ECON 104 HOMEWORK 6 QUESTIONS AND ANSWERS | 100% CORRECT

ECON 104 HOMEWORK 6 QUESTIONS AND ANSWERS Consider the following model i) C = 1500 mpc (Y - tY) ii) I = 800 iii) G = 500 iv) X - M = 500 - mpi (Y) where: t = the (flat) tax rate mpc = the marginal propensity to consume mpi = the marginal propensity to import suppose mpc = .80, t = .25, mpi = .2 Given the information above, solve for the equilibrium output: We know that the formula for the (government) spending multiplier is 1/(1-mpc(1-t) mpi). The value of the government spending multiplier in this problem is: Round to 2 decimal places. When we discussed the multiplier we discussed the impact effect. For example, suppose that G increases by 100 to 600 and we assume, as we often do, that firms match the increase in demand by increasing Y by 100. In round two, this is an increase in income of 100 to consumers. We will trace out exactly where this 100 increase in income goes in the second round. Recall, there are three leakages to address (via taxes, imports and savings). Given that t=.25, we know that .25 of every dollar increase in gross income is a leakage due to taxes. Since the increase in income is $100, we know the leakage due to taxes is: Given that mpi=.2, we know that .2 of every dollar increase in gross income is a leakage due to imports. Since the increase in income is $100, we know the leakage due to imports is: Given that the MPC=.8, we know that .2 of every dollar increase in gross income is saved. Since the increase in income is $100, we know the leakage due to savings is: To find out how much consumption increases we need to take the increase in income ($100) and subtract out the leakages. So take the $100 and subtract your answers from #3, #4 and #5 above. When income increases by $100, consumption increases by: What would happen to the multiplier if the mpi rises to .25? Round to 2 decimal places. What would happen to the size of the leakage if the mpi rises to .25? In this question, we are going dig deeper into the Taylor Rule and it variants (modifications). Federal Reserve data from October 1, 2011: Potential GDP growth y* = 1.7% Actual GDP Growth yA = 2.0% Inflation PCE (actual inflation) πA = 2.6% Effective Federal funds Rate = .07% As Taylor assumed, we assume the equilibrium real rate of interest r* = 2% and the optimal inflation rate, the target inflation rate π* is also equal to 2%. The standard (original) Taylor rule formula: iff TR = r* πA 0.5[πA - π*] 0.5 [ yA - y*] Using the 'standard' Taylor rule from above and using the data provided, what is the federal funds rate implied by the 'standard' Taylor Rule? According to the actual federal funds rate (use the Effective Federal Funds Rate provided above for ), is the Fed being hawkish or dovish? Now consider the modified version of the Taylor using the unemployment gap instead of the GDP gap just like we did in the lectures. Also, we will use the PCE core rate of inflation instead of overall inflation like you used above - the Fed arguably cares more about core inflation than overall inflation. Modified Taylor Rule formula: iff TR = r* πA 0.5[πA - π*] (-1.25) [URA - NAIRU] Additional needed data from Federal Reserve data from October 1, 2011: Unemployment Rate URA = 8.7% NAIRU = 5.5% Inflation PCE Core (actual inflation) πA = 1.8% Now what is the federal funds rate implied by the modified Taylor Rule above? According to the actual federal funds rate, is the Fed being hawkish or dovish? Unemployment benefits are an example of discretionary fiscal policy. According to Ricardian Equivalence in a strict sense, the tax multiplier is zero. When looking at the GDP data from quarter 3 of 2012, government purchases accounted for a larger share of the economy than investment expenditures did. According to one of the lectures featuring a pie chart on federal government expenditures, transfer payments went from about 25% of total expenditures in the 1960s to over 46% of total expenditures in 2010. As of 2010, interest payments on the federal debt exceeded 10% of total expenditures. We argued that the tax revenue that the federal government collects is pro-cyclical, that is, when economic activity is growing so is tax revenue. An example of this is the new economy when tax revenue increased along with the economic growth. If aggregate expenditures exceed aggregate income then inventories will rise and firms will eventually lay off workers. We argued that cutting the corporate income tax will have supply side effects in that cutting the corporate income tax can potentially increase the pace of technological change with the implication being the aggregate supply will shift to the right. According to the Laffer curve, increases in tax rates always result in less tax revenue. One reason that tax revenue may fall when tax rates are increased is due