MACROECONOMIC DECISION CASE STUDY (GROUP) You are expected to collaborate in you
ID: 1114857 • Letter: M
Question
MACROECONOMIC DECISION CASE STUDY (GROUP)
You are expected to collaborate in your groups on the questions and submit the answers as a team.
DEMAND SIDE EQUILIBRIUM, INFLATIONARY VERSUS RECESSIONARY GAP, AND FISCAL STIMULUS VERSUS TAX CUT
In the country of Utopia, the structure of the economy is described as the following:
Where Y is the level of real GDP in the economy, DI denotes the disposable income in the economy, C represents the level of consumption in the economy, C0 is the autonomous consumption level, mpc denotes the marginal propensity to consume, I is the level of investment in the economy, I0 characterizes the autonomous investment, mpi is the marginal propensity to invest, G characterizes the level of government expenditure, X is the level of export from the country, M represents the amount of import in the country, M0 is the level of autonomous import, mpm denotes the marginal propensity to import, T is the amount of tax imposed in the country, and t represents the average tax rate in the economy.
After extensive research, the economists in Utopia believe that the following values (all the dollar values are in number of millions) can be assigned to the structure of the economy,
C0 = $500; mpc = 0.8; I0 = $200; mpi = 0.2; G = $400; X = $300; M0 = $100; mpm = 0.1; and t = 0.25. The Utopian economists further believe that the level of potential GDP in the country is $4,000.
The country of Utopia is probably experiencing a recessionary pressure in its economy now. The economists are suspecting that, since the latest estimates of mpc, mpi, and mpm indicate that their estimated values have gone down to 0.65, 0.15, and 0.05 respectively.
The economists have disclosed their concerns to the Utopian lawmakers. Due to that conversation between the economists and the lawmakers and based on the latest estimated values of mpc, mpi, and mpm; the average tax rate has been reduced by the lawmakers to 12.5% to stimulate the economy.
Alternatively, the lawmakers are also thinking about a fiscal stimulus instead of a reduction in the tax rate. In other words, lawmakers could increase the level of government spending instead of reducing the tax rate from current 25%. The objective for the lawmakers is to have the same level of stimulus from spending increase that they could achieve from the decrease in the tax rate.
What is the demand side equilibrium level of real GDP in the country? Please show your calculations.
Is the overall Utopian economy in equilibrium? Elaborate your answer.
If the economy is not in equilibrium, what will happen eventually? Explain your answer.
What is the value of the overall multiplier? Please show your calculations and explain the value.
What is the demand side equilibrium level of real GDP in the country now? Please show your calculations.
Is the overall Utopian economy now in equilibrium? Elaborate your answer.
If the economy is not in equilibrium now, what will happen eventually? Explain your answer.
What is the adjusted value of the overall multiplier? Please show your calculations and explain the value.
What is the demand side equilibrium level of real GDP in the country eventually? Please show your calculations.
Is the overall Utopian economy now in equilibrium? Elaborate your answer.
If the economy is not in equilibrium now, what will happen eventually? Explain your answer.
What is the eventual value of the overall multiplier? Please show your calculations and explain the value.
What can you infer from the reduction in the tax rate to stimulate the economy? Did it serve its intended purpose? How? Explain your answer in detail.
How much increase in government spending needs to happen to have the same level of stimulus, then what can be achieved through a reduction of the tax rate to 12.5% instead?
Do you feel that tax cut is always a solution to stimulate the economy? How about the increase in government spending instead? Elaborate your argument.
In the particular case of the Utopian economy, which policy (tax cut or fiscal stimulus) do you feel would serve the citizens better? Elaborate your argument.
Y = C + I + G + (X – M) C = C0 + (mpc)(DI) I = I0 + (mpi)(Y) M = M0 + (mpm)(DI) DI = Y – T T = (t)(Y)Explanation / Answer
NOTE: First 4 questions are answered.
Answer:
(1) In demand side equilibrium,
Y = C0 + [MPC x (Y - tY)] + I0 + (MPI x Y) + G + X - M0 - [MPM x (Y - tY)]
Y ($) = 500 + [0.8 x (Y - 0.25Y)] + 200 + 0.2Y + 400 + 300 - 100 - [0.1 x (Y - 0.25Y)]
Y = 500 + (0.8 x 0.75Y) + 200 + 0.2Y + 400 + 300 - 100 - (0.1 x 0.75Y)
Y = 1,300 + 0.6Y + 0.2Y - 0.075Y
(1 + 0.075 - 0.8)Y = 1,300
0.275Y = 1,300
Y = $4,727
(2) Since demand-side equilibrium GDP is higher than potential GDP, the economy is not in equilibrium.
(3) Since demand-side equilibrium GDP is higher than potential GDP, price level will be higher than at potential GDP level, causing an inflationary gap. In the long run, higher price level will increase the cost of inputs, which will make firms lower output, reducing aggregate supply. Therefore, short-run aggregate supply will fall, which will further increase the price level but will restore the demand-side equilibrium GDP to the potential GDP of $4,000.
(4) Multiplier = 1 / [1 - (t x MPC) + MPI + MPM]
= 1 / [1 - (0.25 x 0.8) + 0.2 + 0.1] = 1 / (1 - 0.2 + 0.2 + 0.1) = 1 / 1.1
= 0.91
This signifies that as consumption, investment and import demands each increases by 1 unit, total output of the economy will increase by 0.91 units.
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