BEFORE YOU TAKE THE TEST:

you buy something, the money you spend doesn't disappear. For example, it goes into a cash register and becomes income for the seller. The seller will then spend some part of that new income. That spending becomes someone else's income, and so on. The initial spending has a multiplier effect. How does this multiplier process affect fiscal policy? If any change in spending has a multiplier effect on income, that effect must be considered when determining the amount that G, T, or transfers are changed. If the multiplier process is not considered, then changes in G, T, or transfers will be too large and move the economy past potential output (creating a different problem).make sure you are comfortable with the calculations associated with implementing the appropriate fiscal policy in hypothetical situations. Remember that the spending multiplier equals 1/(1 MPC). Start any multiplier problem by finding your multiplier! Then use the equation: Autonomous change in aggregate spending x multiplier = final change in real GDP Two multipliers are presented and used in this chapter: the multiplier for a change in government spending and the multiplier for a change in taxes. The multiplier for a change in government spending equals 1/(1 MPC), while the multiplier for a change in taxes is smaller [ MPC/(1 MPC)]. For example, if the MPC equals 0.8, then the multiplier for a change in government spending is 5, while the multiplier for a change in taxes is 4. Make sure you work some problems using these multipliers and that you understand why they do not have equivalent values. Also, spend time thinking about why the multiplier for government spending is positive while the multiplier for a change in taxes is negative. Understand the distinction between fiscal policy that is discretionary versus fiscal policy that reflects the impact of automatic stabilizers. BEFORE YOU TAKE THE TEST: i Draw the Featured Model: Aggregate Demand-Aggregate Supply Model Draw an AS AD graph showing long-run macroeconomic equilibrium. Label AD, SHAS, LRAS, potential output, equilibrium aggregate price level, and output. Note points on the horizontal axis indicating where aggregate output would be if there were a recessionary gap (label this Yr) or an inflationary gap (label this Yi). Before You Take The Test 141

Complete the Exercises 1. Consider an economy that is initially in long-run equilibrium as drawn in the following graph. Aggregate price level Real GDP a. Draw a graph of the AS AD model to show the effect of each of the following (ceteris paribus) changes. (1) The economy's central bank decreases the money supply. y-axis label (2) Productivity decreases in the economy. Pt1-4-44 17 x-axis label All y-axis label 111 II x-axis label 4110 142 section 4 National Income and Price Determination

(3) Consumer confidence in the economy increases. y-axis label l La r (4) Commodity prices fall dramatically. y-axis label '1 tee x-axis label b. What happens to the aggregate output and price level relative to the initial long-run equilibrium in each case? ( z- Y 0 ) P I 1 r c. For each case, determine whether the economy faces a short-run recessionary gap or an inflationary gap. (r) 26- ( 1-) 116- ) f 6- d. For each case, what active stabilization policy can offset the particular shock? Li/to t- Ate k 41,s 0 v 1-7--Fej v r j (Vejjc rv-^) yt rf-et,4 c -k t,ild /4,Eve f(1,6, (ZS) jr 44 StrYtti-. 1 ik(4-eex Complete the Exercises 143 ("a forma

e. For each case, what would happen in the long run to the aggregate price and output levels without an active stabilization policy? (I) aacv f (ILL $ IAA ad et,ffreivaili 11-4,1A41._ (- 17 1-7 (1) S4-1 S 64--krv- t 1 -}ritiel (7) ka` tythlw.04. 1 Problenis f Ike ;) v41 1. In Mainland, a small, closed economy with no government sector, when disposable income is $800, consumer spending is $800. and when disposable income is $1,800, consumer spending is $1,600. Assume that the aggregate price level and the interest rate are fixed in Mainland. a. What is the value of autonomous consumer spending in Mainland? i c y b. What is the value of the MPC in Mainland? c. What is the consumption function in Mainland? C- 1 4-2. Suppose you are given the following information about Macroland, a small, closed economy where Y is real GDP, T is taxes, C is consumption spending, and I is planned investment spending. Assume that government spending is currently $0, taxes are constant at $50, and the aggregate price level is originally fixed at $100. Year Y 1 $100 $50 $40 $50 2 150 50 80 50 3 300 = 50 200/ 50 a. Fill in the following table, using the information given above. Year 1 2 3 Disposable income -,... 12 I 6 P -i S.-a b. What is the MPC for this economy? Lti/CL) v /14-7.2 ci) 144 section 4 National Income and Price Determination

