Tutorial 8

Question 1

1. [B] If investment increases, there will be
   a) a movement along the aggregate demand curve
   b) no effect on the aggregate demand curve
   c) a shift of the aggregate demand curve to the right
   d) a shift of the aggregate demand curve to the left e) a shift of the aggregate supply curve to the left

Answer 1

c) a shift of the aggregate demand curve to the right

Question 2

2. Starting with output being at the potential level, if income taxes increase, in the short run this would
   a) leave output unchanged and have no effect on inflation
   b) reduce output and put downward pressure on inflation
   c) increase output and put downward pressure on inflation
   d) reduce output and put upward pressure on inflation
   e) increase output and put upward pressure on inflation

Answer 2

b) reduce output and put downward pressure on inflation

Question 3

Starting with output being at the potential level, if exports increase but there is no underlying growth in potential output, in the long run

a) output and unemployment do not change
b) output decreases and unemployment falls
c) output increases and unemployment falls
d) output decreases and unemployment rises
e) output stays the same and unemployment rises

Answer 3

a) output and unemployment do not change

Question 4

[B] Which of the following would be considered an expansionary fiscal policy action?

a) a tightening of eligibility criteria which makes it more difficult for people to qualify for social security payments, such as unemployment benefits, age pensions, and sickness benefits.
b) a tax cut
c) an increase in exports
d) both (a) and (b)
e) none of the above, because expansionary fiscal policy requires an increase in government expenditure.

Answer 4

b) a tax cut

Question 5

E] Other things being equal, an expansionary fiscal policy action is likely to bring about:

a) an increase in interest rates
b) an increase in the government budget deficit, or a reduction in its surplus
c) faster growth in the money supply
d) one or more of the above
e) none of the above

Answer 5

d) one or more of the above

Question 6

6. Other things being equal, an increase in government purchases matched by a tax increase of exactly the same value would, on balance:
   a) worsen the government budget position
   b) have no impact of the government budget and, therefore, no impact on the economy
   c) have a dampening effect on the economy
   d) have a stimulatory effect on the economy
   e) none of the above

Answer 6

d) have a stimulatory effect on the economy

Question 7

2. If the economy can be adequately represented by a simple Keynesian model, where I, G, T, X, and IM do not vary as Y varies, and where c (the MPC) is 0.75, what effect would a decrease of $100m in exports have on equilibrium GDP? Reminder: the income multiplier in a simple Keynesian model is 1 / (1 – c).

Answer 7

The effect on equilibrium income is ∆Y = k . ∆X, where ∆X = -$100m (a decrease) and k = 1 / (1 - c) = 1 / (1 - 0.75) = 4. These give ∆Y = -$100 x 4 = -$400m, that is, a decrease of $400m in equilibrium income.

Question 8

3. [E] In a simple Keynesian model, where I, G, T, X, and IM do not vary as Y varies, if c (the MPC) is 0.6, what is the value of the income multiplier? Note: For an exam question at the [E] level, there will be no formulas sheet or any reminder (as in SAQ 2 above) of the formula for the income multiplier

Answer 8

[E] The multiplier is k = 1 / (1 – c). In this case, c = 0.6, so k = 1 / (1 – 0.6) = 1 / 0.4 = 2.5.

Question 9

Imagine that the economy is currently experiencing normal conditions, on both the demand and supply sides. Now a recession in the economy of a major trading partner reduces the demand for our exports.

(a) If the government takes no action in response to this demand shock, what are the likely effects on key macroeconomic variables in the short run?

Answer 9

As a result of the decrease in export demand, real GDP demanded at any given inflation rate will fall. The AD curve shifts leftward, as shown in the diagram.

(Draw a new AD curve in the same diagram as before and clearly label the effects.)

In the short run, both the inflation (π) and real GDP (Q) will fall. Consequently, employment will fall and unemployment will rise.

(Eventually, if there is no further shock, the AS curve will shift to the right, etc. However, that is in the long run, and the question asks about the short run only.)

Question 10

Imagine that the economy is currently experiencing normal conditions, on both the demand and supply sides. Now a recession in the economy of a major trading partner reduces the demand for our exports.

If the government wishes to use fiscal policy to respond to this situation, what actions can it take and how will these affect the economy in the short run?

Answer 10

The government can increase government purchases (G) or reduce income tax (T) or increase income transfers. For simplicity, assume that it will raise G.

The increase in G will raise real GDP demanded at any given P level. The AD curve will shift rightward, as shown in the figure on next page.

Note that the increase in real GDP will probably be several times as large as the original increase in G, because of the multiplier effect: recipients of the increased government expenditures will spend a fraction of their extra income, and these induced expenditures will in turn lead to further expenditures, and so on.

The expansionary fiscal action will offset (partially or fully) the above export shock, so the effects in (a) will be reduced or possibly even nullified completely. In particular, real GDP will move back toward its potential level and unemployment will move back toward the natural unemployment rate.

