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The multiplier model

Congratulations! You have been appointed as economic policy advisor to the United States. You are told that the economy is significantly below its potential output and the following is projected for next year: world output will fall significantly and the price of oil will rise significantly.
a. What is meant by potential output?

b. What will happen to the price level and output?

c. What policy might you suggest to the government?

2.
a. Marginal propensity to expend is 0.5 and there is a recessionary gap of $200. What fiscal policy would you recommend?

b. Why does cutting taxes by $100 have a smaller effect in GDP than increasing expenditures by $100?

3.
a. Suppose imports were a function of disposable income instead of income. What would be the new multiplier? How does it compare with the multiplier when imports were a function of income?

b. Explain why making taxes and imports endogenous reduces the multiplier?

4.
State how the following information changes the slope of the AD curve.
a. The effect of price level changes on autonomous expenditures is reduced.
b. The size of the multiplier increases.
c. Autonomous expenditures increase by $20
d. Falls in the price level disrupt financial markets which offset the normally assumed effects of a change in the price level.

5.
a. Your employer offers you a choice of two bonus packages: $1,400 today or $2,000 five years from now. Assuming a 6 percent rate of interest, which is the better value? Assuming an interest rate of 10 percent, which is the better value?

b. Suppose the price of a one-year 10 percent coupon bond with a $100 face value of $98. Are market interest rates likely to be above or below 10 percent? Explain. What is the bond's yield or return? If market interest rates fell, what would happen to the price of the bond?

Solution Preview

1.
a. Potential output is the amount the economy is capable of generating, given current technology, known reserves, and workforce composition.
b. If output falls the supply curve will shift leftwards. This will cause price to increase as quantity declines.
c. The government needs to increase domestic output by fully utilizing all resources available for oil production. This could be done with expansionary fiscal and monetary policies specifically aimed at the oil industry.

a. Marginal propensity to expend is 0.5 and there is a recessionary gap of $200. What fiscal policy would you recommend?

The multiplier is 1/1-.5 = 1/.5 = 2. Increasing government spending by $100 would therefore close the gap.

b. Why does cutting taxes by $100 have a smaller effect in GDP than increasing expenditures by $100?

When taxes are cut, people pay less tax and have more left for saving and spending. Most people save something, which is indicated by the MPC (marginal propensity to consume). People spend only the percentage ...

Solution Summary

Questions on a variety of topics - autonomous spending, the multiplier model, employer bonuses and bonds

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