Question

14. Consider the following sets of values for MPC, t, and m, and recall that the simple multiplier is given by 1/[1 – MPC (1 – t) – m). Assume the AS curve is upward sloping and identical in each economy. Economy A: MPC =0.84, t = 0.15, m=0.19 Economy B: MPC =0.84, t = 0.40, m=0.19 Economy C: MPC =0.93, t = 0.15, m=0.12 Economy D: MPC = 0.75, t = 0.30, m=0.27 Economy E: MPC = 0.75, t = 0.10, m=0.30 a. For each economy, calculate the simple multiplier. b. Which economy would experience the largest swings in real GDP in response to a given AD shock? Which would experience the smallest swings? c. Explain why the change in real GDP in response to an AD shock would not be solely determined by the simple multiplier for each of these economies. d. Compare Economies A and B and explain how the tax-and-transfer system provides greater automatic stabilization in one of the two economies. e. Explain how the slope of the AS curve would affect the short-run change in real GDP in response to an AD shock.

Answer 1

Ans: Simple Multiplier = $\frac{1}{[1-MPC(1-t)-m]}$

For Economy A putting the values in the formula of multiplier

Simple Multiplier = $\frac{1}{[1-0.84(1-0.15)-0.19]}$

Simple Multiplier = 10.41

For Economy B

Simple Multiplier = $\frac{1}{[1-0.84(1-0.40)-0.19]}$

Simple Multiplier = 3.26

For Economy C

Simple Multiplier = $\frac{1}{[1-0.93(1-0.15)-0.12]}$

Simple Multiplier = 11.17

For Economy D

Simple Multiplier = $\frac{1}{[1-0.75(1-0.30)-0.27]}$

Simple Multiplier = 4.87

For Economy E

Simple Multiplier = $\frac{1}{[1-0.75(1-0.10)-0.30]}$

Simple Multiplier = 40

(b) In response to a given AD shock the economy with a larger multiplier which means economy E will experience the largest swings in real GDP whereas the economy with smallest multiplier which is Economy B will experience the smallest swings in real GDP in response to given AD shock;but this is not true because the change in Real GDP will also depend on slopes of AD and AS curves in these economies which depends further on price levels and other factors.

(c) Change in real GDP in response to a given AD shock will not solely depend on simple multiplier it will also depends on slopes of AD and AS curves which further depend on a lot of variables like price level, interest rates, Government expenditure etc; thus it also matter how steeper or flatter the AD and AS curves are which determine the change in real GDP in response to AD shock; thus simple multiplier is not a sole factor behind the change in real GDP.

(d) In economy B tax rate is more than the economy A and rest of the variables is same which means that there will be a more impact on real GDP in economy B. Tax and transfer system like unemployment insurance tend to reduce this negative impact they are like automatic stablizer they pull back the economy to the normal level without intervention of government expenditures,they automatically adjust the tax and transfer payments to stablize income, consumption etc.

There will be a greater automatic stabilization in economy B because there is a higher tax rate and there will be more transfer payments required to stablize this effect.

(e) Flatter AS curve will cause more changes in real GDP in response to given AD shock whereas steeper the AS curve will cause more changes in real GDP in response to given AD shock; thus higher the slope of AS curve there will be less changes in real GDP whereas lower slope of AS curve there will be more changes in real GDP.