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Midterm: Macroeconomics and Government

Though net investment can be positive, negative, or zero, it is quite impossible for gross investment to be less than zero. ” 4. (7 points) What are the major factors that have affected U. S. Household consumption since the recession in 2001? 5. (7 points) Briefly explain how the following would shift the IS function to the right.

A. A change to lump-sum taxation (Specify whether increase or decrease is needed to shift IS curve to the right. ) b. A change to government spending (Specify whether increase or decrease is needed to shift IS curve to the right. ) 6. Points) Explain briefly how a change to the following MS, MD, or P (sisters Paramus) would shift the ELM function to the right. Include in your discussion whether the variable would have to increase or decrease to cause the rightward ELM shift. Discuss which of these the FED exercises control over. A. MS. B. MD (money demand). C. P (price index). 7. (7 points) By how much will GAP change if firms increase their investment by $8 billion and the MAC is .

80? If the MAC is . 67? 8. (10 points) Suppose that private sector spending is highly sensitive to a change in interest rate.

Compare the effectiveness of monetary and fiscal policy in terms of rising and lowering real GAP 9. (10 points) Assume that a hypothetical economy with an MAC of . 8 is experiencing severe recession. By how much would government spending have to increase to shift the aggregate demand curve rightward by $25 billion? How large a tax cut would be needed to achieve this same increase in aggregate demand? Why the difference? Determine one possible combination of government spending increases and tax decreases that would accomplish this same goal.

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10. 7 points) What are government’s fiscal policy options for ending severe demand-pull inflation? Use the aggregate demand-aggregate supply model to show the impact of these policies on the price level. Which of these fiscal policy options do you think might be favored by a person who wants to preserve the size of government? A person who thinks the public sector is too large? 1 1 . (10 points) Explain why relatively flat as opposite relatively steep labor demand curves are more consistent with the empirical observation that there are relatively minor changes in the real wage rate over the course of the business cycle. 12. 7 points) Is sustainable long-run equilibrium always cached when the AD and ASS curves intersect? Why or why not? 13. (7 points) If the equilibrium real wage remains constant, what happens to the nominal wage when the actual inflation rate exceeds the expected inflation rate? 14. (7 points) “In the Midterm: Macroeconomics and Government By foresightedness Answers Question 1. Studies have proven that presidential election outcomes are definitely related to the performance of the economy. The winning presidential party retains the office of presidency while personal income grows at a faster, higher rate than the long-term rate.

The incumbent presidential party will be voted out of office when income grows at a rate lower than the long term rate. Question 2. Microeconomics meaning small, is a branch of economics that studies the behavior of individual households and firms by making decisions on the allocation of limited resources. Normally, it applies to markets where goods or services are bought and sold. Macroeconomics meaning large, is a branch of economics dealing with the performance, structure, behavior, and decision-making of an economy in a whole, rather than individual markets like in Microeconomics.

This includes national, regional, and global economies. Question 3. Depreciation + Net Investment = Gross Investment if I rearrange it, it will say; Depreciation – Gross Investment = Net Investment Since capital stock of an economy only rises when net investment is positive, that is when gross investment exceeds depreciation. So naturally the capital stock falls when net investment is negative, that is when gross investment is less than depreciation. In 1933 net private domestic investment was minus $6 billion.

This does NOT mean the country produced no capital goods: what it means is that the reduction of capital goods was less than what was lost due to wear and tear, thus the net impact was an overall loss in capital stock. Gross private investment in most cases cannot be negative, since you can decide not to invest in new factories, but how do you decide to make a negative investment on an economy wide scale. Question 4. Household consumption has been diminishing or is flat to be honest. Income and employment rates have slowly been declining or stays in one particular place.

Energy producers have increased the percentage of household budgets for fuel and electricity. According to economics, it shows minimal growth since 2001. Question 5. The IS function is the investment-saving function. A shift to the right implies that for any given level of output the interest rate has gone up, and vice versa. Now for the examples: (a) A change in lump-sum taxation: A lump-sum reduction in the tax rate has the same effect as increased government deficit with people and firms increasing their spending, pushing out the IS curve. B) A change in government spending: Increased government spending will have the same impact as Question 6. The ELM function is liquidity preference minus the money supply. It tells that real money balances are a primary function of the interest rate and real income. This is usually represented as MIPS = L(r, Y), which states real money balance M/P, where M is nominal money balance and P is price level, depends on the real interest rate r and real output Y. An increase in money supply will cause the ELM curve to shift to the right, thus lowering the equilibrium interest rate and increasing the equilibrium output.

