Consider a closed economy with fixed prices and wages. Suppose consumption function takes the form C = 150+0,8Yd, Investments are I = 200, government purchases are G = 350, tax rate t= 0,1. There are no lump-sum taxes. (some calculations are added in the images)1)Compute the government spending multiplier before and after changes in tax rate. Explain why multiplier is changed?2) If the potential output is 3000 and economy is in initial equilibrium (a) what changes in government purchases the Government need to implement in order to achieve potential output? Show how changes in government purchases affect the planned aggregate spending line and new equilibrium output. Step 1The equilibrium output and budget deficit are as follows:Y=C+I+ GY=150 + 0. 8 (Y – 0. 1Y) + 200 + 350Y=700 + 0. 72YY=7000.28Y=2, 500Budget Deficit=Tax Revenue – Government Expenditure=(2, 500 x 0. 1) – 350=-100Hence, the equilibrium level of output is 2,500 and the budget deficit is 100, this can be seen in the diagrambelow:AggregateExpenditure45°AggregateExpenditure(C+l+G)2,500GDP Step 2If there is a balanced budget then the new tax rate would be:tY=3502, 5001=3503502,500t=0. 14Hence, the new tax rate would be 0.14 or 14%.Step 3The new equilibrium output after the change in the tax rate would be as follows:Y=C+I+GY=150 +0.8 (Y – 0. 14Y) + 200 + 350Y=700 + 0. 688Y7000.312Y=2, 243. 6Hence, the new equilibrium output will be 2,243.6. This can also be shown graphically as:AggregateExpenditureAggregateExpenditure(C+l+G)45°AggregateExpenditure 1(C1+l+G)2,243.6 2,500GDP

The new tax rate is 0.14 C=150+0.8Yd From here, we know initial MPC = 0.8 As MPC = Change in C/…

Answered: Consider a closed economy with fixed…

Principles of Economics 2e

2nd Edition

ISBN:9781947172364

Author:Steven A. Greenlaw; David Shapiro

Publisher:Steven A. Greenlaw; David Shapiro

Chapter30: Government Budgets And Fiscal Policy

Section: Chapter Questions

Problem 51P: A government starts off with a total debt of $3.5 billion. In year one, the government runs a...

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Consider a closed economy with fixed prices and wages. Suppose consumption function takes the form C = 150+0,8Yd, Investments are I = 200, government purchases are G = 350, tax rate t= 0,1. There are no lump-sum taxes. (some calculations are added in the images)

1)Compute the government spending multiplier before and after changes in tax rate. Explain why multiplier is changed?

2) If the potential output is 3000 and economy is in initial equilibrium (a) what changes in government purchases the Government need to implement in order to achieve potential output? Show how changes in government purchases affect the planned aggregate spending line and new equilibrium output.

Step 1
The equilibrium output and budget deficit are as follows:
Y=C+I+ G
Y=150 + 0. 8 (Y – 0. 1Y) + 200 + 350
Y=700 + 0. 72Y
Y=700
0.28
Y=2, 500
Budget Deficit=Tax Revenue – Government Expenditure
=(2, 500 x 0. 1) – 350
=-100
Hence, the equilibrium level of output is 2,500 and the budget deficit is 100, this can be seen in the diagram
below:
Aggregate
Expenditure
45°
Aggregate
Expenditure
(C+l+G)
2,500
GDP

Step 2
If there is a balanced budget then the new tax rate would be:
tY=350
2, 5001=350
350
2,500
t=0. 14
Hence, the new tax rate would be 0.14 or 14%.
Step 3
The new equilibrium output after the change in the tax rate would be as follows:
Y=C+I+G
Y=150 +0.8 (Y – 0. 14Y) + 200 + 350
Y=700 + 0. 688Y
700
0.312
Y=2, 243. 6
Hence, the new equilibrium output will be 2,243.6. This can also be shown graphically as:
Aggregate
Expenditure
Aggregate
Expenditure
(C+l+G)
45°
Aggregate
Expenditure 1
(C1+l+G)
2,243.6 2,500
GDP

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