1. Suppose the Govt. decides to cut taxes to increase consumer spending and investment in the economy. a) Will this plan succeed in accomplishing both goals? b)In equilibrium what happens to interest rate as a result of this action? c) Would you characterize this as a case of fiscal crowding out?
Ans. a) The equilibrium equation : Y = C(Y-T) +G +I(r) where Y = aggregate output, C = consumer demand, I = Investment demand, G = Govt expenditure, T= taxes, r= interest rate. Since consumer spending is a function of taxes and has an inverse relationship with tax rate; if tax burden is decreased consumer spending will increase. However, national saving will fall as S = Y – C – G. Therefore investment will have to decrease as savings is equal to investment in macroeconomic accounting.
b) As investment is falling interest rate will rise as these two are inversely related.
c) Yes a decrease in taxes is like an increase in Govt expenditure. The overall result is a fall in investment expenditure as the Govt has to borrow more money due to decrease in tax revenue.
2. If the Govt wants to increase the amount of savings in the economy how should it alter Govt spending? What effect will this action have on the interest rate in the economy?
Ans. Savings (S) = Y – C -G. From this equation it is evident that Govt should decrease its spending to promote savings. From the saving and investment identity we can say that if savings increases investment will increase too. Since interest rate and investments are inversely related it will drop when investment increases.
3. Y = C+I+G ; Y= 200; C = 23 +0.8(Y-T); I= 50 – 9r ; G =60 ; T= 40+0.1Y. a) Now calculate National Saving, Private Saving and Public saving. b) Determine equilibrium interest rate. c) if output increases to 209, then redo a and b. d)What caused the change in private saving? Why did public saving change?
Ans. a) S = Y-C-G = 200 -23 – 0.8 * 200 + 0.8 *40 +0.8*0.1*200 – 60 =5
S(public) =T-G =40+0.1*200 -60 = 0
S (private) = S – S(public) = 5 -0 =5
b) 200 = 23 + 0.8 *200 +0.8 *40 – 0.8 *0.1*200 + 60 +50 – 9r
Solving this equation we can see that r =5
c) S = 7.52 ; S(public) =0.9 ; S(private) =6.62
d) Private saving increased because not all of the additional income is spent on consumption. Public saving increased because of the marginal tax rate charged on additional income.
4. Explain the effects of following changes on the nominal interest rate, money demand and price level.
a) one time increase today in the money supply
b) decrease in the real interest rate
c) increase in output
d) a sudden announcement of a planned decrease in the money supply growth rate
Ans. a) a one time increase in money supply will result in an increase in price level. Money demand and interest rate will remain unchanged.
b) Nominal Interest Rate = Real Interest Rate + Expected Inflation
Fall in nominal interest rate will cause an increase in money demand. Price level will fall to match the increase in real money demand.
c) An increase in output will raise money demand which will in turn decrease the price level keeping the interest rate unchanged.
d) An announcement today of a planned decrease in money supply growth rate will lead to a fall in expected inflation. Therefore, nominal interest rate will fall. Money demand will increase pushing price level down.
5. Explain how velocity is affected by interest rates and money demand. If the Fed increases the money supply, will there be a bigger change in output if the velocity remains constant or if it adjusts.
Ans. As interest rate increases people hold less money as opportunity cost of holding money has increased. A change in money demand will in turn affect the velocity. With a lower money demand caused by higher interest rates the velocity of money will increase.
Since, MV = PY ; An increase in M will lead to a proportional increase in output if V is constant. If V is a function of interest rate i.e. V = V(r), we will see a decrease in velocity as people hold more money and therefore spend the money at a slower rate. Therefore, fall in velocity will diminish the increase in output caused by the increase in money supply.
Part 2 solved answers here.
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