Short-answer questions 1. Consider the following linear version of the AA-DD model: consumption is given by C = (1- s)(YT) and the current account balance is given by CA =aE-m(YT). (s is sometimes referred to as the marginal propensity to save and m is called the marginal propensity to import.) Then the condition of equilibrium in the goods market is Y=C+I+G+CA = (1-s) (Y-T)+ I+G+aE-m(YT). We will write the condition of money-market equilibrium as M³/P = bY dR. Assume that the central bank can hold both the interest rate R and exchange rate E constant, and assume that investment I is also constant. = a) Consider the equilibrium in the output market. Other things equal, what is the effect of an increase in government spending G by 1 unit on output Y? (This number is often called the open-economy government spending multiplier, but as you can see it is relevant only under strict conditions.) How does a higher value of m affect the government spending multiplier? Explain your result intuitively. b) Consider the equilibrium in the output market. Other things equal, what is the effect of an increase in taxes T by 1 unit on output Y? Under what conditions will higher taxes reduce output? Explain your result intuitively. c) Suppose that the government finances a 1 unit increase in G by increasing taxes T by 1 unit, so the government balances its budget. From your analysis in parts a) and b), will this policy increase or decrease output Y? By how much?
Short-answer questions 1. Consider the following linear version of the AA-DD model: consumption is given by C = (1- s)(YT) and the current account balance is given by CA =aE-m(YT). (s is sometimes referred to as the marginal propensity to save and m is called the marginal propensity to import.) Then the condition of equilibrium in the goods market is Y=C+I+G+CA = (1-s) (Y-T)+ I+G+aE-m(YT). We will write the condition of money-market equilibrium as M³/P = bY dR. Assume that the central bank can hold both the interest rate R and exchange rate E constant, and assume that investment I is also constant. = a) Consider the equilibrium in the output market. Other things equal, what is the effect of an increase in government spending G by 1 unit on output Y? (This number is often called the open-economy government spending multiplier, but as you can see it is relevant only under strict conditions.) How does a higher value of m affect the government spending multiplier? Explain your result intuitively. b) Consider the equilibrium in the output market. Other things equal, what is the effect of an increase in taxes T by 1 unit on output Y? Under what conditions will higher taxes reduce output? Explain your result intuitively. c) Suppose that the government finances a 1 unit increase in G by increasing taxes T by 1 unit, so the government balances its budget. From your analysis in parts a) and b), will this policy increase or decrease output Y? By how much?
Chapter1: Making Economics Decisions
Section: Chapter Questions
Problem 1QTC
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Transcribed Image Text:Short-answer questions
1. Consider the following linear version of the AA-DD model: consumption is given by C = (1-
s)(YT) and the current account balance is given by CA =aE-m(YT). (s is sometimes
referred to as the marginal propensity to save and m is called the marginal propensity to import.)
Then the condition of equilibrium in the goods market is Y=C+I+G+CA = (1-s) (Y-T)+
I+G+aE-m(YT). We will write the condition of money-market equilibrium as M³/P =
bY dR. Assume that the central bank can hold both the interest rate R and exchange rate E
constant, and assume that investment I is also constant.
=
a) Consider the equilibrium in the output market. Other things equal, what is the effect of an
increase in government spending G by 1 unit on output Y? (This number is often called the
open-economy government spending multiplier, but as you can see it is relevant only under
strict conditions.) How does a higher value of m affect the government spending multiplier?
Explain your result intuitively.
b) Consider the equilibrium in the output market. Other things equal, what is the effect of an
increase in taxes T by 1 unit on output Y? Under what conditions will higher taxes reduce
output? Explain your result intuitively.
c) Suppose that the government finances a 1 unit increase in G by increasing taxes T by 1 unit,
so the government balances its budget. From your analysis in parts a) and b), will this policy
increase or decrease output Y? By how much?
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