c. What is the MPS for this economy? Pim) _I-, _ --, d. What is the value of the spending multiplier for this economy?,...,,.._ e. What is the consumption function for this economy? f. Given the above information, what is the equilibrium output level for this economy? 3. Use a graph of the AS AD model to illustrate long-run economic growth in an economy. Explain how your graph illustrates economic growth. Assume AD does not change over time. g A), 0 1- cea4 Jvc 4 ' 1 vv1/4,6y g vtr cai t' swl \t. 4. Macroland is a small, closed economy that is currently operating at the long-run equilibrium level of output. It is therefore producing Y p where Y, is potential output. Its aggregate price level is P 1. a. Draw a graph of long-run equilibrium for Macroland depicting the AD, SRAS, and LRAS curves. Label both axes, and identify Y, and P 1 on your graph. ( 7 Problems 145

b. Suppose that Macroland experiences a negative demand shock. Draw a new graph depicting the short-run changes in the original equilibrium that will occur because of this demand shock. On your graph, identify the new short-run equilibrium level of output Y2 and the new short-run equilibrium aggregate price level P2. Label any shifts in AD or AS clearly. A, L s A-1 In) 02f) c. Given the change in part (b), draw a third graph illustrating the long-run adjustment to the negative demand shock. Label any shifting curves clearly, and identify the new long-run equilibrium level of aggregate output Y3 and the new long-run aggregate price level P3. 1 d. Given the change in part (b), suppose the government wishes to engage in activist fiscal policy in order to restore the economy to its initial equilibrium. Provide two fiscal policies that would accomplish this. ---m Ore 1-71, ottiarti4e. ) 5. For each of the following, describe the effect on the AD, SRAS, and LRAS curves, identify whether the effect causes a shift of or a movement along the curve, and identify the direction of the shift/movement. a. An increase in the money supply causes interest rates to fall. k-c- - In, t e i---(,-4,_bn---i A, r9 1-1 cts _ ri.0 ci-..- i-ct 0, < Ai' b. The price of commodities increases by 10% this year. 1-, -- I., If, -1._ s Lireli.4-, tit i-i t- 146 section 4 National Income and Price Determination

c. The price of oil falls. 5 1.1, v 4-7) /f -nom i d. Labor unions successfully negotiate an increase in nominal wages for their workers. AJ 41-,./rJ Le 6---) I At0 C 11i e. The supply of unsold houses in an economy increases by 20%. 5 eil-f -17 r-ze pt & Ci e- t- L kr, T f. There is an increase in labor productivity due to increases in human capital. e/1 -, - aret 4711 r2( g. The government increases spending in order to finance a war. /IT 44 ' vit p (. 1 6. For each of the following situations, identify whether it is an example of expansionary discretionary fiscal policy, contractionary discretionary fiscal policy, or an automatic stabilizer. a. During 2006, tax revenue for Macrovia falls as the economy enters a recession. ft ' b. During 2006, in light of projected deficiencies in AD, Macrovia's legislature authorizes an expenditure of $200 million to build a new hydroelectric dam. c. In 2009, fearing a too rapidly expanding economy, Macrovia adopts a budget that calls for 10% spending cuts in all government departments for the following fiscal year. d. In 2008, unemployment benefits rise 5% in response to rising unemployment in Macro via. Problems 147

