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EC 100

EC 100. Macro Exercise 1. Discussion of LT Week 3 . First class for the Macroeconomics part Hand-out corrected Receive some model solutions with some general comments . Problem 1. Why is the aggregate equilibrium condition Y = E? What happens if E <Y? If E >Y ?

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EC 100

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  1. EC 100 Macro Exercise 1

  2. Discussionof LT Week 3 • First classfortheMacroeconomicspart • Hand-out corrected • Receivesomemodelsolutionswithsomegeneralcomments.

  3. Problem 1 • Why is the aggregate equilibrium condition Y = E? What happens if E <Y? If E>Y? • Definition: Y =total supply, defined as the value of all goods and services produced in a year, or other fixed unit of time • Definition: E = total demand, i.e., total spending that same period of time • So condition Y = E is a simple equilibrium condition, that supply equals demand. • If E < Y: less spending than value of output. Producers produce less? Spenders spend more? • Where do the adjustments come from? • Note that Y = P * Q, so equilibrium can be achieved by changes in P or in Q.

  4. Problem 1 • Note aside: • In an open economy: Y = ED + EF • Output is absorbed by domestic spending or foreign spending. In case Y < ED, we could have that the difference is absorbed by foreign spending in form of exports.

  5. Problem 2 • Why is it important to know the equilibrium level of GDP? • Knowing the equilibrium level of GDP helps guide policy. • If the economy is capable of producing higher GDP in equilibrium, then macroeconomic policy might raise aggregate demand to achieve that higher GDP level. • If, on the other hand, the economy’s equilibrium GDP level is lower than currently observed, the economy might be close to already experiencing unnecessarily high inflation: in that case, macroeconomic policy might lower aggregate demand. That’s why knowing evolution of P is of key importance! • In either case, again, knowing the equilibrium level of GDP helps guide policy.

  6. Problem 3 • Why is it useful to split up E into C, I, G, X, and M? • Total demand (or, in equilibrium, total output) is usefully split into its different components C , I , G , X , M because the behaviour of each of these is driven by different economic considerations. • Consider Consumption: • C(YD) = c0 + mpc YD • An increase in taxes reduces disposable income, but is likely not going to have a direct effect on X or M or investment I • So studying these elements separately is very important as it allows us to isolate the effects of certain policies. • Consider G • If the share of G in total output is large – is this good or bad?

  7. Problem 4 • What does the analysis so far suggest might be done to prevent the high unemployment of the 1930s? • We will discuss this a lot further, I just want to give a little preview here – we do not have the whole model set-up yet to be able to discuss this in a lot of detail.

  8. Problem 4 • The government could have expanded its share of expenditure, by increasing G. • This is a policy instrument, that many governments did employ following Lehman brothers. • Can you think of some problems? • How do governments finance their spending? • Imagine that governments need to access private savings to finance their expenditure <> this may increase the interest rate, which could affect private Investment • Need a model to capture savings…

  9. Problem 5 • Given the analysis so far, explain intuitively why an increase in government spending G increases GDP by more than the initial rise in G.

  10. Problem 5 • Given the analysis so far, explain intuitively why an increase in government spending G increases GDP by more than the initial rise in G. • Each additional dollar of consumption is somebody else‘s income, out of this additional one unit of income mpc*1 is additionally consumed by this agent, again, this is somebodys income who is consuming 1*mpc*mpc of it and so on and so forth. • This infinite geometricserieshas a finite andclosed form sumaslongasmpcisbetween 0 and 1.

  11. Problem 5 • Where is the multiplier coming from?

  12. Problem 5 • Where is the multiplier coming from?

  13. Problem 6 • Explain the government spending multiplier in your own words. What is the significance of this multiplier having value greater than one? • The government spending multiplier is the increase in GDP from an increase in government spending, expressed as a proportion of that government spending increase. That the multiplier exceeds 1 means the government has an effective instrument in its spending decisions for guiding changes to GDP.

  14. Problem 7 Whataboutchanges in TAXES? So taxmultiplieris:

  15. Problem 8 Whataboutchanges in IMPORTS? So importmultiplieris:

  16. Problem 9 Supposeyouincrease TAXES by same amountasyouincrease G –whatistheneteffect? The G multiplieris: The T multiplieris: Whatisthe NET EFFECT:

  17. Problem 9 So GDP still increases by 1 unit --- why? The governmentconsumes all, whereasiftaxesarereducedthehouseholds save a fractionofthisnewincome. Hence, themultiplierislowerastheinitialagentswhogetshigherincomedoes not consume all ofit but onlympc*dTof it. The Government is a more „effective”consumer.

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