Suppose that taxes and transfers are fixed, so that a change in the government’s

Question

Suppose that taxes and transfers are fixed, so that a change in the government’s spending is equivalent to a change in its deficit. The multiplier is three. For each increase in the deficit of 100, interest rates rise by one percentage point. When the government increases its spending by 200, what is the change in equilibrium GDP if:

a)     For every 1 percent increase in interest rates, investment spending falls by 50.

b)     For every 1 percent increase in interest rates, investment spending falls by 100.

c)     Investment spending is not affected by interest rates.

Explanation / Answer

a. From the GDP we get:

y=c(y)+i(r)+g

or, dy(1-c')=i'dr+dg

or, dy=(1/1-c')(i'dr+dg)=3(-50+200)=450

b. If dI=-100

then, dy=3(-100+200)=300

c. If investment is not affected by rate of interest then,

dy=3x200=600

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