ECON 104 HOMEWORK #10 (100 points total)

ECON 104 HOMEWORK #10 (100 points total)
1. (35 points total) We discussed the idea of crowding out and why it occurs. In this
problem we are considering two scenarios: Scenario 1: G rises and the Fed does not
accommodate the shock to money demand. Scenario 2: G rises and the Fed
accommodates the shock to money demand, as they would if they were committed to
the zero bound.
a. (10 points for each correct and completely labeled diagram). Draw three
diagrams side by side. On the left, draw a consumption function, in the middle,
draw a money market diagram, and on the right, draw an investment demand
function. Locate the initial equilibrium as point A, labeling the relevant values
using subscript A as in the level of consumption at point A as CA, the level of
interest rates as iA, etc.
Scenario 1: G rises, no accommodation by the Fed, locate the new equilibrium
as point B on all three diagrams, being sure to label your diagrams completely.
Show and explain the crowding out that Barro discusses in the “Government
Spending is no Free Lunch” article. In particular, we are assuming total crowding
so that Y does not change, along with the assumption of a closed economy. Be
sure to explicitly identify the crowding out on the consumption function and
investment demand functions that you drew above.
Scenario 2: G rises, the fed completely accommodates the shock to money
demand so that interest rates remain unchanged (identical to the Romer
assumption). Show this development as point C on all three diagrams.
b. (5 points) In the Romer paper, the multipliers that they use assume that the Fed
will keep interest rates constant for the foreseeable future. Referring to your
diagrams, does this assumption increase/decrease/ or have no effect on the
estimated spending multiplier? Explain.
2. (25 points total) Consider the following model
i) C = 1500 + mpc (Y – tY)
ii) I = 800
iii) G = 500
iv) X – M = 500 – mpi (Y)
where:
t = the (flat) tax rate
mpc = the marginal propensity to consume
mpi = the marginal propensity to import
suppose mpc = .80, t = .25, mpi = .2
a. (5 points) solve for the equilibrium output
b. (5 points) Solve for the (government) spending multiplier.

c. (10 points) When we discussed the multiplier we discussed the impact effect.
For example, suppose that G increases by 100 to 600 and we assume, as we
often do, that firms match the increase in demand by increasing Y by 100. In
round two, this is an increase in income of 100 to consumers. Trace out exactly
where this 100 increase in income goes in the second round and compare to our
simpler treatment with a closed economy and lump sum taxes. Hint, there are
three leakages to address(again, please be very specific as to where the 100
increase income ‘goes’ in this second round).
d. (5 points) What would happen to the multiplier if the mpi rises to .25. Please
explain the intuition.
True/False (40 points total – 2 points each)
1) Unemployment benefits are an example of fiscal policy.

2) According to Ricardian Equivalence in a strict sense, the tax multiplier is zero.
3) When looking at the GDP data from quarter 3 of 2012, government purchases
accounted for a larger share of the economy than investment expenditures did.
4) According to one of the lectures featuring a pie chart on federal government
expenditures, transfer payments went from about 25% of total expenditures in the 1960s
to over 46% of total expenditures in 2010.
5) As of 2010, interest payments on the federal debt exceeded 10% of total expenditures.
6) We argued that the tax revenue that the federal government collects is pro-cyclical, that
is, when economic activity is growing so is tax revenue.
An example of this is the new
economy when tax revenue increased along with the economic growth.
7) If aggregate expenditures exceed aggregate income then inventories will rise and firms
will eventually lay off workers.
8) We argued that cutting the corporate income tax will have supply side effects in that
cutting the corporate income tax can potentially increase the pace of technological
change with the implication being the aggregate supply will shift to the right.
9) According to the Laffer curve, increases in tax rates always result in less tax revenue.
10) One reason that tax revenue may fall when tax rates are increased is due to tax evasion,
that is, the higher the tax rate, the higher the probability of the tax evasion and thus,
lower tax revenue. The example I used was when Canada quadrupled the tax rate on
cigarettes Canadian citizens sought out to buy illegally smuggled in US cigarettes to
evade the tax on Canadian cigarettes.
11) The term ‘voodoo economics’ is a term used by the proponents of supply side
economics trying to explain to its critics that lower tax rates will result in higher tax
revenue.12) Barro is considered to be a supply side economist which is consistent with his idea that
we should eliminate the corporate income tax.
13) According to the table depicting the effective tax rate on capital for 2007, the only
country that has a higher effective tax rate on capital is Greece.
14) According to our discussion of supply side economics, there are positive aggregate
demand side effects and positive supply side effects, similar to what happened during
the new economy.
15) We argued that the tax multiplier is higher in absolute value than the government
spending multiplier.16) The more the Fed accommodates shocks to money demand, the larger the
(government) spending multiplier.17) According to the Congressional Budget Office (CBO), the stimulus package worked in
terms of creating jobs, lowering unemployment, and raising GDP.
18) Spending by local governments to stimulate or slow down their local economies is an
example of fiscal policy.19) When talking about tax multipliers using tax rates instead of the more simple lump sum
taxes, we argued that the social security tax cut resulted in a higher tax multiplier.
20) When we add the marginal propensity to import to our model, the spending multiplier
falls. In fact, the higher the marginal propensity to import, the smaller the spending
multiplier, all else constant.