EDUSURE SCHOOL: SKM

EduSure School
Eco PG Entrance Exams
SKM Practice problems
Learning under: Mahima Banthia

SKM practice problems

1. Label each of the following statements true, false, or uncertain. Explain briefly.
a. The largest component of GDP is consumption.
c. The propensity to consume has to be positive, but otherwise it can take on any positive value.
d. Fiscal policy describes the choice of government spending and taxes and is treated as exogenous in our
goods market model.
e. The equilibrium condition for the goods market states that consumption equals output.
f. An increase of one unit in government spending leads to an increase of one unit in equilibrium output.

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g. An increase in the propensity to consume leads to a decrease in output.

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Answers1:
a. True.
c. False. The propensity to consume must be less than one for our model to make sense.
d. True. Sc
e. False.
f. False. The increase in output is one times the multiplier.
g. False.

2. Suppose that the economy is characterized by the following behavioral equations:

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C = 160 + 0.6YD
I = 150
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G = 150
T = 100
Solve for the following variables.
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a. Equilibrium GDP (Y)

b. Disposable income (YD)
c. Consumption spending (C)
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Answers 2:
a. Y=160+0.6(Y-100)+150+150 Y=1000
b. YD=Y-T=1000-100=900
c. C=160+0.6(900)=700

3. Use the economy described in Problem 2.

a. Solve for equilibrium output. Compute total demand. Is it equal to production? Explain.
b. Assume that G is now equal to 110. Solve for equilibrium output. Compute total demand. Is it equal to
production? Explain.
c. Assume that G is equal to 110, so output is given by your answer to (b). Compute private plus public
saving. Is the sum of private and public saving equal to investment? Explain.

Answers: 3
a. Equilibrium output is 1000. Total demand=C+I+G=700+150+150=1000. Total demand equals
production. We used this equilibrium condition to solve for output.

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b. Output falls by (40 times the multiplier) = 40/(1-.6)=100. So, equilibrium output is now 900. Total
demand=C+I+G=160+0.6(800)+150+110=900. Again, total demand equals production.

c. Private saving=Y-C-T=900-160-0.6(800)-100=160. Public saving =T-G=-10. National saving (or in

short, saving) equals private plus public saving, or 150. National saving equals investment. This statement
is mathematically equivalent to the equilibrium condition, total demand equals production. In other
words, there is an alternative (and equivalent) equilibrium condition: national saving equals investment.

4. The balanced budget multiplier

For both political and macroeconomic reasons, governments are often reluctant to run budget deficits.
Here, we examine whether policy changes in G and T that maintain a balanced budget are
macroeconomically neutral. Put another way, we examine whether it is possible to affect output through
changes in G and T so that the government budget remains balanced.
a. By how much does Y increase when G increases by one unit?
b. By how much does Y decrease when T increases by one unit?

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c. Why are your answers to (a) and (b) different?

Suppose that the economy starts with a balanced budget: G = T. If the increase in G is equal to the

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increase in T, then the budget remains in balance. Let us now compute the balanced budget multiplier.

d. Suppose that G and T increase by one unit each. Using your answers to (a) and (b), what is the change
in equilibrium GDP? Are balanced budget changes in G and T macroeconomically neutral?
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e. How does the specific value of the propensity to consume affect your answer to (a)? Why?

Answers 4:
a. Y increases by 1/(1-c1)
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b. Y decreases by c1/(1-c1)
c. The answers differ because spending affects demand directly, but taxes affect demand indirectly
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through consumption, and the propensity to consume is less than one.

d. The change in Y equals 1/(1-c1) - c1/(1- c1)=1. Balanced budget changes in G and T are not
macroeconomically neutral.
e. The propensity to consume has no effect because the balanced budget tax increase aborts the multiplier
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process. Y and T both increase by one unit, so disposable income, and hence consumption, do not change.

5. Automatic stabilizers
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So far, we have assumed that the fiscal policy variables G and T are independent of the level of income.
In the real world, however, this is not the case. Taxes typically depend on the level of income and so tend
to be higher when income is higher. In this problem, we examine how this automatic response of taxes
can help reduce the impact of changes in autonomous spending on output.

Consider the following behavioral equations:

C = c0 + c1YD
T = t0 + t1Y
YD = Y - T
G and I are both constant. Assume that t1 is between 0 and 1.
a. Solve for equilibrium output.
b. What is the multiplier? Does the economy respond more to changes in autonomous spending when t1 is
0 or when t1 is positive? Explain.
c. Why is fiscal policy in this case called an automatic stabilizer?

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Answers 5.
a. Y=c0+c1YD+I+G implies Y=[1/(1-c1+c1t1)][c0-c1t0+I+G]
b. The multiplier=1/(1-c1+c1t1)<1/(1-c1), so the economy responds less to changes in autonomous
spending when t1 is positive. After a positive change in autonomous spending, the increase in total taxes
(because of the increase in income) tends to lessen the increase in output. After a negative change in
autonomous spending, the fall in total taxes tends to lessen the decrease in output.
c. Because of the automatic effect of taxes on the economy, the economy responds less to changes in
autonomous spending than in the case where taxes are independent of income. Since output tends to vary
less (to be more stable), fiscal policy is called an automatic stabilizer.

6. Balanced budget versus automatic stabilizers

It is often argued that a balanced budget amendment would actually be destabilizing. To understand this
argument, consider the economy in Problem 5.
a. Solve for equilibrium output.

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b. Solve for taxes in equilibrium.

Suppose that the government starts with a balanced budget and that there is a drop in c0.

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c. What happens to Y? What happens to taxes?
d. Suppose that the government cuts spending in order to keep the budget balanced. What will be the
effect on Y? Does the cut in spending required to balance the budget counteract or reinforce the effect of
the drop in c0 on output? (Don’t do the algebra. Use your intuition and give the answer in words.)