An increase in the demand for money should have the same impact: shift the ELM curve to the right. If the price level falls the ELM curve will shift to the right since al money balances will increase in such a case. The Fed has control over the nominal money supply but not on money demand and price level. Money demand depends on the transaction demand of money and the Fed cannot influence the prices (they are determined by the market and customers) so as powerful as the Fed is they cannot influence demand for money. Question 7. If MAC = 0. 67, multiplier = 1/1-0. 67 = 1/0. 3=3. Income should increase to ex. so it would end up at $24 billion. If Pm = 0. 8, Multiplier = 1/1-0. 8=1/0. 2=5, income should increase to ex. so it would end up at $40 billion. Question 8. K, if the private sector spending is highly sensitive to changes in interest rates then the monetary policy will be more effective in determining the movement of real output. This is due to the fact that a small rise in interest rates then a small reduction in money supply will quell any demand-pull inflation and therefore bringing the economy back to the long-run equilibrium.

While a small reduction in interest rates should push up the aggregate demand in similar measures. Government policy has a bigger impact on the autonomous part of aggregate expenditure and hence will have a lower impact in such a scenario. Question 9. MAC = 0. 8, we can say that the multiplier, which is defined to be Multiplier = 1 IMPS 1/(1-MAC) then is equal to 5. So, we increase AD by $25 billion the government has to increase spending by $5 billion. A larger tax cut would be needed to achieve the same goal since people do not want to or wish to spend everything they get.

Given that people are spending 80% of each additional dollar if the government provides a tax cut of $5 billion I would say people would only spend $4 out of that. Thus the final impact will be ex. = $20 billion. To get people to spend $5 billion, the government as to lower taxes by $6. 25 billion (6. Ox. 8 = 5 if the formula I used). Any combination that hopes to achieve the $25 billion raise in AD will have to increase initial spending by at least $5 billion. Suppose the government increase spending by G and provides a tax cut T, then any combination that satisfies: G + 0. 8TH = 5 will serve Question 10.

The government has two options when it wants to influence the macroeconomic: A. It can change taxes or B. It can change its spending patterns. If economics is facing a demand-pull inflation it means AD is rising quicker than expected. The four components of AD are; 1. Should consumption (C), 2. Gross private investment (l), 3. Government expenditure (G), 4. Net exports (NIX). Normally we would take I, G and X to be exogenous variables. Sotto curtail a demand- pull inflation the government has to work on somehow curtailing consumption (C) and imports (M), or we can also cut down its own personal spending.

The two options with the government in such a case then would be: (a) Cut down government spending: a reduction in G will then also make a reduce in AD. (b) Increase taxes: This would bring down the disposable income and will then also bring down both C and M. For a person who wants to preserve the size of the government the second option I think would be a better choice, since the government is retaining its size and is still able to bring the requisite change in AD.

A person who thinks public sector is too large will opt for the first move, reducing G, since that will immediately mean the government has become smaller. Which I personally would vote for, out government could use a little trimming. Question 11. The simplest way for me to look at it is like this; If the demand curve is flat, then a reduction or an increment in labor demand does not alter the price at all. But on the other hand, if the demand curve is, then an equivalent change in demand has much bigger change in the wage rates.

Empirical results suggest that wages are sticky, and the steep labor demand curve cannot explain this observation. Question 12. When the AD and ASS intersect it is called a “short-run macroeconomic equilibrium. ” This is NOT sustainable unless it the intersection point falls on the LASS curve. The reason is any such intersection to the left of the LASS curve will not be using any resources, and companies will have an incentive to increase production without outing too much pressure on the costs, while an intersection to the right will put too much inflationary pressure therefore making it unsustainable.

Question 13. Inflation- Nominal Wage Rate = Real Wage Rate So therefore, Expected inflation- Expected Nominal Wage Rate = Expected Real Wage Rate. It can also be written as; Expected Real Wage Rate + Expected inflation = Expected inflation exceeds expected inflation then the nominal wage rate has to rise, there is no other choice. Question 14. In the steady state, the government benefits from inflation. I assume that the steady state here means the long-run macroeconomic equilibrium.

The economy would like some small inflation at some point since with a small inflation the real costs for companies always fall and they have to have an incentive in order to increase production. To see why consider the contracts that companies set up, They are all based on nominal variables. A small inflation will reduce the real value of these contracts, and keeping with the domino affect the firms have an incentive to increase real output at lower real costs. Total output will rise in this particular case, pushing out the LASS curve. The government would also benefit with higher tax earnings.

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