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ECON1002 Introductory Macroeconomics

TUTORIAL 5

(Week 6)

Reading Guide: Review Chapter 8 of BOF as preparation for this tutorial. You should also look over your lectures notes for Week 5.

Key Concepts: Balanced budget multiplier, Automatic stabilisers, Government budget constraint, Intergenerational equity, Stance of fiscal policy, Public debt.

REVIEW OF CONCEPTUAL UNDERSTANDING

These are to be attempted before the tutorial. They will not normally be covered in the tutorial, maybe, except for a quick review, time permitting. The answers are typically found in the textbook and lecture notes.

1. What do you understand by the balanced budget multiplier? Why do taxes and government purchases have different impacts on the economy? Explain.

2. What are the limitations of fiscal policy as a stabilization tool? How could these limitations be overcome, if any?

3. Why is the intergenerational consideration important for fiscal policy? What is the economic rationale for the ‘Future Fund’?

4. What is the relation between fiscal policy and the public debt?

PROBLEMS

1. Discuss the reasons why the use of fiscal policy to stabilize the economy is more complicated than suggested by the basic Keynesian model.

2. An economy is described by the following equations:

C = 40 + 0.8(Y – T)

IP = 70

G = 120

NX = 10

T = 150

Y* = 580

The multiplier in this economy is 5.

a. Find the numerical equation relating planned aggregate expenditure to output.

b. By how much would government purchases have to change to eliminate any output gap?

c. Suppose that government is considering a tax cut (or increase), rather than changing purchases, to eliminate the output gap in the above economy. By how much would taxes have to change?

3. This problem illustrates the workings of automatic stabilizers. Suppose that the components of planned aggregate expenditure in a 4-sector economy are: C =  + c (Y – T), T = tY, with exogenous components IP, G, and NX.

Note that t is the fraction of income paid in taxes (the tax rate). As we will see in this problem, a tax system of this sort serves as an automatic stabiliser, because taxes collected automatically fall when incomes fall.

a. Find an algebraic expression for short-run equilibrium output in this economy.

b. Find an algebraic expression for the multiplier. Compare the expression you found to the formula for the multiplier when taxes are fully exogenous as in Problem 2 above.

c. Show that making taxes proportional to income reduces the multiplier. Explain how reducing the size of the multiplier helps to stabilize the economy, other things constant.

d. Suppose = 500, I = 1500, G = 2000, X = 0, M =0, c = 0.8, and t = 0.25. Calculate numerical values for short-run equilibrium output and the multiplier.

4. Explain the likely implications of the ageing of the population for fiscal policy? In light of these implications, how should fiscal policy respond?

5. Extend yourself.  An economy is described by the following equations:

C = 3000 + 0.5(Y – T)

IP = 1500

G = 2500

X = 200

M = 0

T = 2000

t = 0

Y* = 12000 

For this economy, find exogenous expenditure, the multiplier, short run equilibrium output and the output gap.  By how much would exogenous expenditure have to change to eliminate the output gap?

6. Extend yourself: Attempt Problem 5 in the Textbook page 213, Chapter 8.