borrowing
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B. See demand curve D 2 above. Note that without knowing the slope of the curves or being
given the change in the equilibrium values, you can’t illustrate unique exact values. I used
the same model as that used in the example on pages 507-508 of the text in preparing this
answer. Your numbers may be different than mine. So long as the interest rate and total
amount outstanding in the loanable funds market both increase and the rest of your answer is
internally consistent that is fine.
C. New interest rate: 6%
New quantity of loanable funds: $860
D. Savings: $860
Investment: $760
New Government Spending: $100
E. Private consumption fell by the increase in savings, $60.
Question 3
The New Classical critique is based on the idea of Ricardian equivalence which argues that people
will save the proceeds of any tax cut in order to have the funds available to pay for the expected
future tax increase that will be used to pay back the government debt. Note that if the government
uses debt financing to increase spending rather than to cut taxes, consumers will still increase saving
today in expectation of future tax increases. In either case, the supply of loanable funds increases by
exactly the same amount (due to increased saving) as the demand for loanable funds resulting in no
change in the interest rate and hence no crowding out.
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