Economics 102

L. Stone

Spring 2003

Quiz 7

EACH QUESTION IS WORTH 5 POINTS. BE SURE TO SHOW YOUR WORK.

1. a. In an open economy, the marginal propensity to consume = 0.9, and the marginal propensity to import = 0.10. Find the change in exports required to increase GDP by 1000.

Change in Y = 1/[1 – (b-m)]*change in X

1000 = 5*change in X

change in X = 200

b. Using this model, carefully explain why a recession in a large country like the United States could have a negative effect on the rest of the world.

When the U.S. has a recession, Y (income) falls. The fall in income leads to a fall in imports. U.S. imports are exports for, say, France. Thus French exports fall, and in turns France’s GDP falls. (And the fall in France’s GDP leads to a fall in French imports, which are U.S. exports, and thus U.S. GDP falls more, etc.)

2. In the short run, the following information describes the economy:

C = 2000 + .8(1-t)Y

I = 1000

G = 500

t = 0.20

a. Find equilibrium GDP. (5 points)

Y = 2000 + .8(1-.20)Y + 1000 + 500

Y = 9722

b. By how much would the government have to increase spending to raise GDP by 2000?

Change in Y = 1/[1 – b(1-t)]*change in G

2000 = 1/[1 – .8(1-.20)]*change in G

Change in G = 720

3. In open economies and when there are proportional taxes, we know that the spending multiplier is smaller than it would be otherwise. What’s good about this? What’s bad about this?

The good news is that a smaller multiplier makes the economy more stable. Change in investment and consumption, or supply shocks, will have less of an effect on the economy (the business cycle will swing less wildly).

The bad news is the government policies (changes in G and T) will be less effective… it will take more of a change in government spending, for example, to have the same effect on GDP.