The following information is available for an economy: Consumption function: C =

Question

The following information is available for an economy: Consumption function: C = 220 + .8(Y-T) Investment: I = 400 Net Exports: NX = -140 Full Employment or Potential GDP = 3500 Currently, G = 500 and T =400. Note: G: Govt. Expenditure, T: Taxes, NX: Exports-Imports (in the data above, NX is negative).

(a) Calculate the current level of (equilibrium) GDP.

(b) Suppose that you work for the President’s Council of Economic Advisers (not a bad job if you can keep your name out of the press). How will you advise the administration to adjust the level of G in order to ensure that the economy operates at the full employment level? Show and explain your calculations. Note that you are only adjusting G.

(c) Now suppose that some of President’s close political advisers are urging him to adjust taxes but not spending. Assuming the same initial level of G (=500), how would you advise the administration to adjust taxes to reach potential GDP? Show and explain all your calculations.

(d) Some senators are urging the administration to design a deficit neutral fiscal package so that no fiscal policy measure affects the level of current budget deficit. In other words, any proposed increase in government spending must be paid for by an equal increase in taxes, or any tax cut must be accompanied by an equal (government) spending cut. Starting from the initial values of G (=500) and T (=400) how would you recommend to adjust both G and T so that the economy produces at the Potential GDP level but the size of the budget deficit remains unchanged? Show and explain all calculations

Explanation / Answer

(a)

C = 220 + 0.8(Y - T) = 220 + 0.8(Y - 400) = 220 + 0.8Y - 320

C = 0.8Y - 100

I = 400, G = 500, NX = -140

National income equation is:

Y = C + G + I + NX

Y = 0.8Y - 100 + 400 + 500 - 140

0.2Y = 660

Y = 660 / 0.2 = 3,300

(b)

Actual GDP < Potential GDP. Therefore, there is a recessionary gap.

This gap can be closed down by increasing G.

So, Y = 0.8Y - 100 + 400 + G - 140

0.2Y = 160 + G

0.2 x 3,500 = 160 + G

G = 700 - 160 = 540

So, to increase GDP to the potential level of 3,500, G has to be increased by 540.

(c)

Now, G remains 500 but Taxes should change.

Y = C + I + G + NX

= 220 + 0.8(Y - T) + 400 + 500 - 140

0.2Y = 980 - 0.8T

0.2 x 3,500 = 980 - 0.8T

0.8T = 980 - 700 = 280

T = 280 / 0.8 = 350

(d)

Y = 220 + 0.8(Y - T) + 400 + G - 140

3,500 = 220 + 0.8(3,500 - T) + 260 + G

220 = G - 0.8T   ..... (1)

Therefore, level of G and T must be kept at such levels that equation (1) is always satisfied.

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