EC201: Intermediate Macroeconomics

Semester 1 2016
Tutorial Three Solution
1) Label each of the following statements true, false or uncertain. Explain briefly.
a. The largest component of GDP is consumption.
True
b. The propensity to consume has to be positive, but otherwise it can take on any positive
value.
False, another natural restriction would be that people are more likely to spend part
of their income and save the rest. Therefore the marginal propensity to consume
(MPC) is expected to be positive but less than one. This assumption is backed up by
most empirical evidence.
c. Fiscal policy describes the choice of government spending and taxes, and is treated as
exogenous in our goods market model.
True
d. The equilibrium condition for the goods market states that consumption equals output.
False, the equilibrium condition for the goods market states that production =
demand, i.e. Y = Z.
e. An increase of one unit in government spending leads to an increase of one unit in
equilibrium output.

False, the increase in output is one times the multiplier, i.e. 1/(1c1).
f. A decrease in the propensity to consume leads to an increase in output.
False, a smaller c1 causes the multiplier to become smaller hence leads to a decrease
in output.
g. The government can affect the demand and output by using fiscal policy effectively in the
short run.
True

2) Consider the following model of the economy:

C c 0 c1YD

(consumption)

YD Y TR TA

(disposable income)

I I

(investment)

G G

(government expenditure)

TR TR
TA tY

(government transfer payments)

(taxes)

a. Derive an algebraic expression for total demand (aggregate expenditure) in this model?
Z=C+I+G
= c0 c1YD I G
= c0 c1 (Y TR tY ) I G
Z = c0 I G c1 TR c1 (1 t )Y
b. Derive an algebraic expression for equilibrium level of income (Y) in this model?
In equilibrium Y = Z, therefore
Y = c0 I G c1 TR c1 (1 t )Y

[1 c1 (1 t )]Y c0 I G c1 TR
Y*

1
[c0 I G c1 TR]
1 c1 (1 t )

c. Using the algebraic expression in (b), determine the multiplier for this model.

A
d.

Y *
1

A 1 c1 (1 t ) , where A = Autonomous expenditure.

(i) What is the marginal propensity to consume out of disposable income (MPCYD)?
Given C c 0 c1YD ,
MPCYD

C
c1 .
YD

(ii) What is the marginal propensity to save out of disposable income (MPSYD)?
Since MPCYD MPS YD 1 ,

MPS YD 1 MPCYD 1 c1

(iii) What is the marginal propensity to consume out of income (MPCY)?

Given YD Y TR TA
Y TR tY (1 t )Y TR
C c 0 c1YD

c0 c1 [(1 t )Y TR]
c0 c1 TR c1 [(1 t )Y
MPCY

C
c1 (1 t )
Y

3) Consider the following model of the economy. Figures (except the parameters) are in millions of
dollars.

C 50 0.8YD
I 70
G 200
TR 100
TA 0.25Y
YD Y TR TA
a. Calculate the value of the equilibrium level of income (Y) and determine the equilibrium
values of other endogenous variables and complete the following NAM:
Z=C+I+G
= 50 + 0.8 YD + 70 + 200
= 50 + 0.8 (Y - 0.25Y + 100) + 70 + 200
= 320 + 0.8 (100)+ 0.8 (1 0.25) Y
= 400 + 0.6Y.
In equilibrium Y = Z, therefore
Y = 400 + 0.6Y
(1 0.6) Y = 400
Y* = 400/(1 0.6)
= 400/0.4
= $1000m.

Values for Endogenous variables.

TA 0.25Y
0.25(1000)
$250m

YD Y TR TA
1000 100 250
$850m
C 50 0.8YD
50 0.8(850)
$730m
S p Y TR TA C
1000 100 250 730
$120m
S g TA G TR
250 200 100
$50m (deficit)
Expenses
Producers Households

Govt.

Investors

$200

$70

Total

Income
Producers

$730

Households
Govt.
Investors

$1000

Total

$1000

$100
$250
$120

-$50

$1100

$250

$1000
$1100
$250
$70

$70

b. Explain the financing of total investment in the economy. What proportion of investment is
financed by private saving?
The total investment in the economy is financed through Sp + Sg.
That it is financed through the proportion of income saved by the Households and
government. Since S = 120 > I = 70, investment is totally financed by private saving.

c. What is the government budget deficit and how is it financed?

The budget deficit is:
BD = G+ TR t Y
= 200 + 100 0.25 (1,000)
= $50m.
The budget deficit is thus financed with the difference between private saving and
investment: BD = S I = 120 70 = $50m.
d. Suppose government expenditure (G) increases by 100m, what would be the change in
income? Show this effect in a diagram (similar to Figure 3.2 of the textbook). Using your
answer, determine the value of government expenditure multiplier (G).
Y
1
Multiplier : G

G 1 c1 (1 t )

1
1 0.8(1 0.25)
2.5

Y G G
2.5 100
$250m
A $100m increase in Government expenditure increases the equilibrium income by
$250m.

Demand (Z),
Production (Y)

Effect of an increase in Govt. spending on income

Y=Z
ZZ"
B
ZZ

500

G=100
400
450
0

1000

1250

Income (Y)

Y=250

e. Now suppose (G) increases by 100m and the government also increases taxes (TA) by the
same amount. Determine the net change in income. Can you derive a suitable multiplier
associated with this policy change?
c1
1

Multiplier Equation =
1 c1 (1 t ) 1 c1 (1 t )

1 c1
1 c1 (1 t )

Net change in income

1 c1
G or TA
1 c1 (1 t )

1 0.8
0 .2

100 (since G and TA both increase by same amount)

1 0.8(1 0.25) 0.4

$50m

f. Briefly explain how a decrease in the marginal propensity to save would affect the size of the
expenditure multiplier
If the marginal propensity to save (s) decreases, then the marginal propensity to
consume (c1) increases since c + s = 1. Therefore, since A= 1 / (1 slope of ZZ)
and c is the slope of the ZZ curve, then as s decreases the expenditure multiplier
increases. The economic explanation is as follows. As s decreases, a larger fraction of
each additional dollar of YD will be spent and thus the multiplying impact on Y will
be larger.
4) Comment on the following logic: When output is too low, what is needed is an increase in
demand for goods and services. Investment is one component of demand, and saving equals
investment. Therefore, if the government could just convince the households to attempt to save
more, then investment, the demand for goods and services, and output, would increase.
Clearly this logic is faulty. When output is low, what is needed is an attempt by
consumers to spend more. This will lead to an increase in output, and
thereforesomewhat paradoxicallyto an increase in private saving. Note, however,
that with a linear consumption function, the private saving rate (private saving divided
by output) will fall when c0 rises.