1 Why does a $1 tax cut have a smaller multiplier effect than a $1 increase in government spending on goods and services?

1 Why does a $1 tax cut have a smaller multiplier effect than a $1 increase in government spending on goods and services?

2 Explain briefly and show in a diagram the effect of the following on the AE curve:

a. A $1 million increase in government expenditure on goods and services.

b. A $1 million decrease in autonomous taxes.

c. A decrease in the marginal tax rate.

d. A $5 million increase in government expenditure on goods and services accompanied by a $5 million increase in autonomous taxes.

3 The government is proposing to increase the tax rate on labour income and asks you to report on the supply-side effects of such an action. Answer the following questions using appropriate graphs and report directions of change but not exact magnitudes.

a. What will happen to the supply of labour and why?

b. What will happen to the demand for labour and why?

c. What will happen to the equilibrium before-tax wage rate?

d. What will happen to the equilibrium after-tax wage rate?

e. What will happen to the equilibrium level of employment?

f. What will happen to the potential GDP?

4 For various reasons, fiscal policy changes automatically when output and employment fluctuate.

a. Explain why tax revenue changes when the economy goes into a recession.

b. Explain why government spending changes when the economy goes into a recession.

5 Why might fiscal stimulus crowd out investment?

6 Economy H is in macroeconomic equilibrium. In the AS-AD diagram, the equilibrium price level is 100. Assuming that the price level stays constant, the expenditure plans of the different entities in this economy are:

????=10+0.8????????, where 0.8 = b (or MPC) ????=3+0.2???? ????=5.4 ????=8

????=3

????=2+0.14????

where all variables are measured in billions of dollars per year.

a. Use algebra to find the equilibrium expenditure (=equilibrium real GDP) for this economy.

b. Show the economy’s macroeconomic equilibrium situation, using the AE diagram and the AS-AD diagram. Draw the SAS curve as upward sloping. Indicate the equilibrium expenditure, equilibrium real GDP, and the equilibrium price level.

c. Suppose that the current macroeconomic equilibrium is an unemployment equilibrium and the government then stimulates the economy by increasing G by $6 billion a year. If the price level remained constant, use algebra to find the new equilibrium expenditure for the economy

d. What is the value of the multiplier for this economy?

Given an increase in G by $6 billion a year, use the value of the multiplier to calculate the change in equilibrium expenditure. Do you get the same answer for the new equilibrium expenditure as the answer you obtained in (c)?

e. Show the effect of the $6 billion increase in G on the AE curve in the AE diagram that you drew for part (b), and indicate the new equilibrium expenditure. How will the change in equilibrium expenditure affect the AD curve? Illustrate this in the AS-AD diagram that you drew for part (b).

f. Does the price level stay constant at P=100? How much is the increase in equilibrium real GDP?

7 [Optional] The economy is in a recession, and the recessionary gap is large.

a. Describe the discretionary and automatic fiscal policy actions that might occur.

b. Describe a discretionary fiscal stimulation package that could be used that would not bring an increase in the budget deficit.

c. Explain the risks of discretionary fiscal policy in this situation.

8 [Optional] Using the information given below, answer each question. All figures except parameters are in millions of dollars.

????=250+0.8????????, where 0.8 = b (or MPC) ????=50+0.2???? ????=230 ????=270 ????=220

????=120+0.15????

a. Derive an algebraic expression for equilibrium output (Y) in terms of the variables and parameters.

b. Calculate the equilibrium level of real GDP

c. Calculate the size of the autonomous expenditure multiplier

d. Assume that the economy’s full employment level of output is $1200m. Identify the type and compute the magnitude of the output gap persistent in this economy.

e. What policies would you recommend to eliminate the gap in (c) above? Give both the direction and magnitude of your policy options.