ECO403 Macroeconomics Assignment 3 Idea solution spring 2011 June 2011

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Question 01:
Assume that the following data taken from the economy of Pakistan.
C = 400 + 0.7(Y-T)
G = 200
T = 70
I = 100
Calculate the equilibrium level of output.
(Note: Write down all relevant steps involved in calculation)

Formula
Y = C + I + G
Y = 400 + 0.7(Y-70) + 100 + 200
Y = 700 + 0.7(Y-70)
Y = 700 + {0.7Y + 0.7(-70)}
Y - 0.7Y = 700 – 49
0.3Y = 651
Y = 651/0.3 = 2170 answer

Question 02:
If the marginal propensity to consume (MPC) of the economy of Pakistan is 0.77, then,
a) What is the Government-spending multiplier?
b) What is the Tax multiplier?
(Note: Write down all relevant steps involved in calculation)

THE GOVERNMENT PURCHASES MULTIPLIER
ΔY / ΔG = 1 / 1-MPC

ΔY / ΔG = 1/ (1- 0.77)
ΔY / ΔG = 1/0.23
=4.35

b) What is the Tax multiplier?

ΔY / ΔT = -MPC / 1-MPC
= - 0.77 / 1-0.77
=- 0.77 / 0.23 = -3.45
Tax multiplier is smaller than the govt. spending multiplier: Consumers save the fraction (1-MPC) of a tax cut, so the initial boost in spending from a tax cut is smaller than from an equal increase in G.