Assume the following parameters: C = 200 + 0.85*DI; t = 0.25; I = 260; G = 200;

Question

Assume the following parameters: C = 200 + 0.85*DI; t = 0.25; I = 260; G = 200; NX = -70; TR = 100

(a) Calculate equilibrium output. Calculate the budget deficit (or surplus), where the budget deficit is given by G + TR - tY.

(b) Suppose the economy is initially as in part (a). Then suppose a decline in business confidence reduces investment to 200. Calculate the new level of equilibrium output and the new budget deficit. Intuitively, why has the budget deficit changed even though fiscal policy is unchanged? (Note: the intuition is part of the answer! Don’t omit it).

(c) Suppose the government responds to the decline in investment in part (b) by using an increase in government purchases to counteract the decline in output due to the decline in investment. What new level of G is required to restore output to its equilibrium level from part (a)?

(d) Calculate the new budget deficit when G is set to the level from part (c), assuming that investment is 200 and that all other parameters are still at their original values. How much has the deficit increased from its value from part (b)? Explain intuitively why the increase in the deficit is smaller than the increase in G. Again, the intuition is part of the answer—don't omit it! (Hint: don't forget that Y has changed and that this affects tax revenue!)

(e) Now suppose that instead of trying to counteract the decline in output, the government chooses to focus on maintaining a balanced budget, and responds to the decline in investment by reducing G by an amount equal to the increase in the budget deficit in part (b). What is the new level of G? Calculate the resulting levels of equilibrium output and the budget deficit, assuming that investment is 200, and that all other parameters (except for G) are at their levels from part (a). Is output lower than in part (b)? Is the budget balanced? If not, explain intuitively why not.

Explanation / Answer

DI = Y - T + TR = Y - tY + TR = (1 - t)Y + TR = (1 - 0.25)Y + 100 = 0.75Y + 100

(a) In equilibrium, Y = C + I + G + NX

Y = 200 + 0.85(0.75Y + 100) + 260 + 200 - 70

Y = 590 + 0.6375Y + 85

(1 - 0.6375)Y = 675

0.3625Y = 675

Y = 1,862

Budget deficit = G + TR - 0.25Y = 200 + 100 - (0.25 x 1,862) = 300 - 465.5 = - 165.5

A negative budget deficit means, Budget surplus = 165.5

(b) When I = 200, there is a decrease in I by 60 (= 260 - 200). Therefore,

0.3625Y = 675 - 60 = 615

Y = 1,697

Budget deficit = G + TR - 0.25Y = 200 + 100 - (0.25 x 1,697) = 300 - 424.25 = - 124.25

A negative budget deficit means, Budget surplus = 124.25

Budget deficit has decreased because the tax is not a lump-sum tax, instead, tax revenue depends on output, while lower output is a result of lower investment confidence.

(c) Required increase in output = 1,862 - 1,697 = 165

MPC = 0.85

Spending multiplier = 1 / (1 - MPC) = 1 / (1 - 0.85) = 1 / 0.15 = 6.67

Therefore, required increase in government spending = Required increase in output / Multiplier = 165 / 6.67 = 24.75

New level of G = 200 + 24.75 = 224.75

(d) When G = 224.75 & Y = 1,862:

Budget deficit = G + TR - 0.25Y = 224.75 + 100 - (0.25 x 1,862) = 324.75 - 465.5 = - 140.75

A negative budget deficit means, Budget surplus = 140.75

Compared to part (b), Increase in budget surplus = Decrease in budget deficit = 140.75 - 124.25 = 16.5

Inrcrease in budget surplus is lower than the increase in government spending because, while government spending is autonomous, budget surplus depends on the value of Y, which is higher compared to in part (b), leading to higher tax revenue and a lower increase in budget surplus compared to the increase in government spending.

NOTE As per Chegg answering guidelines, first 4 parts are answered.

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