to tax evasion, that is, the higher the tax rate, the higher the probability of the tax evasion and thus, lower tax revenue. The example I used was when Canada quadrupled the tax rate on cigarettes Canadian citizens sought out to buy illegally smuggled in US cigarettes to evade the tax on Canadian cigarettes. The term 'voodoo economics' is a term used by the proponents of supply side economics trying to explain to its critics that lower tax rates will result in higher tax revenue. Barro is considered to be a supply side economist which is consistent with his idea that we should eliminate the corporate income tax. According to the table depicting the effective tax rate on capital for 2007, the only country that has a higher effective tax rate on capital is Greece. According to our discussion of supply side economics, there are positive aggregate demand side effects and positive supply side effects, similar to what happened during the new economy. We argued that the tax multiplier is higher in absolute value than the government spending multiplier. The more the Fed accommodates shocks to money demand, the larger the (government) spending multiplier. According to the Congressional Budget Office (CBO), the stimulus package worked in terms of creating jobs, lowering unemployment, and raising GDP. Spending by local governments to stimulate or slow down their local economies is an example of fiscal policy. When talking about tax multipliers using tax rates instead of the more simple lump sum taxes, we argued that the social security tax cut resulted in a higher tax multiplier. When we add the marginal propensity to import to our model, the spending multiplier falls. In fact, the higher the marginal propensity to import, the smaller the spending multiplier, all else constant. According to the "We are all Keynesians Now" article, the labor secretary at that time wanted the unemployment rate to fall down to 3%. The misery index in 1980 exceeded 25. The mid to late 1970s was the 'heyday' of Keynesian economics in the US economy. Keynes believed that it was the responsibility of the government to use its powers to increase production, incomes and jobs. Consistent with his thought on spending heavily, Keynes was known as an excellent tipper. The steeper the SRAS curve, the steeper the short-run Phillips curve. If the long-run aggregate supply curve is vertical so is the long-run Phillips curve. Friedman and Phelps agreed that there is a trade-off between unemployment and inflation, but only in the long run. If actual inflation is lower than expected inflation, then the actual real wage is higher than the expected real wage. This being the case, firms will lay off workers. According to the Taylor Rule described in the lectures, if the Fed is getting an A , then the federal funds rate should be set at 5%. According to the Taylor principle, if actual inflation rises by 1% over target inflation, then the Fed should raise the federal funds rate by 2% to make sure that the real federal funds rate rises which is referred to as "leaning against the wind." If the actual federal funds rate is higher than the funds rates implied by the Taylor rule, then we say that the central bank is hawkish. If actual inflation rises one percent above target and the central bank raises the actual funds rate by one percent then according to the Taylor rule, the central bank is being hawkish. According to the Taylor rule, the Greenspan Fed was hawkish during the new economy years. According to the Taylor rule, the Greenspan Fed was hawkish during the job-less recovery as well as the job-loss recovery. One way to explain the apparent tradeoff between inflation and unemployment during the 1960s, expected inflation was consistently higher than the actual inflation implying that firms would be willing to hire more workers given this difference between expected and actual inflation. The result therefore would be higher inflation and lower unemployment, consistent with the facts during the 1960s. We argued that the modified version of the Taylor rule during the jobless recovery following the recession explained Greenspan and the Fed's behavior much better than the original Taylor Rule. According to the Phillips curve analysis, if expected inflation is equal to actual inflation then we are at NAIRU. However, if actual inflation is higher than expected, then the actual unemployment rate will be higher than that associated with NAIRU. If firms and workers had perfect foresight as to inflation so that actual = expected inflation at all times, then the Phillips curve would be vertical and thus, there would be no trade between unemployment and inflation, even in the short run. We argued that a federal funds rate target of 4% is consistent with the stance of monetary policy being neutral as in neither tight nor loose.