Question

2. Suppose the president would like to stimulate the level of output in the economy, and he succeeds in introducing a tax cut. However, he also would like to keep a balanced budget. Assume a consumption function C = 100+ 0.8(Y-T), and let G=100, T=100, 1=100. a. First, suppose that both government spending and taxes are reduced from 100 to 90. i. Use the relevant Keynesian multipliers to compute the total change in output. ii. Compute the effect on government saving. ill. Will the president be satisfied (i.e. did he get an increase in output and a balanced government budget)? (7 pts) b. Using a diagram of the IS-LM framework, depict the net effect of these policies on output and the interest rate, and briefly explain these effects (5 pts)

Answer 1

Given: c= 100+0=8(Y-T) => mpc = 0.8 G=100 I=100 T=100 multiplies is (a) we know, Keynesian K= 1-mpe and using it, we can get ДУ 1 or sy a DG t-mpe BG 1-mpc and ду -mpc or AY = AT 1- мре -mpc AT 1-mpe Now, the change income be AYI caused by governme enment purchases on be AY2. and that of tax Thus to ral change in Output (AY) is AY = DY, & AY2 AY = AG l-ripe (-ape) AT l-ripe Now reduced by since both tax and governa vernment purchases 10 units (since 1co-90), thes, A9 = AT = -10 Therefore, by= (-0.8) (-10) I-0.8 I-0.8 - -10 + 8 - 2 0.2 old 10.8 DY=-10 unila.

we know, Government Savings Tax Government Purchases Transfers reduction a and T Before g Gout. Savings = 100 - 100 =0 After reduction Gout Savings 90-900 There is no budget deficit for current year and the budget is balanced. (i) Though, the budget is balanced, the output has reduced by 10 units.

Thus, the president would not be satisfied.

I is and thirs on (b) we know for equation of is curre Y=C+I+G autonomous sie. it is nol- question dependent interest rate. Thus, output also is noir dependen on interest rate, so, we have vertical is cusue. As shown, we are initially we are at co with Yo level of output and to level of interest rate with the policies, the output would reduce by 10 units seducing interest rart as well, Thus, y, and is are neto new equilibrium ausput and interest IS .LM E eo وا I - I i Y Yo Y lounits