A U.S. Stimulus package of over 700 billion dollars was designed to pull the eco

Question

A U.S. Stimulus package of over 700 billion dollars was designed to pull the economy out of a recession in 2008. Note that Figure 1-2 in the Blanchard text books shows that unemployment rate increased considerably during the crisis (recession) of 2008- 2009. Using the Goods Market model in Chapter 3 of Blanchard, answer the following questions.

b. Suppose you are told that the marginal propensity to consume is 0.8. Further suppose all of the stimulus money was instantaneously introduced in the beginning of 2010. Using these data and the size of the total stimulus package, find the change in total output (Y) between December 2010 and December 2009? Explain clearly the assumptions you are making in arriving at your calculation.

c. Suppose that the package money was split as follows: 200 billion dollars in Tax cuts (T), 300 billion in an increase in Government construction and payroll (G), and another 200 billion dollars in increasing unemployment benefits. Calculate the increase in Y arising from the aforementioned stimulus package. Is it the same as the increase you found in (b) above? Explain your answer.

d. Now assume (more realistically) that the total taxes collected by the Government depend on the total income (Y). For every 100 dollar increase in income, assume that the tax collection goes up by 20 dollars. Using these numbers, recalculate the increase in Y in (c) above. Is it higher or lower or unchanged? Explain why?

e. The worry about the stimulus package is that it could potentially increase total debt- since it involved both and increase in G and a reduction in T. The economic advisor of the Government suggests that the increase in G (by 300 billion) must be done in a balanced-budget manner (i.e. G=T). Under this alternate stimulus package, calculate the increase in Y. Here, assume that the total taxes collected are not a function of Income so that you are back in the situation described in (c) above.

Explanation / Answer

a. The stimulus package will increase the level of National Income or aggregate demand by multiplier amount times the government spending. The increase in national income will increase the production level in the economy. This will lead to hiring of more laborers to fulfill the increased demand. Thus, unemployment level will decline in the economy.

b. It is assumed that MPC will remain constant and there is no lag in the adjustment process.

Change in total output = Multiplier ( 1 / 1- MPC) * Change in government spending

= 1 / 1- 0.8 * 700

= 5 * 700

= $ 3500 billion

c. Tax Multiplier / Transfer payment multiplier = b / 1 - b

Change in Income = 0.8 / 0.2 * 200 + 1 / 1-0.80 * 300 + 0.80 / .20 * 200

= 4 * 200 + 5 * 300 + 4 * 200

= 800 + 1500 + 800

= $ 3100

This is low as compared to the former change in output. This is because taxes or transfer payments first impact the disposable income of the consumer and then will impact the national income. On the other hand, increase in government spending will directly impact the national income of the consumer. Thus, impact of tax multiplier is less as compared to government spending multiplier.

d. For every dollar increase in income, tax collection go up by $0.20.

Thus, for $3100 increase in income, the tax collection will increase by $620.Thus, national income will fall by this amount as this amount is going to the government and is not adding to the total aggregate demand of the economy.Thus, national income will be lower as compared to part c.

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