Answer: 6
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a. Y=[1/(1-c1+c1t1)][c0-c1t0+I+G]
b. T = t0 + t1[1/(1-c1+c1t1)][c0-c1t0+I+G]
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c. Both Y and T decrease.
d. If G is cut, Y decreases even more. A balanced budget requirement amplifies the effect of the decline
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in c0. Therefore, such a requirement is destabilizing.

7. Taxes and transfers

Recall that we define taxes, T, as net of transfers. In other words, T = Taxes - Transfer Payments
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a. Suppose that the government increases transfer payments to private households, but these transfer
payments are not financed by tax increases. Instead, the government borrows to pay for the transfer
payments. Show in a diagram how this policy affects equilibrium output. Explain.
b. Suppose instead that the government pays for the increase in transfer payments with an equivalent
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increase in taxes. How does the increase in transfer payments affect equilibrium output in this case?
c. Now suppose that the population includes two kinds of people: those with high propensity to consume
and those with low propensity to consume. Suppose the transfer policy increases taxes on those with low
propensity to consume to pay for transfers to people with high propensity to consume. How does this
policy affect equilibrium output?
d. How do you think the propensity to consume might vary across individuals according to income? In
other words, how do you think the propensity to consume compares for people with high income and
people with low income? Explain. Given your answer, do you think tax cuts will be more effective at
stimulating output when they are directed toward high-income or toward low-income taxpayers?

Answers 7
a. In the diagram representing goods market equilibrium, the ZZ line shifts up. Output increases.
b. There is no effect on the diagram or on output.
c. The ZZ line shifts up and output increases. Effectively, the income transfer increases the propensity to
consume for the economy as a whole.

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d. The propensity to consume is likely to be higher for low-income taxpayers. Therefore, tax cuts will be
more effective at stimulating output if they are directed toward low-income taxpayers.

8. Investment and income

This problem examines the implications of allowing investment to depend on output.
a. Suppose the economy is characterized by the following behavioral equations:
C = c0 + c1YD
YD = Y - T
I = b0 + b1Y
Government spending and taxes are constant. Note that investment now increases with output. Solve for
equilibrium output.
b. What is the value of the multiplier? How does the relation between investment and output affect the
value of the multiplier? For the multiplier to be positive, what condition must (c1 + b1) satisfy? Explain
your answers.

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c. Suppose that the parameter b0, sometimes called business confidence, increases. How will equilibrium
output be affected? Will investment change by more or less than the change in b0? Why? What will
happen to national saving?

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Answers 8:
a. Y=C+I+G Y=[1/(1-c1-b1)]*[c0-c1T+b0+G]
b. Including the b1Y term in the investment equation increases the multiplier. Increases in
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autonomous spending now create a multiplier effect through two channels: consumption and investment.
For the multiplier to be positive, the condition c1+b1<1 is required.
c. Output increases by b0 times the multiplier. Investment increases by the change in b0 plus b1 times the
change in output. The change in business confidence leads to an increase in output, which induces an
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additional increase in investment. Since investment increases, and saving equals investment, saving must
also increase. The increase in output leads to an increase in saving.
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9. The paradox of saving revisited

You should be able to complete this question without doing any algebra, although you may find making a
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diagram helpful for part (a). For this problem, you do not need to calculate the magnitudes of changes in
economic variables—only the direction of change.
a. Consider the economy described in Problem 8. Suppose that consumers decide to consume less (and
therefore to save more) for any given amount of disposable income. Specifically, assume that consumer
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confidence (c0) falls. What will happen to output?

b. As a result of the effect on output you determined in part (a), what will happen to investment? What
will happen to public saving? What will happen to private saving? Explain. (Hint: Consider the saving-
equals-investment characterization of equilibrium.) What is the effect on consumption?

c. Suppose that consumers had decided to increase consumption expenditure, so that c0 had increased.
What would have been the effect on output, investment, and private saving in this case? Explain. What
would have been the effect on consumption?

d. 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 households to attempt to save more, then investment, and output,
would increase.”
.

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Answers 9.
a. Output will fall.
b. Since output falls, investment will also fall. Public saving will not change. Private saving will fall,
since investment falls, and investment equals saving. Since output and consumer confidence fall,
consumption will also fall.
c. Output, investment, and private saving would have risen.
d. 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 therefore—somewhat paradoxically—to 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.

Do It yourself questions:

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10. Using fiscal policy in this first (and simplest model) to avoid the recession of 2010: Assume GDP in
2010 was roughly $15,000 billion. GDP fell by approximately 3 percentage points in 2009.a. How many
billion dollars is 3 percentage points of $15,000 billion?

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b. If the propensity to consume were 0.5, by how much would government spending have to have
increased to prevent a decrease in output?
c. If the propensity to consume were 0.5, by how much would taxes have to have been cut to prevent any
decrease in output?
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d. Suppose Congress had chosen to both increase government spending and raise taxes by the same
amount in 2009. What increase in government spending and taxes would have been required to prevent
the decline in output in 2009?
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11. The “exit strategy” problem
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In fighting the recession associated with the crisis, taxes were cut and government spending was
increased. The result was a very large government deficit. To reduce that deficit, taxes must be increased
or government spending must be cut. This is the “exit strategy” from the large deficit.
a. How will reducing the deficit in either way affect the equilibrium level of output in the short run?
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b. Which will change equilibrium output more: (i) cutting G by $100 billion (ii) raising T by $100 billion?
c. How does your answer to part (b) depend on the value of the marginal propensity to consume?
d. You hear the argument that a reduction in the deficit will increase consumer and business confidence
and thus reduce the decline in output that would otherwise occur with deficit reduction. Is this argument
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valid?

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