Ecoii PS1

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Problem Set 1

Principles to Economics I

Professor Khieu Van Hoang

December 22th, 2021


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Question 1

a. The largest component of GDP is consumption

➔ True, GDP accounts for 70.5% of total GDP in 2010

b. Government spending, including transfers, was equal to 20.4% of GDP in 2010

➔ False, government spending, excluding transfer, was equal to 20.4% of GDP in 2010

c. The propensity to consume has to be positive, but otherwise it can take on any
positive value.

➔ False, the propensity to consume does have to be positive but also must be less than 1 in
order for our model to work.

d. Fiscal policy describes the choice of government spending and taxes and is treated
as exogenous in our goods market model.

➔ True, government spending and taxes are exogenous, taken as given

e. The equilibrium condition for the goods market states that consumption equals
output.

➔ False, aggregate demand = aggregate output

f. An increase of one unit in government spending leads to an increase of one unit in


equilibrium output.

➔ False, the increase in equilibrium output is 1 x multiplier not just one unit

g. An increase in the propensity to consume leads to a decrease in output.

➔ False, a increase in propensity to consume leads to an increase in output since they have
a positive relationship.

Question 2
a. Equilibrium GDP (Y ):

Y = 𝑐0 + 𝑐1 (Y − T) + G + I

Y= 160 + 0.6 (Y – 100) +150+ 150


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Y= 460 + 0.6Y – 60

Y-0.6Y= 400

Y= 1000
b. Disposable income (YD): 𝑌𝐷 ≡ Y - T = 1000 – 100 =900

c. Consumption spending (C): C = 160 + 0.6YD = 160 + 0.6(900) = 700

Question 3
a. Solve for equilibrium output. Compute total demand. Is it equal to production?
Explain.

Z = 𝑐0 + 𝑐1 (Y - T)+ I + G = 160 + (0.6 × 900) + 150 +150 = 1000

b. Assume that G is now equal to 110. Solve for equilibrium output. Compute total
demand. Is it equal to production? Explain.

Y = 𝑐0 + 𝑐1 (Y − T) + G + I

Y = 160 + 0.6 (Y – 100) +110+ 150

Y = 460 + 0.6Y – 60

Y - 0.6Y= 360

Y = 900

This problem set could be solved using the multiplier.

The multiplier is 1/(1 − c1) = 1/(1−0.6) = 2.5.

Therefore, multiply the change in government spending (as that is going to affect demand
directly) by the multiplier to get 2.5 (−40) = −100. Therefore, Y = 900.

C = 160 + 0.6YD = 160 + 0.6(900 − 100) = 640

I = 150

G = 110
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Therefore, we are in equilibrium and therefore Y = Z(Y ), the total demand is Z = 900.
c. Assume that G is equal to 110, so output is given by your answer to (b). Compute
private plus public saving. Is the sum of private and public saving equal to investment?
Explain.

Private Savings: Y − C − T = 900 − 640 − 100 = 160.

Public Savings: T − G = −10

Total Savings: Private Savings + Public savings = 160-10= 50

I= 150 so total savings are equal to investment

At equilibrium, demand equals production. The reason can be claimed that the investment
will be financed through saving.

Question 4 - The balanced budget multiplier


a. By how much does Y increase when G increases by one unit?

Y= 𝑐0 +𝑐1(Y=T) +I+G

Y= 𝑐0 +𝑐1Y +𝑐1T +I+G

Y- 𝑐1 𝑌= co- 𝑐1T + I +G

Y=G/(1-𝑐1 ) + (𝑐0 − 𝑐1 T + 1)/(1- 𝑐1 )

 dY/dG = 1/(1- 𝑐1 ) > 0 (if 0 < 𝑐1 < 1)

Summary: if G increases by 1 unit, Y increase by 1/(1- 𝑐1 ) 𝑢𝑛𝑖𝑡𝑠. 1/(1- 𝑐1 ) is multiplier of


government spending based on 𝑐1 .
b. By how much does Y decrease when T increases by one unit?

Y= 𝑐0 +𝑐1(Y=T) +I+G

Y= 𝑐0 +𝑐1Y +𝑐1T +I+G

Y- 𝑐1 𝑌= co- 𝑐1T + I +G

Y(1- 𝑐1 ) = co- 𝑐1T + I +G

Y = (co- 𝑐1T + I +G)/( (1- 𝑐1 )


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=> dY/dT = − 𝑐1/ (1- 𝑐1 ) < 0 (𝑖𝑓 0 < 𝑐1 < 1

Summary: if T increases by 1 unit, Y decreases by 𝑐1/ (1- 𝑐1) units or Y equal minus

𝑐1/(1- 𝑐1 )

c. Why are your answers to (a) and (b) different?


