Page 3 Question I, continued The government is running a huge budget deficit of
ID: 1161840 • Letter: P
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Page 3 Question I, continued The government is running a huge budget deficit of 100 at general equilibrium. This makes it for the government to sell its bonds and explains why the Central Bank must set its policy interest rate,I-10%, so high. In an effort to close the deficit, Mike M. Hirt, the newly confirmed Finance Minister, institutes a policy of brutal austerity. Hirt slashes autonomous transfer payments- Social Security benefits, the pensions of retired public employees- by an amount b) equal to the government's deficit, ? t,- + 100. i. Will cutting autonomous transfer payments by the amount of the deficit eliminate the deficit? Explain why or why not. No calculations are necessary. (10 points) what must the Central Bank do to keep the interest rate at its 10% target (f .) when the austerity program described above is implemented? (Just cite the direction in which the money supply must change and how the Central Bank should go about changing it. Numerical values are not necessary.] (5 points)Explanation / Answer
i) disposable income is equal to income plus transfers minus taxes. Consumer spend certain proportion of this disposable oxime on goods. Marginal propensity to consume is the proportion of disposable income spent, which is less than one. So any increase in transfers will not have full effect. Change in gdp will be the product of marginal propensity to consume and transfers which will be less than transfers. This increase in transfers will not eliminate deficit completely.
ii) Central bank can keep the interest rate as high as at 10% by decreasing the money supply. Money supply should decrease. This leads to increase in interest rate.
Central bank can decrease money supply through open market sale of securities, by increasing discount rate or by increasing required reserve ratio.
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