1. Aggregate demand

2. Long-run aggregate supply

Sample answer:

1. Being in a deep recession, the United States economy is producing below its potential level. The following graph illustrates this situation:

P LAS SAS

P

AD

Y Y₀ Y

Y₀ – potential output.

Y and P – current output and price level.

2. The relative effectiveness of the two policies depends on the size of the tax and government expenditure multipliers. The tax multiplier is equal to – c/(1-k), where c is the marginal propensity to consume, and k – the slope of the aggregate expenditure line. The government purchases multiplier is 1/(1-k). Thus, a $1 decrease in taxes will result in a c/(1-k) dollar increase in real gross domestic product, whereas a $1 increase in government purchases will cause GDP to go up by 1/(1-k) dollars. As c<1, increasing public expenditure proves to be more effective than reducing taxes. The explanation for this can be found in the way the two policies work. While changes in government purchases directly affect planned expenditure, reduction in taxes increases disposable income, which, in turn, through consumption demand and marginal propensity to consume alters planned expenditure.

3. i) In our simple model C = c₀ + c* Y_d, where Y_d – disposable income, income left over after paying taxes (Y_d = Y – T). Obviously, a decrease in personal income taxes will increase the amount of money people have at their disposal at every level of GDP. In addition to that, as we established earlier, it will produce an expansion of output, which will increase disposable income still further. Hence, given that 0<c<1, reduction in taxes will lead to a higher level of consumption.

ii) A decrease in personal taxes will increase aggregate demand, which, as the following diagram shows, will produce an increase in both prices and real gross domestic product:

P

SAS

P ₂

P ₁ AD₂

AD₁

Y₁ Y₂ Y

iii) Since imports are directly related to income, the increase in GDP, produced by the reduction in taxes, will boost imports. On top of that, inflation, brought about by fiscal expansion, will make foreign goods more competitive and therefore more attractive to domestic consumers, resulting in an even greater increase in imports demand.

iv) Another effect of the increase in prices will be a fall in the United States exports. Higher prices mean that domestically produced goods have become less competitive in the international markets and contraction in the demand for these goods by foreigners will cause exports to decline.

4. Aggregate demand curve shows the locus of points in the price-output space where the money and goods markets are in equilibrium. Assuming that depreciation has not changed the increase in net investment must be wholly due to an increase in gross investment, which, in turn, is a component of planned expenditure: AE^pl = C + I + G + NX. The equilibrium condition for the goods market is the equality of planned and actual expenditure, i.e. AE^pl = Y. With increased AE^pl, this equality is achieved at a higher level of output, so that for each price level the level of income, which ensures equilibrium in the goods and money markets, goes up (though there will be partial crowding out of investment due to an increase in interest rates). Thus, an increase in net investment will lead to an increase in aggregate demand:

P

AD₂

AD₁

Y

ii) Long-run aggregate supply curve depicts the potential level of output the economy can produce given the resources available to it. Since net investment is the actual increment to the capital stock, an increase in net investment will bring about a faster growth of capital resources. With growing amount of capital, the economy’s potential output increases as well, so that the long-run AS curve shifts to the right:

P LAS₁ LAS₂

Y₁ Y₂ Y

Problem 3 (APT,2001, P1)

Assume that the economy is operating below the full-employment level of output and that the government’s budget is balanced.

1. Using a correctly labeled aggregate demand and aggregate supply graph, show how an increase in government spending will affect each of the following in the short run.

1. Real output

2. Price level

2. Explain how this increase in government spending will affect each of the following in the short run.

1. Real interest rates

2. Investment

Now assume that instead of increasing government spending, the government decreases corporate-profits taxes.

3. Using a correctly labeled aggregate demand and aggregate supply graph, show and explain how this decrease in corporate-profits taxes will affect each of the following.

1. Aggregate demand

2. Long-run aggregate supply

3. Real output

4. Price level

4. Assume that this country produces two goods, X and Y. Draw a correctly labeled production possibilities curve for this economy. Now show on the graph how this decease in corporate-profits taxes will affect this economy’s production possibilities curve.

Sample answer:

1. Increase in government spending will raise the demand for the economy’s output, which corresponds to a rightward shift in the aggregate demand curve. At the same time, the aggregate supply curve will remain unaffected so that the real output of the economy and the price level will both go up:

P AS

P ₂

P ₁ AD₂

AD₁

Y₁ Y₂ Y

2. With an increase of the aggregate demand households will need more money to hold as а cash for their needs. The demand for money will increase. As a result, the equilibrium interest rate will rise partially choking off private investment which is inversely related to the real rate of interest (the process often referred to as crowding-out):

r M^S₁ r

r₂

r₁ M^D₂ I

M^D₁

(M/P) I₂ I₁ Investment

3. The reduction in corporate-profit taxes is going to have a twofold effect on the economy. On the one hand, for any given level of output the disposable income will go up so that the immediate result will be an increase in consumption and hence aggregate demand (i). On the other hand, with lower taxes firms will have more money to invest. This will further boost aggregate demand, but what is more important, it will also expand the economy’s production possibilities. However, it may take some time for the latter effect to materialise. So even though the long run supply curve will ultimately shift to the right (ii) indicating an increase in the economy’s potential output, the short run supply curve will stay unchanged. Consequently, the result of this policy will be the same as that of increasing the government spending, i.e. higher output (iii) accompanied by higher prices (iv).

P LAS₁ LAS₂

SAS

P ₂

P ₁ AD₂

AD₁

Y₁ Y₂ Y

4. Higher level of investment resulting from the decrease in corporate-profits taxes will lead to the accumulation of capital and consequently an expansion of the production possibilities frontier (for each given output of one good the economy can now produce more of the other good).

Y

X

Money Market and Monetary Policy.

Problem 1 (APT’93, P3)

The reserve requirement for the banking system is at 20 percent. Currently, Third National Bank has no excess reserves. Then Behroz deposits $100 in her checking account at Third National.

1. Explain, without using a mathematical formula, why Behroz’ deposit can lead to a greater-than-$100 increase in the money supply.

2. Discuss TWO limitations of this process

Sample answer:

1. Money supply is comprised of highly liquid assets which are accepted in payment for goods and services and settlement of debts. These include hard cash and demand deposits. When Behroz deposited $100 in her checking account, she simply converted one type of money into another, without affecting the total money supply in the economy. However, with fractional reserve banking, the bank which received the money will lend up to 80% of the sum to someone else, thus increasing the total amount of money going around. As a result, Behroz still has, though only figuratively, $100 in her account which she can use to pay for goods and services, but now the person who secured the loan also has money which he did not have initially. This person can either put the money into a bank or use it to buy something. In any case, the money will sooner or later return to the banking system and the same circle will start all over again. It is enough to look at the first several rounds of the process to realize that ultimately the money supply will increase by far more than $100 initially deposited.

2. One limitation of this process is that banks are bound to keep reserves (either by legislation or by considerations of safety), so that after each cycle of depositing and lending less and less money leaves the banking system to take part in the next round of money creation. Another restriction is that people prefer at any moment to have some money in cash rather than in bank deposits. Thus, not all the money that is lent out will return to the banking system but part of it will settle in men’s pockets. In the real life both these factors curb the infinite growth of money supply which would have been quite feasible otherwise.