Homework Answers

Homework - Chapter 12 Key Questions #2, 3

#2) Assume that a hypothetical economy with an MPC of .8is experiencing severe recession. By how much would governmentspending have to increase to shift the aggregate demandcurve rightward by $25 billion? How large a tax cut would beneeded to achieve this same increase in aggregate demand?Why the difference? Determine one possible combination of government spending increases and tax decreases that would accomplishthis same goal.

To calculate the increase in government spending, the multiplier needs to be determined.

Multiplier = 1/ MPS (1-MPC)
= 1/.8
= 5 - and therefore the government spending = $5 billion

As the marginal propensity to consume is 0.8, only 80% of the tax will be spent and therefore

.8 x Tax Cut = 5 Billion
by solving for Tax Cut , Tax Cut = 6.25 Billion

The difference occurs because not all of the tax cut is spend, some is saved.

Possible Combination - $1 billion increase in gov. spending and $5 billion tax cut

#3) What are government’s fiscal policy options for endingsevere demand-pull inflation? Use the aggregate demand-aggregatesupply model to show the impact of these policies onthe price level. Which of these fiscal policy options do you thinka “conservative” economist might favor? A “liberal” economist?

Options are to : 1) reduce government spending 2) increase taxes

The person who wants to preserve the size of the government might opt for option 2 while the person who thinks the public sector is too large might opt for option 1.