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    Questions Multiplier Model With Key

    Uploaded by

    Aranya Adak
    The document analyzes the effects of a fiscal policy change on the budget surplus in an economy. It is initially at equilibrium with income of $1,000. The government increases taxes by 0.05 and spending by $50. While the balanced budget theorem may suggest no effect, the tax increase will raise income above $1,000 due to the multiplier effect. Calculations show income rises to $1,022.77, raising tax revenue by more than the $50 spending increase. Therefore, the budget surplus increases rather than remaining the same.

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    Questions Multiplier Model With Key

    Uploaded by

    Aranya Adak
    47 views2 pages
    The document analyzes the effects of a fiscal policy change on the budget surplus in an economy. It is initially at equilibrium with income of $1,000. The government increases taxes by 0.05 and spending by $50. While the balanced budget theorem may suggest no effect, the tax increase will raise income above $1,000 due to the multiplier effect. Calculations show income rises to $1,022.77, raising tax revenue by more than the $50 spending increase. Therefore, the budget surplus increases rather than remaining the same.

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    Questions Multiplier Model with Key

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    The document analyzes the effects of a fiscal policy change on the budget surplus in an economy. It is initially at equilibrium with income of $1,000. The government increases taxes by 0.05 and spending by $50. While the balanced budget theorem may suggest no effect, the tax increase will raise income above $1,000 due to the multiplier effect. Calculations show income rises to $1,022.77, raising tax revenue by more than the $50 spending increase. Therefore, the budget surplus increases rather than remaining the same.

    Copyright:

    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
    47 views2 pages

    Questions Multiplier Model With Key

    Uploaded by

    Aranya Adak
    The document analyzes the effects of a fiscal policy change on the budget surplus in an economy. It is initially at equilibrium with income of $1,000. The government increases taxes by 0.05 and spending by $50. While the balanced budget theorem may suggest no effect, the tax increase will raise income above $1,000 due to the multiplier effect. Calculations show income rises to $1,022.77, raising tax revenue by more than the $50 spending increase. Therefore, the budget surplus increases rather than remaining the same.

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    © All Rights Reserved
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    1. Suppose the consumption function is given by C= 100+ .

    8Y, while investment is given by


    I = 50. There is no government, and economy is closed.
    a. What is the equilibrium level of income in this case?
    b. What is the level of saving in equilibrium?
    c. If, for some reason, output is at the level of 800, what will the level of involuntary
    inventory accumulation be?
    d. If I rises to 100, what will the effect be on the equilibrium income?
    e. What is the value of the multiplier, α, here?
    f. Draw a diagram indicating the equilibria in both (a) and (d).

    a. AD = C + I = 100 + (0.8)Y + 50 = 150 + (0.8)Y


    The equilibrium condition is Y = AD ==>
    Y = 150 + (0.8) Y ==> (0.2)Y = 150 ==> Y = 5*150 = 750.

    b. Since TA = TR = 0, it follows that S = YD - C = Y - C. Therefore


    S = Y - [100 + (0.8) Y] = - 100 + (0.2) Y ==> S = - 100 + (0.2)750 = - 100 + 150 = 50.
    As we can see S = I, which means that the equilibrium condition is fulfilled.

    c. If the level of output is Y = 800, then AD = 150 + (0.8)800 = 150 + 640 = 790.
    Therefore the amount of involuntary inventory accumulation is
    UI = Y - AD = 800 - 790 = 10.

    d. AD' = C + I' = 100 + (0.8)Y + 100 = 200 + (0.8)Y


    From Y = AD' ==> Y = 200 + (0.8)Y ==> (0.2)Y = 200 ==> Y = 5*200 = 1,000

    Note: This result can also be achieved by using the multiplier formula:
    Y = (multiplier)(I) ==> Y = 5*50 = 250,
    that is, output increases from Yo = 750 to Y1 = 1,000.

    e. From 1.a. and 1.d. we can see that the multiplier is α = 5.

    f.

    AD Y = AD
    AD1 = 200 = (0.8)Y

    ADo = 150 + (0.8)Y

    200

    150
    0
    750 1,000 Y
    2. Suppose the economy is operating at equilibrium, with Y 0 = 1,000. If the government
    undertakes a fiscal changes whereby the tax rate ,‘t’, increases by .05 and government
    spending increases by 50, will the budget surplus go up or down ? Why?
    Try with assumptions that initial macroeconomic aggregates for the economy are: Y o =
    1,000, to = 0.25, Go = 200, C= 100+ .8YD

    On first sight, one may want to conclude that this is an application of the balanced budget
    theorem, since, as long as Y = 1,000, a change in the tax rate by 5% will cause tax
    revenues to change by ∆TA = 50, which is the same as the change in government
    purchases, that is, ∆G = 50. As long as income (Y) stays the same, the budget surplus will
    not be affected. However, this combined fiscal policy change will have an effect on
    national income and, since national income goes up, so does the government’s tax
    revenue, due to the fact that we have proportional income taxation. Therefore we should
    expect an increase in the budget surplus. This can easily be shown with a numerical
    example.
    Assume: Yo = 1,000, to = 0.25, Go = 200, C= 100+ .8YD, then
    Multiplier = 1/(1-c(1-t)) = 1/(1-0.8(1-.25)) = 1/0.4 =2.5
    Since Y is 1000, A = 400 (I would automatically be 100)

    Now with G increasing by 50, and tax rates going up by 5%


    A = 450, Multiplier = (1/(1- 0.8(1- 0.3)) = 1/0.44 = 2.27
    Y = 450 * 2.27 = 1022.77
    Income tax: 1022.77 * 0.3 = 306.81
    Previous income tax = 250
    Change in fiscal/budget deficit = 306.81 – 250 – 50 = 6.81

    Therefore we see that the budget surplus has increased, since the increase in total
    income tax revenue is larger than the increase in government purchases.

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