AF1605 Introduction to Economics TUT006
Problem Set 8 Written Report
Suppose that the economy of FarFarAway is described by the following equations:
C = 1000+0.8(Y-T)
I = 2000-1000r
Planned government expenditure:
G = 2000
Planned net export:
NX = 90
T = tY
Income tax rate:
Real interest rate:
r = 0.05
Yf = 15000
What is the short-run equilibrium output for FarFarAway? Please show your calculation.
Briefly explain how the government of FarFarAway can change from the short-run equilibrium output (i.e. your answer to (a)) to the potential output using fiscal policy. In your answer, please state only one tool that the government can use to implement this policy and explain how it can affect output.
The short run equilibrium output is the output level at which Y = AE, which AE is the sum of consumption (C), private investment ( I ), Government expenditure (G) and Net export (NX). The equation Y = 1000+0.8(Y-T) + 2000-1000r +2000 + 90 will be obtained. Given in the question, the income taxes is T = tY. This can be substituted into the consumption function.
The equation is as follow:
Y = 1000+0.8(Y-T) + (2000-1000r) +2000 + 90
Y = 5090 + 0.8(Y-tY) -1000r
Y = 5090 + 0.8(Y-tY) -1000(0.05)
Y = 5040 + 0.8(Y-0.2Y)
Y = 5040 + 0.64 Y
Y = 14000
Therefore, the short run equilibrium output is 14000.
b. We can change from the short-run equilibrium output 14000 to the potential output 15000 using expansionary fiscal policy, which aims at increasing the short-run equilibrium output.
There are two tools that the government can use. The first one is to increase the government expenditure. The second one is to decrease taxes. Refer to the question, only one tool that the government can use to implement this policy. So to increase government expenditure should be used.
The increase in government expenditure can lead to an increase in aggregate demand such that the aggregate demand curve shifts to the right. At this new equilibrium, both the equilibrium price level and the equilibrium output increase. Therefore, increasing the government expenditure can achieve potential output.
Suppose the government increases spending by 100, that is from 2000 to 2100, on education such that the new value of G = 2100. At Equilibrium, AE = Y,
Y= 5140 + 0.64Y
So the equilibrium output Y = 14278. But the change in equilibrium output is equal to (14278-14000) = 278, which is much larger than the increase in the actual government spending 100.
This process includes two steps. At first, the government expenditure increases by 100 and the equilibrium output also goes up by 100. But then, the consumption goes up by 64 with the increase in 100 of the equilibrium output. Therefore, we can conclude that the overall change in equilibrium depends on the size of the multiplier.
The following table shows the planned expenditure of Country A at various levels of real GDP. This country’s potential real GDP is 220. The current personal income tax rate is 20 percent.
G minus T
If this country is currently at equilibrium, what is the value of its real GDP? What is the government’s budget deficit position? What is the value of the output gap? Briefly explain your answer.
Suppose the government of Country A in part (a) would like to eliminate the output gap, can you suggest one possible fiscal policy that can help the government of Country A to achieve its target? Briefly explain how your suggested policy can eliminate the output gap.
Please join StudyMode to read the full document