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. Equation 3-8 gives the output level as a direct function of the govt spending, investment, autonomous consumption and taxation level. 1/(1-c1) is the simple Keynesian multiplier. In the context of fiscal expansion it means that the output increases by multiplier times the govt spending and tax cuts. It further helps to reduce the unemployment assuming that there is one-to-one correspondence between output and employment.

b. If MPC is 0.8 then the value of the multiplier is1/0.2 = 5. A stimulus of $700 billion translates into an increase in output of 5 x $700 bn = $3,500 bn.
It is assumed that the relationship i.e. equation 3-8 holds over time and the values of the parameters do not change over these 2 years. It is also assumed that there is no other counteracting force affecting the economy.

c. We now find the net stimulus which is the sum of the all the fiscal policy measures.

Net stimulus = 200 + 300 + 200 = $700 bn

Since overall stimulus package doesn't change, the impact on output won't change and it will be same as in (b). Another way to look at it would be to assume that output changes can be seen as a linear combination of these stimulus change which share the multiplier and hence give the same output change.

d. Now, the tax rate is 0.2. This will change the multiplier value.

Multiplier = 1/(1 - 0.8 + 0.2) = 1/0.4 = 2.5

Since multiplier has halved, the increase in output level will also be halved to $1750 billion.

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