C = 4 +.8Yd Consumption Ii = 18 Intended Investment G = 20 Government spending Y
ID: 1201205 • Letter: C
Question
C = 4 +.8Yd Consumption Ii = 18 Intended Investment G = 20 Government spending Yd = Y - T + TR Disposable income T =.25 Taxes TR = 25 -.12Y transfers Solve the model above for equilibrium GDP. Along the way, write down and circle the simplified AD function. What is the multiplier? Find the budget deficit or surplus. What are the automatic stabilizers here? I.e. which element[s] of the model is/are [a] government program[s] that reduce[s] the multiplier? Be very specific. Suppose Potential GDP were 120. At Potential GDP, with no change in discretionary fiscal policy, what would the budget deficit/surplus be? Note: this calculation gives you what is sometimes called the "structural budget surplus/deficit" or the "full employment surplus/deficit". At a GDP of 115, would the budget be in surplus or in deficit? Don't bother to recalculate to answer this. Now let's return to the equilibrium GDP situation from (a) through From that starting point, suppose Congress and the President cut G, believing the economy was overheated. Without solving for GDP, list the contradictory influences on the budget surplus that will ensue. Don't work with exact numbers, just the direction of changes. Remember there are three elements of the budget.Explanation / Answer
(a) AD function is as follows -
AD = C + Ii + G = 4 + 0.8Yd + 18 + 20 = 42 + 0.8Yd
Economy is in equilibrium when -
Y = AD
Y = 42 + 0.8Yd ... [Yd = Y - T + TR]
Y = 42 + 0.8(Y - T + TR) [T = 0.25Y, TR = 25 - 0.125Y]
Y = 42 + 0.8(Y - 0.25Y + 25 - 0.125Y)
Y = 42 + 0.5Y + 20
Y = 124
The equilibrium GDP (Y) is 124.
(b) C = 4 + 0.8Yd
Coefficient of Yd is the MPC
So, MPC is 0.8.
Multiplier = 1/1-MPC = 1/1-0.8 = 5
The Multiplier is 5.
(c) Equilibrium GDP (Y) = 124
Taxes = 0.25Y = 0.25 * 124 = 31
Transfers = 25 - 0.125Y = 25 - 0.125 * 124 = 25 - 15.5 = 9.5
Government spending = 20
Total government expenditure = Government spending + Transfers = 20 + 9.5 = 29.5
As government revenue (taxes) is greater than the government expenditure, budget is in surplus.
Surplus = Government revenue (taxes) - Government spending = 31 - 29.5 = 1.5
The budget surplus is 1.5
(d) Automatic stabilizers refers to those taxes and expenditure patterns of government that vary automatically in appropriate direction with the changes in national income. In other words, these vary with national income.
In the given model, taxes and transfers are dependent on income and thus vary with level of national income and thus are the automatic stabilizers here.
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