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EC 100 Macro Exercise 1 1 Discussion of LT Week 3 - First class for the Macroeconomics part - Hand-out corrected - Receive some model solutions with some general comments. 2 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. 3 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. 4 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. 5 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? 6 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. 7 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… 8 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. 9 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. 10 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 11 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 12 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. 13 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 14 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 15 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 16 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. 17