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```					                        MACROECONOMICS WORKSHEET 1

FISCAL POLICY

PART ONE

1. Point C is potential GDP. Point A is GDP with inflationary gap (inflation is
undesirable). In order to operate at Point C, GDP should decrease by \$500. Since
the spending multiplier is 1/MPS = 2, government would have to increase spending
by \$250. Or if this is to be achieved by way of taxes (since the tax multiplier is -
MPC/ MPS = -1) government would have to increase tax by \$500.

2. Point B is GDP with recessionary gap (unemployment is undesirable). Since the
balanced budget multiplier is always 1, government must increase spending by
\$500 and at the same time raise taxes by \$500 in order to balance the budget.
PART TWO

1. POINT A is where EXP > Y, hence there is inflationary gap. In order to be at
potential GDP, government must engage in contractionary fiscal policy.

2. Depending upon the size of the inflationary gap, one must divide that gap by the
spending multiplier in order to determine how much spending should be cut.

3. Depending upon the size of the inflationary gap, one must divide that gap by the
tax multiplier in order to determine how much tax must increase.

MACROECONOMICS WORKSHEET 2

FISCAL POLICY

1. CROWDING OUT EFFECT

in order to finance spending, government issues more bond lowering its price in
order to attract investors, which increases the yield on the bond. In order for
companies to attract investors, firms will now have to offer higher yield as well.
Such increased interest payments raise the cost of investment and thus lowering
overall investment in the economy. Since Investment is one of the components of
GDP (Expenditure approach), GDP decreases.

2. TIME LAG

By the time policies are enacted, much of the problems have already passed. Such
time lags can potentially create even more instability in the economy.

The multiplier concept assumes that prices do not change. When prices do change a
full multiplier effect cannot take place.
4. AUTOMATIC FISCAL POLICY COUNTERACTS DISCRETIONARY FISCAL POLICY.

In order to fight recession, discretionary fiscal policy calls for higher spending. But
as soon as spending increases and national income increases, tax collection
increases and transfer payments decrease. Both of which lowers disposable income
discouraging consumption, which in turn causes national income to decrease.

5. SHIFTS IN AGGREGATE SUPPLY

Discretionary fiscal policy assumes changes in aggregate demand only but changes
in tax and spending can cause Aggregate Supply to shift as well.

MACROECONOMICS WORKSHEET 3

FISCAL POLICY

1. Since MPS = 0.2, spending multiplier = 1/ MPS = 5.

2. Tax multiplier = -MPC/MPS = -4

3. Equilibrium GDP is where AD = AS, hence at \$300 trillion. The full capacity real
output is \$400 trillion (where AS becomes a vertical line). Hence, equilibrium GDP
is lower than the full capacity GDP in this case.

4. At \$100 trillion, economy is operating with recessionary gap & government
should conduct an expansionary fiscal policy.

5. In order to reach equilibrium GDP, government should increase spending by
\$200/5 = \$40.

6. In order to reach equilibrium GDP, government should decrease tax by \$200/4
=\$50.

7. AD shifts to the right. EXP shifts out. Multiplier cannot work to its full extent
because prices adjust. As prices adjust, there is a walk along up the new AD & EXP
will shift back in.

8. Crowding out effect causes a fall in investment. Decrease in Investment causes AD
shifts back in and also causes EXP to shift back in—not to their original starting
point but somewhere less than the initial shift that occurred when Government
spending increased.

9. Built in stabilizers are progressive taxation and transfer payments. When
National income begins to rise as expansionary discretionary fiscal policy takes
effect, tax collection increases and transfer payments decrease which in turn causes
consumption to decrease, causing national income to decline back a little. Hence,
this adjustment causes AD to shift back in as well as EXP to shift back in as well.

MACROECONOMICS WORKSHEET 4

FISCAL POLICY

1. AD decreases since income tax has risen. AS decreases as well since production
tax has risen. Overall, GDP decreases but how price level changes is indeterminate.

2. GDP will decrease by 4%.

3. Only cost push inflation can cause increase in inflation and unemployment.

4. MPC = 0, MPS = 1. The multiplier is one. This makes sense since MPS = 1, the
entire increase in income is saved and so there is no further injection into the
economy after the initial spending.

5. MPC = -2. When national income increases by \$100, households actually save
\$200! That is, when households make more income, instead of spending more,, they
save more than the extra income they earned! In fact, they save more than the extra
earnings. MPC cannot be a negative number for an entire nation, since as national
income increases, nation as a whole would not increase saving by more than the
increase in income.

MACROECONOMICS WORKSHEET 5

FISCAL POLICY

1. Deficit spending means Bond financed spending. Increase in bonds would lower
prices on these bonds and increase in yield which in turn creates a crowding out
effect discouraging Investment.

2. Increased domestic interest rates would cause foreigners to invest in our
government bonds as well. In order to invest in our bonds, thy need to exchange
their currency for ours. Such increase in demand for our currency causes foreign
exchange rate to increase. Increased foreign exchange rate would cause our exports
to become more expensive.

3. Higher foreign exchange rate causes our exports to appear more expensive
MACROECONOMICS WORKSHEET 6

FISCAL POLICY

1. Spending multiplier = 1/ MPS =2

2. Tax multiplier = -MPC/MPS = -1

3. \$1000/2 = \$500

4. AD shifts out and there is a walk along as prices adjust.

5. EXP shifts out and then adjusts back slightly when prices changes.

6. \$1000/-1 = -\$1000

7. Spending must increase by \$1000 and tax must increase by \$1000 in order to
balance the budget.

8. AD shifts out and then there is a walk along as prices adjust.

9. EXP shifts out and then shifts back in as prices change.

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