Y = 5000 + .9(Y-500) + 1000 +500

Y = 60,500

b. What is the change in GDP if government spending increases TO 1000? (5 points)

change in Y = 10*500 = 5000

c. By how much and in what direction would taxes have to change to have the same effect as in b.? (5 points)

Taxes would have to decrease.

5000 = -9(change in T)

change in T = -555.55

d. In open economies, and when there are proportional taxes, the spending multiplier is different. How is it different (don’t just write down the formulas), and why does that matter? (8 points)

In each case, the multiplier is SMALLER. This makes the economy more stable if there are supply or demand shocks, but it also means that it is more difficult for fiscal or monetary policy to change output by much.

e. Assume that nothing has changed since part a.

The savings function for this economy is S = -5000 + .1(Y-T).

1. What are the current equilibrium levels of C and S? (2 points)

S = -5000 + .1(60,500 – 500) = 1000

C = 5000 + .9(60,500 – 500) = 59,000

2. Suppose that consumes decide to save $500 MORE. Carefully explain what will happen in this economy, and what the effect will be on equilibrium GDP, consumption, and savings. (You must calculate Y, C, and S to receive full credit, and a graph would probably help your answer.) (8 points)

C falls, so C+I+G falls, and Y falls. The new level of output will be 55,500, C = 54,000, S = 1000

3. Explain WHY this is called the Paradox of Thrift, and why it occurs. (5 points)

It’s a paradox because by trying to save more, people actually save the same (but output falls). It occurs because the fall in demand reduces output, so while autonomous savings (the constant part of the savings function) increases, income has fallen, so the amount saved from current income falls, and savings remains constant.

3. The graph below shows the economy in long-run equilibrium. Suppose that there is a sudden increase in oil prices. Show on the graph and explain (in words or symbols) the short- and long-run effects on the economy. (10 points)

In the short run: Supply decreases, output falls, prices rise.

In the long run: Output is below full employment output, so wages and prices fall. This increases supply, and the economy returns to full employment at the original price level.

(The above should be SHOWN ON GRAPH as well… I didn’t do that here because the graphics are hard to upload.)

4. The graph below shows the economy in long-run equilibrium. Suppose that the government increases TAXES to finance a war. . Show on the graph and explain (in words or symbols) the short- and long-run effects on the economy. (10 points)

In the short run: Demand decreases, output falls, prices fall.

In the long run: Output is below full employment output, so wages and prices fall. This increases supply, and the economy returns to full employment at the original price level.

(The above should be SHOWN ON GRAPH as well… I didn’t do that here because the graphics are hard to upload.)

5. Using the Solow model, CAREFULLY and fully explain why countries with higher savings rates will grow faster and to greater levels of output than those with lower savings rates. Your answer must include a carefully-labeled graph and must explain sufficiently to demonstrate that you understand how the Solow model works. (20 points)

MUST be accompanied by a graph that CLEARLY shows all relevant parts of Solow model and is labeled correctly. The easiest way to do this is to show two savings functions.

If a country saves more, the gap between savings and depreciation will be larger. Thus net investment will be larger, and the capital stock will be bigger in the next period (than for a country that saves less), and output will be higher as well. Thus the country that saves more will grow faster.

If a country saves more, it will take “longer” to reach the steady state, or in other words, the steady state level of output will occur at a higher capital stock because there is more savings to cover depreciation of a larger capital stock.

6. Why is financial intermediation necessary, and what functions does it perform? (Your answer should clearly explain the differences between savers and investors.) (12 points)

Savers save small amounts, are risk averse, and need liquidity. Investors are risk-neutral or risk-loving, need to borrow large amounts, and need long-term loans. Financial intermediaries pool small savings into large investment funds and diversify to minimize risk, and thus they bridge the gap between the two groups.

7. A little more than a year ago, the current President passed a tax cut bill. This bill provided for tax cuts, but with a “sunset clause” that phases them out after 10 years. The goal of these programs was supposedly to stimulate the economy through expansionary fiscal policy. President Bush is now trying to have these tax cuts made permanent. Why would there be any reason to believe that this would have any further effect on the economy at this time? Carefully explain your reasoning, and you might wish to relate this to the past examples of fiscal policy that we have discussed in class. (10 points)

If this makes any sense at all, it’s because of the difference between permanent and temporary changes. Consumers make consumption decisions based on lifetime or permanent income. A temporary tax cut doesn’t have much effect on permanent income, and thus won’t change consumer spending much. A permanent tax cut would have a greater effect on permanent income, and thus might cause consumers to spend more, stimulating demand and thus the economy.