FISCAL POLICY: PART TWO

FISCAL POLICY: GOVERNMENT SPENDING AND TAXATION

a. When MPC = 0.75, if G and T both increase by $1,000, what will happen to equilibrium income?
b. By how much must T be increased (assuming G is increased by $1,000) so that equilibrium income does not increase?

a. The balanced-budget multiplier is 1, so equilibrium income will go up $1,000.
b. To not change equilibrium income the increase in taxes must reduce C by the amount G goes up so that total spending is unchanged. To decrease C by $1,000, DI must fall by $1,3333.33: T must increase by $1,333.33. To get the $1,333.33 figure, solve the equation: Change in C equals – MPC times increase in taxes. (the change in C is - $1,000).

If the government wants to increase equilibrium income by $4,000 when MPC = 0.8, by how much must it increase G?

• G must increase by $800 (the spending multiplier is 5: 5 x 800 = $4,000).

If the government wants to increase equilibrium income by $4,000 when MPC = 0.8, by how much must it reduce T?

• T must be reduced by $1,000 (the tax multiplier is – 4).

Suppose that in equilibrium, business firms want to invest more than households want to save. For this to be possible, what must be true about G and T?

• Injections must equal leakages in equilibrium, so I + G must equal S + T. Rewriting this, I – S = T – G. Since I is greater than S, T must be greater than G. The government must be running a surplus. This surplus retires part of the government’s debt, freeing these funds to support the excess of I over S.

Government spending goes up by $5,000 while taxes go up $3,000. What will happen to equilibrium income if the MPC = 0.6?

• The increase in G increases equilibrium income by $12,500 (2.5 x $5,000). The increase in T decreases it by $4,500 (-1.5 x $3,000). On net, equilibrium income will go up $8,000.

If the economy is at or near full employment, what will be the main impact of a reduction of government spending on real GNP and prices?

• The AD curve will shift left by the change in G times the spending multiplier. In the short run, with the AS curve unchanged, prices will fall as output falls. Unemployment will go up. In the long run, wages (and thus prices) will fall, shifting the AS curve down and right, causing output to return to its full-employment level but pushing the price level down below its short-run level.

Households decide to save $10,000 more. By how much must the government increase G if it wants to maintain the same level of national income? (Assume C is going down by $10,000).

• By $10,000.

If “deficits don’t matter,” what will happen to DI, C, and S when T goes down $5,000?

• DI goes up $5,000, savings go up $5,000, C remains unchanged (C = DI – S).

If G goes up $1,000 and equilibrium income goes up $4,000, what is the MPC?

• MPC = 0.75

Copyright 2008 by Sujanto Rusli
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