Question

Consider the following behavioral equations:

C=c0 +c1YD T=t0 +t1 Y YD = Y – T

G and I are both constant. Assume that t1 is between 0 and 1.
(1) Solve for equilibrium output and equilibrium taxes.
(2) What is the multiplier? Does the economy respond more to changes in autonomous spending when t1

is 0 or when t1 is positive? Explain.
(3) Why is the fiscal policy in this case called an automatic stabilizer?
Now suppose that the government starts with a balanced budget and that there is a drop in c0.

4. (4) What happens to Y? What happens to taxes?

5. (5) Suppose that the government cuts spending in order to keep the budget balanced. What will be the

   effect on Y (compared with your answer in (4))? Does the cut in spending required to balance the budget counteract or reinforce the effect of the drop in c0 on output? (Give the answer in words briefly and no need to do the algebra.)

6. (6) Based on your answer in (5), would a balanced budget requirement actually be stabilizing or destabilizing?

Answer 1

1. Y=C+1+G=c0+c1(Y-t0-t1Y)+b0+b1Y+G=c0+c1Y-c1t0-c1t1Y+b0+b1Y+G

Y-c1Y+c1t1Y-b1Y-b1Y=c0-c1t0+b0+G

Y= (c0-c1t0+bo+G)/(1-c1+c1t1-b1)

2.

Multiplier is the factor by which increase in total output are greater than the variance in spending that caused it.

c0– Autonomous consumption

c1–Marginal propensity to consume

t0–lump-sum tax

t1–Rate of income tax

YD–Disposable income

b0 –Autonomous investment

b1–Marginal propensity to invest

3. Drop in all Investment,Consumer and government spending negatively affects on aggregate demand: like in the diagram AD1 shifts to AD2 and price falls from P1 to P2.