Question 11

Imagine that the economy is currently experiencing normal conditions, on both the demand and supply sides. Now a recession in the economy of a major trading partner reduces the demand for our exports.

[E] Suppose that the government finances any deficit in its budget (in essence, this is the gap between T and G) by borrowing from the public or the Central Bank. Compare and contrast the effects of the actions in part (b) above on interest rates and on inflation under two scenarios:

(i) the government borrows from the public only; and
(ii) the government borrows from the Central Bank only.

Answer 11

E] Effects of financing the expansionary fiscal action (increase in G).

(i) If the government borrows from the public only:

The increased borrowing by the government will tend to increase interest rates. As a result, investment and consumption will tend to fall, thereby reducing to some extent the effects described in (b) above. In short, there will be some “crowding-out” of private expenditures by government purchases.

(ii) If the government borrows from the Central Bank only:

When the government borrows from the Central Bank, this will increase the money supply. There will be no crowding-out because interest rates will not be increased. However, the increase in the money supply will tend to increase inflation.

Question 12

[B] If income taxes increase, we can expect

a. a movement along the aggregate demand curve
b. no effect on the aggregate demand curve
c. a shift of the aggregate demand curve to the right
d. a shift of the aggregate demand curve to the left
e. a shift of the aggregate supply curve to the right

Answer 12

d. a shift of the aggregate demand curve to the left

Question 13

[B] If government expenditure increases, there will be

a. a movement along the aggregate demand curve
b. no effect on the aggregate demand curve
c. a shift of the aggregate supply curve to the left
d. a shift of the aggregate demand curve to the left
e. a shift of the aggregate demand curve to the right

Answer 13

e. a shift of the aggregate demand curve to the right

Question 14

Starting with output being at the potential level, if government expenditure decreases, in the short run

a. output stays the same and unemployment falls
b. output decreases and unemployment falls
c. output increases and unemployment rises
d. output decreases and unemployment rises
e. output stays the same and unemployment rises

Answer 14

d. output decreases and unemployment rises

Question 15

[B] Which of the following would cause the AD curve to shift to the left?

a. a tightening of eligibility criteria which makes it more difficult for people to qualify for social security payments, such as unemployment benefits, age pensions, and sickness benefits.
b. a tax cut
c. an increase in exports
d. both (a) and (b)
e. none of the above

Answer 15

b. a tax cut

Question 16

The “crowding-out” effect refers to:

a. the unintended effects of fiscal policy on private investment
b. the fact that export demand represents an avenue whereby foreigners squeeze domestic residents out of the local market
c. the fact that any purchase made by one person must prevent another person from buying the same good or service.
d. none of the above

Answer 16

a. the unintended effects of fiscal policy on private investment

Question 17

Income multiplier

Answer 17

•Keynes’s insight: The increase in equilibrium GDP is often larger than the original increase in planned spending, due to the income multiplier effect .

–Underlying reason: one person’s additional expenditure is another person’s additional income.

Question 18

Fiscal policy

Answer 18

•Fiscal policy is the use of the government’s spending and taxing programs to manage AD and the overall state of the economy.

Question 19

Disposable income

Answer 19

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Question 20

Expansionary policy

Answer 20

If AD is weak, i.e. Q < Qp, and unemployment is considered too high, the government can take an expansionary fiscal action (shifting AD to the right):-

• either increase G
• or decrease T (or increase transfers)

Question 21

Contractionary policy

Answer 21

If AD is too strong, i.e. Q > Qp (actual real GDP is higher than potential real GDP) and there are concerns about high inflation, the government can take a contractionary fiscal action (shifting AD to the left):–

• Either:
• Or
• Or

Question 22

Crowding-out

Answer 22

A second option: gov’t can borrow from the public (e.g., selling bonds). But in that case:-

• upward pressure on interest rates, reducing private investment and consumer spending on durables
• this “crowding-out” effect will partially offset the expansionary effects (see previous diagram)

Question 23

Would you expect the income multiplier for G to have the same magnitude as for I or X? What about the multipliers for taxes and transfers – do they have the same magnitude?

Answer 23

We would expect the income multiplier for G to have the same magnitude as for I or X, because all these 3 variables are components of aggregate demand and, as such, changes in these variables affect AD directly and fully. By contrast, taxes and transfers are not a direct component of AD. Changes in taxes or transfers affect AD only indirectly and partially through their effects on disposable income. A $1 decrease in tax, leading to a $1 increase in disposable income, does not increase consumption (and AD) by $1, but only by a fraction of this amount (due to increased savings). Thus the income multiplier for taxes is typically smaller in magnitudes than for G, I or X.

Question 24

If the government decides that aggregate demand is excessive, what fiscal policy options are open to it? Compare and contrast the macroeconomic effects under each option.

Answer 24

If the government wishes to tighten fiscal policy (take a contractionary fiscal action), it can

• reduce government purchases;
• increase taxes; or
• reduce transfers.

Here you should point out that the size of the income multiplier under the first option is larger than under the other two options. Explain why this is the case (see DQ 1 above).