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Berkeley ECON 98 - Midterm 2 Review - Macroeconomics

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Econ 98- Chiu Spring 2005 Midterm 2 Review: Macroeconomics Page 1 of 7 Disclaimer: The review may help you prepare for the exam. The review is not comprehensive and the selected topics may not be representative of the exam. In fact, we do not know what will be on the exam. We try to make our answers complete, but we cannot guarantee their correctness. Use at your own risk and use good judgment. SUGGESTED SOLUTIONSEcon 98- Chiu Spring 2005 Midterm 2 Review: Macroeconomics Page 2 of 7 Problem 1. Fiscal Responsibility. HELLA DIFFICULT QUESTION (too hard for even the midterm). Congress runs a budget deficit of $200. Fiscal responsibility becomes the new hit-sensation for politicians. Fiscal responsibility becomes almost as hot as William Hung. Congress wants to close the budget deficit, but does not want to affect equilibrium output. How much should G and T rise (by different amounts)? PAE=C+I+G+NX C=60+.8(Y-TA+TR) I=50 NX=0 Assume a closed economy, fixed interest rates, and fixed prices. Step 1. Translate the problem into equations. The prompt tells us lots of information. Lets take those words and turn them into math. Currently Congress faces a budget deficit of $200. Let the subscript “0” represent the present. We know that Congress wants to balance the budget in the future. Let the subscript “1” represent the future. Equation 1: G0-T0=200 Equation 2: G1-T1=0 Take the difference between Equation 2 and Equation 1. G1-T1=0 Minus G0-T0=200 Equation 3: (G1-G0)+(-T1+T0)= -200 Remember that the “change” in anything is the new value minus the old value. Hence we can rewrite Equation 3 as follows: Equation 4: ∆G - ∆T = -200 If we rewrite Equation 4 in terms of ∆T, then we get a very useful equation: Equation 5: ∆T = 200 + ∆G Excellent, we know how to balance the budget! But do not forget that Congress does not want to change equilibrium output. Hence the effects on output from increasing net taxes and increasing government spending must cancel each other out. Let ∆YT be theEcon 98- Chiu Spring 2005 Midterm 2 Review: Macroeconomics Page 3 of 7 output change caused by a change in net taxes (∆T). Let ∆YG be the output change caused by a change in government spending (∆G). Or in equation: Equation 6: ∆YT + ∆YG = 0 Step 2. Solve for the tax and government spending multipliers. Let ∆YT be the output change caused by a change in net taxes (∆T). We know that: Equation 7: ∆YT = (-mpc)(1/(1-mpc)) * ∆T Remember that mpc=.8. Hence, Equation 8: ∆YT = -4∆T Let ∆YG be the output change caused by a change in government spending (∆G). We know that: Equation 9: ∆YG = (1/(1-mpc)) * ∆G Equation 10: ∆YG = 5∆G Step 3. Substitute. Combine Equation 5 and Equation 8: ∆T = 200 + ∆G ∆YT = -4∆T ∆YT = -4 (200 + ∆G) Equation 11: ∆YT = -800 - 4∆G Combine Equation 6, Equation 10, and Equation 11: ∆YT + ∆YG = 0 ∆YG = 5∆G ∆YT = -800 - 4∆G Equation 12: [-800 - 4∆G] + [ 5∆G] = 0 Step 4: Solve for ∆G and ∆T. ANSWER: ∆G = 800 ANSWER: ∆T = 200 + ∆G = 200 + 800 = 1000Econ 98- Chiu Spring 2005 Midterm 2 Review: Macroeconomics Page 4 of 7 Problem 2. Expansionary Fiscal Policy and Money Markets. a) The economy is in trouble. Congress engages in expansionary fiscal policy. Calculate the rise in government spending necessary to get the economy back to full-employment output (Yf). The economy is currently at Y1. Assume Congress does not want to mess with net taxes. Assume Congress ignores the money market effects on output because they overlooked it. C = 60 + .95Yd Y1=1000 Yf=5000 ∆Y = (1/(1-mpc)) * ∆G ∆Y = (1/(1-.95)) * ∆G ∆Y = 20∆G ∆Y = Yf – Y1 = 5000-1000 = 4000 4000 = 20∆G ANSWER: ∆G = 200Econ 98- Chiu Spring 2005 Midterm 2 Review: Macroeconomics Page 5 of 7 b) Show the effects of the expansionary fiscal policy on the Keynesian-cross diagram. Label the economy’s recessionary output Y1 and the full-employment output Yf. Assume the government ignores the money market effects on output. PAE Y Y=PAE PAE1 Y1 PAE2 YfEcon 98- Chiu Spring 2005 Midterm 2 Review: Macroeconomics Page 6 of 7 c) Congressional ignorance takes hold in the economy. Using the money market diagram show the expansionary fiscal policy effects on interest rates. Label any new curves or interest rates with the subscript 2. ASSUME CONSTANT MONEY SUPPLY. REMEMBER THAT THE FED NO LONGER HAS A MONEY SUPPLY TARGET. BUT LETS ASSUME THAT IT DOES MAINTAIN THE MONEY SUPPLY FOR THE SAKE OF THIS QUESTION. r Md1 Md2 Ms r1 r2 MEcon 98- Chiu Spring 2005 Midterm 2 Review: Macroeconomics Page 7 of 7 d) Show the money market effects on the Keynesian-cross diagram. Why is the economy not at full-employment as originally planned by Congress? ASSUME CONSTANT MONEY SUPPLY. REMEMBER THAT THE FED NO LONGER HAS A MONEY SUPPLY TARGET. BUT LETS ASSUME THAT IT DOES MAINTAIN THE MONEY SUPPLY FOR THE SAKE OF THIS QUESTION. G up Æ PAE up Æ Y up Æ Md up Æ r up Æ I down Æ PAE down Æ Y down via the multiplier effect PAE Y Y=PAE PAE1 Y1 PAE2 PAE3 Yf


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