2008 Macro FRQ #1

2008 Macro FRQ #1

(A) Using a CLG of the short-run Phillips Curve, show the effect of the decrease in consumption spending. Label the initial position "A" and the new position "B".

(B) What is the impact of the recession on the Federal Budget? Explain.

Initially  the economy was at full employment with a balanced budget. Now (C) Consumption spending has decreased leading to a recession.

During a recession, governments spend more on welfare and unemployment benefits and tax revenues decrease as people's incomes decrease. This happens automatically due to Stabilisers.

Fiscal Policy Cheat Sheet Here.

The Federal budget will be in a deficit.

(C) Assume that the current RGDP falls short of full employment by $500 billion and the MPC (Marginal Propensity to Consume) is 0.8.

(i) Calculate the minimum increase in government spending that could bring about full employment.

Now, I know that with an MPC of 0.8 the multiplier is 5 and therefore the government will need to increase spending by $100 billion to shift the AD curve rightward to full employment.

But please look at the MPC/MPS Cheat Sheet, Here.  Learn it!!!

Here is a post and some videos on the MPC/Multiplier

(ii) Assume that instead of increasing spending the government decides to decrease personal income taxes. Will the reduction in personal income taxes required to achieve full employment be larger than or smaller than the government spending change you calculated in part (c)(i)? Explain why?

So instead of a Spending Multiplier we will be using the Taxing Multiplier.

A taxing multiplier will always be less than the spending multiplier. WHY? When the government spends all of the $100 billion will be spent. A tax cut will increase (C) consumption spending in the economy as people have more money to spend,, but some of that money will be saved (a leakage) and the multiplier will not be as large.

Check out this post on the difference between a spending and taxing multiplier, Here.

• If the government decreases taxes by 100b the (GDP/AD/Incomes) will increase by the        Tax Multiplier,, so,, -MPC/MPS,, so,, -0.8/0.2 = -4 x -100b = 400b increase in AD

** You must read this carefully to answer - to get the AD curve to shift rightward to full employment (500 billion) the personal income taxes must be reduced by more than 100 billion.***

(D) Using a CLG of the loanable funds market, show the impact of the increased government spending on the RIR real interest rate in the economy.

((If Gov't Spending Increases, RIR Increases.))

Understand that the government wanting to spend,, it must borrow this reduces the supply of loanable funds increasing the RIR, real interest rate.

Understand that the government borrowing increases the demand for loanable funds (as the government's demand is added to all other demand) and therefore the RIR rises.

These both happen at the same time as they in essence are the same thing.

If you go into the grocery store and buy a bag of lemons, you are increasing the demand for lemons and reducing the supply.

(E) How will the real interest rate change in part (D) affect the growth rate of the US economy? Explain.

Look again at the Expansionary = Crowding Out graph above.

Notice the bottom sentence in bold - It says,"LR Growth is sacrificed for a Short Run Aggregate Demand increase with an expansionary policy."

This is the essence of crowding out - The Government spends to increase AD but it must borrow to do the spending. This Government spending raises the RIR which keeps some Private Industries from taking out loans and starting businesses. Why does it keep them out? Remember that the RIR is the price to borrow money, if the price is to high (due to gov's borrowing) then the private companies will not borrow and will not produce.

Long-Run Growth is primarily achieved through increasing productivity and this is done through shifting the SRAS curve rightward in the short-run and the LRAS in the Long-run.

This could really use a good post.