7. The following graph depicts the economy of Macroland's short-run aggregate supply curve (SRAS), its long-run aggregate supply curve (LRAS), and its aggregate demand curve (AD). Macroland is currently producing at point E. Y1 Y2 GDP a. Is potential GDP for Macroland equal to Y 1 or Y2? Describe Macroland's current production relative to its potential production. - - 1' 4) LaA, p r-gx I. 4_ 61/ ITV 1 01-1! hf b. Does Macroland have a recessionary gap o an inflationary gap? Explain your answer. c. Holding everything else constant, which of the following policy initiatives might help Macroland produce at its potential output? Explain how each would help. i. The government initiates policies that encourage private investment spending. ii. The government increases taxes on consumers and corporations. iii. The government authorizes new spending programs. ce4 ei_s, _7 3-1A f h '41 -" v yys-0-1-t d. What is the current price level in Macroland? If Macroland engages in expansionary fiscal policy so that AD shifts and actual output equals potential output, what will happen to the price level? 77.3 148 section 4 National Income and Price Determination

8. Funlandia's economists estimate its potential output is $100 in year 1 and grows 5% per year. Assume Funlandia is a closed economy. a. Fill in the following table for Funlandia, given the above information. Year:::::. : : :p fiti46. 0., Ṫ ut Year 1 $100 Year 2 Year 3 Year 4 h c 7, 2,C //0, -- C lib -7 Jl C Suppose Funlandia's economists provide you with the following data. (All numbers are in dollars.) Year Potential output Actual output Year 1 100 i 0 6' T " YD 10 90 55 30 15 Year 2 104 10 s 7 30 17 Year 3 '' c 115 10 j 4 c VI., C 30 22.5 Year 4 ((f ri t h ff 1) 10 108 64 30 24 7 b. What is the consumption function for this economy? C C.) c. Fill in the missing values for the table, using the information you have been given or that you computed in parts (a) and (b). d. Fill in the following table for Funlandia. Year Recessionary gap Inflationary gap Actual output equals potential output Year 1 No No Yes Year 2 Y / /V z..? No Year 3 1 0 LI,k- ) ii 0 Year 4 ' i,( 5 N r,v,) Problems 149

e. Suppose Funlandia maintains a policy of using discretionary fiscal policy to ensure that actual output equals potential output. Summarize the recommended discretionary fiscal policy necessary to achieve this goal in the following table. Year Year 1 140401/ Year 2 54v re-4-4 `te Discretionary fiscal pol io Year 3 VI- ite""t;)t u r 7-7 (l (Ke.4-)e.-S Year 4 Alf 4:e.a y 471 C/V 01 /2 /40 sei cii9441k) allev at4,- - c /41)7_ / f-edse 9 P cx,4( ve 9. The AS-AD model is said to have a self-correcting mechanism. Explain what this means and how it works. Use a graph to illustrate (./ our ans er. P L er 1T- -,L,vol? (k 10. xplain why automatic stabilizers reduce the size of the multiplier. Provide several examples of automatic stabilizers and their effect on the economy during economic fluctuations. 6 Dr kre v ), p Cl e'el^ 6017 5.r-ei viee v 4.7.1. J Ile 14- a fq?v. 16. ) Review Questions I t NI" CI Pe4,-(A 74-4 Circle the correct answer. /4' 1. Consumer spending is affected by changes in A. current disposable income. B. expected future disposable income. wealth. All of the above affect consumer spending. sty 2. Joe's disposable income increases by $500, and he finds that he spends $400 of it. Joe A. saves $100 and his MPS is equal to 0.8. B. saves $100 and his MPC is 0.8. C. saves 20% of any increase in his disposable income. D. Answers (a) and (c) are both correct. so Answers (b) and (c) are both correct. 3. Suppose when Sue's disposable income is $10,000 she spends $8,000 and when her disposable income is $20,000 she spends $14,000. Sue's autonomous consumer spending is and her MPS is A. $0; 0.2 B. $2,000; 0.2 C. $0; 0.4 D. $2,000; 0.4 flat IX Olt* '^-1-150 section 4 National Income and Price Determination