EC 102 Summer School

EC 100
Macro Exercise 1
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Discussion of LT Week 3
- First class for the Macroeconomics part
- Hand-out corrected
- Receive some model solutions with some
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Problem 1
• Why is the aggregate equilibrium condition Y = E?
What happens if E <Y? If E>Y?
– Definition: Y =total supply, defined as the value of all goods
and services produced in a year, or other fixed unit of time
– Definition: E = total demand, i.e., total spending that same
period of time
– So condition Y = E is a simple equilibrium condition, that
supply equals demand.
- If E < Y: less spending than value of output. Producers produce
less? Spenders spend more?
- Where do the adjustments come from?
- Note that Y = P * Q, so equilibrium can be achieved by
changes in P or in Q.
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Problem 1
• Note aside:
• In an open economy: Y = ED + EF
• Output is absorbed by domestic spending or foreign spending.
In case Y < ED, we could have that the difference is absorbed
by foreign spending in form of exports.
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Problem 2
• Why is it important to know the equilibrium level of GDP?
• Knowing the equilibrium level of GDP helps guide policy.
– If the economy is capable of producing higher GDP in
equilibrium, then macroeconomic policy might raise aggregate
demand to achieve that higher GDP level.
– If, on the other hand, the economy’s equilibrium GDP level is
lower than currently observed, the economy might be close to
already experiencing unnecessarily high inflation: in that case,
macroeconomic policy might lower aggregate demand. That’s
why knowing evolution of P is of key importance!
– In either case, again, knowing the equilibrium level of GDP helps
guide policy.
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Problem 3
• Why is it useful to split up E into C, I, G, X, and M?
• Total demand (or, in equilibrium, total output) is usefully
split into its different components C , I , G , X , M because
the behaviour of each of these is driven by different
economic considerations.
- Consider Consumption:
- C(YD) = c0 + mpc YD
- An increase in taxes reduces disposable income, but is likely not
going to have a direct effect on X or M or investment I
- So studying these elements separately is very important as it
allows us to isolate the effects of certain policies.
- Consider G
- If the share of G in total output is large – is this good or bad?
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Problem 4
• What does the analysis so far suggest might be done
to prevent the high unemployment of the 1930s?
• We will discuss this a lot further, I just want to give a
little preview here – we do not have the whole model
set-up yet to be able to discuss this in a lot of detail.
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Problem 4
• The government could have expanded its share of
expenditure, by increasing G.
• This is a policy instrument, that many governments
did employ following Lehman brothers.
• Can you think of some problems?
– How do governments finance their spending?
– Imagine that governments need to access private savings
to finance their expenditure <> this may increase the
interest rate, which could affect private Investment
– Need a model to capture savings…
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Problem 5
• Given the analysis so far, explain intuitively
why an increase in government spending G
increases GDP by more than the initial rise in
G.
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Problem 5
• Given the analysis so far, explain intuitively why
an increase in government spending G increases
GDP by more than the initial rise in G.
– Each additional dollar of consumption is somebody
else‘s income, out of this additional one unit of
income mpc*1 is additionally consumed by this agent,
again, this is somebodys income who is consuming
1*mpc*mpc of it and so on and so forth.
– This infinite geometric series has a finite and closed
form sum as long as mpc is between 0 and 1.
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Problem 5
• Where is the multiplier coming from?
C  c 0  c1 (Y  T )
Y = C + I + G = c0 + c1 (Y - T ) + I + G
1
ÞY =
(c0 + I + G - c1T )
1- c1
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Problem 5
• Where is the multiplier coming from?
C  c 0  c1 (Y  T )
Y = C + I + G = c0 + c1 (Y - T ) + I + G
1
ÞY =
(c0 + I + G - c1T )
1- c1
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Problem 6
• Explain the government spending multiplier in your
own words. What is the significance of this multiplier
having value greater than one?
• The government spending multiplier is the increase in
GDP from an increase in government spending,
expressed as a proportion of that government
spending increase. That the multiplier exceeds 1 means
the government has an effective instrument in its
spending decisions for guiding changes to GDP.
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Problem 7
What about changes in TAXES?
C = a + b(Y -T )
Y =PE= C + I + G + (X - M ) = a + b(Y - T ) + I + G + (X - M )
1
ÞY =
(a + I + G - bT + X - M )
1- b
-b
So tax multiplier is:
1- b
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Problem 8
What about changes in IMPORTS?
C = a + b(Y -T )
Y =PE= C + I + G + (X - M ) = a + b(Y - T ) + I + G + (X - M )
1
ÞY =
(a + I + G - bT + X - M )
1- b
-1
So import multiplier is:
1- b
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Problem 9
Suppose you increase TAXES by same amount as
you increase G – what is the net effect?
The G multiplier is:
1
1- b
The T multiplier is:
-b
1- b
What is the NET EFFECT:
1
b
=1
1- b 1- b
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Problem 9
So GDP still increases by 1 unit --- why?
The government consumes all, whereas if taxes
are reduced the households save a fraction of
this new income. Hence, the multiplier is lower
as the initial agents who gets higher income
does not consume all of it but only mpc*dT of it.
The Government is a more „effective” consumer.
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