(a) and (b) are different because the government spending affects deman and output directly.
However, taxes (T) affect demand and output through the indirect way through consumption
(C) = c1 (Y − T) and propensity to comsume 𝑐1 < 1

d. Suppose that G and T increase by one unit each. Using your answers to (a) and (b),
what is the change in equilibrium GDP? Are balanced budget changes in G and T
macroeconomically neutral?

Balanced budget changes in G and T neutral when dG + dY= dY= 0

In our case: dG +dY = 1/(1- 𝑐1 ) − 𝑐1/ (1- 𝑐1 ) = (1- 𝑐1 ) / (1- 𝑐1 ) = 1

Therefore, the output is not macroeconomically neutral because the change in level of output
equals 1

Summary: Balanced budget changes in G and T are not macro-economically neutral as

dY≠0
d. How does the specific value of the propensity to consume affect your answer to (a)?
Why?

The marginal propensity to cosume 𝑐1 𝑑𝑜𝑒𝑠𝑛′ 𝑡 𝑎ffect Y because dY=1 and dT=1. They both
increase by 1 unit so 𝑌𝐷 and C don’t change

d. 𝑌𝐷 = dY - dT = 0 => dC = 0 as 𝑐1 (dY - dT) = 0


The balanced budget tax increase aborts the multiplier process of 𝑐1

Question 5 - Automatic stabilizers

a. Solve for equilibrium output.

Y=C+I+G
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Y = c0 + c1 (Y − t 0 + t1 Y) + G + I

Y =c0 + c1 Y − c1 t0 + c1 t1 Y + G + I

Y = c0 + c1 (Y+ t1 Y ) + G + I − c1 t0

Y = 1/(1- c1 + c1 t1 ) ( c0 - c1 t1 + I + G)

b. What is the multiplier? Does the economy respond more to changes in autonomous
spending when 𝑡1 is 0 or when 𝑡1 is positive? Explain.

The multiplier is 1/(1- 𝑐1 + 𝑐1 𝑡1 ) . The economy responds less to changes in autonomous


spending when 𝑡1 is larger. Because when 𝑡1 is larger, the multiplier 1/(1- 𝑐1 + 𝑐1 𝑡1 ) is
smaller. At any given changes of autonomous spending ( 𝑐0 - 𝑐1 𝑡1 + I + G), the equilibrium
output will be smaller.

The economy responds less to modifications in autonomous spending once 𝑡1 is larger. In


alternative words, given any positive change in autonomous spending.
c. Why is fiscal policy in this case called an automatic stabilizer?

1/(1- 𝑐1 + 𝑐1 𝑡1 ) < 1/(1- 𝑐1)

Fiscal policy is called an automatic stabilizer when the outputs is more stable and have less changes.
Because of the automatic effect of taxes on the economy, the economy responds less to changes in
autonomous spending than in the case where taxes are independent of income

Question 6 - Investment and income


a.

Y=C+I+G

Y = 𝑐0 + 𝑐1 (Y −𝑇) + G + 𝑏0 + 𝑏1 Y

Y = 𝑐0 + 𝑐1 Y − 𝑐1 𝑇+ G + 𝑏0 + 𝑏1 Y

Y - 𝑐1 Y - 𝑏1 Y = 𝑐0 − 𝑐1 𝑇+ G + 𝑏0

Y(1 - 𝑐1 - 𝑏1 ) = 𝑐0 + 𝑏0 − 𝑐1 𝑇+ G

Y = (1 - 𝑐1 - 𝑏1 ) / ( 𝑐0 + 𝑏0 − 𝑐1 𝑇+ G)
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b. What is the value of the multiplier? How does the relation between investment and
output affect the value of the multiplier? For the multiplier to be positive, what
condition must (c1 + b1) satisfy? Explain your answers.

The multiplier: 1/(1 - 𝑐1 - 𝑏1 ) > 1/(1- 𝑐1). Because when the multiplier is positive, the
condition must be c1 + 𝑏1 < 1 . The autonomous spending creates a multiplier effect through
consumption and investment.

c. Suppose that the parameter 𝒃𝟎 , sometimes called business confidence, increases. How
will equilibrium output be affected? Will investment change by more or less than the
change in 𝒃𝟎 ? Why? What will happen to national saving?

The equilibrium output increases the multiplier in the 𝑏0 time. The investments increase by
the change of 𝑏0 + 𝑏1 times the change in output. The change in business confidence leads to
an increase in output, which leads to a further increase in investment. Since investments
increase and saving equals investments, saving must also increase. Increased production
leads to increased national savings

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