Question

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Answer each question and explain your answer in the space provided. Answers without justification will receive little credit. 1. (4 points) We assume constant MPC in our model. Is this assumption true in the real world? 2. (4 points) What determines the proportion of bonds/money that household keeps? 3. (5 points) What effect an increase of government spending will have on the output equilibrium in the goods market? Explain using autonomous spending.

Answer 1

Ques 1

- The conventional macroeconomic model has government spending, G, adding directly to aggregate demand, AD, and reducing it via taxes, T; these comprise both indirect taxes on expenditures and direct taxes on factor incomes.

- The fiscal multiplier is important in macroeconomics because it tells us how much output changes as exogenous changes occur in government spending or taxation.

- The recipients of the increase in government spending will typically save a proportion 1 – c of each additional dollar of disposable income, where c is the marginal propensity to consume (MPC) this additional income.

- Ignoring income taxes, we can see that $c will, in turn, be spent by these recipients on more goods and services.

- So the assumptions that the MPC is constant in real world may not hold.

- The recipients of this $c will themselves spend a proportion c of this additional income i.e., $c × c.

- This process continues with income and spending growing at a constant rate of c as it passes from hand to hand through the economy.

- This is the familiar geometric progression with constant factor c, where 0 < c < 1. The sum of this geometric series is 1/(1 – c).