ECN 142 Exam 3 Make-up Questions Dr. J.F. Schnell

. . . and answers

For questions 1-5: Consider an economy where, initially, in equilibrium (in $billions), Y = 6500; and I =1200, G = 1400, (X - IM) = -100, and T = 1400 always. Then, consumers decide to increase their savings by 300 at all levels of income. The MPC = .75.

1. What is the initial level of consumption?

a. 4000

b. 3900

c. 3800

d. 3700

Use the equilibrium condition: Y = C + I + G + (X - IM) 6500 = C₁ + fixed spending (1200 + 1400 - 100 = 2500). So, C₁ = 6500 - 2500 = 4000

2. What is the initial level of savings?

a. 800

b. 900

c. 1000

d. 1100

Need DI = Y - T = 6500 - 1400 = 5100, and DI = C + S 5100 = 4000 + S₁, and S₁ = 5100 - 4000 = 1100

3. Following the change in savings, what is the new equilibrium level of consumption?

a. 2700

b. 2800

c. 2900

d. 3000

Need the multiplier to first calculate the change in income: 1/(1 - MPC) = 1/(1 - .75) = 4. Y = 300 (increase in savings, equivalent to the decrease in consumption) x 4 = 1200 decrease, all out of C. So, C₂ = 4000 - 1200 = 2800.

4. Following the change in savings, what is the new equilibrium level of income?

a. 4400

b. 5200

c. 5300

d. 5400

Y₂ = C₂ + fixed spending = 2800 + 2500 = 5300. (Note: Y₂ = Y₁ - 1200 6500 - 1200 = 5300.)

5. At the new equilibrium level of income, what is the level of savings?

a. 800

b. 900

c. 1000

d. 1100

DI = Y - T = 5300 - 1400 = 3900, DI = C + S 3900 = 2800 - S₂, and S₂ = 3900 - 2800 = 1100

For questions 6-10: Suppose the current variable tax rate is 25%, and taxes are then cut by $300 billion. Suppose, also, that the MPC = .8. The current (before the tax cut) equilibrium level of RGDP is $7,000 billion.

6. The change in consumption spending is

a. 240

b. 300

c. 750

d. 890

C = tax cut x MPC = 300 x .8 = 240

7. The multiplier for the change in consumption spending is

a. 2.78

b. 2.68

c. 2.60

d. 2.50

To get the multiplier for the change in consumption: With a variable tax rate, t = 25%, there will be $.75 more DI for every $1 increase in income, Y. The increase in consumption spending, therefore, would be $.75 x MPC = .75 x .8 = .6. For the next question, note that .6 must be the slope of the expenditure function. This multiplier is then 1/(1 - .6) = 2.5. (This calculation also yields the multiplier formula 1/(1 - [MPC(1 - t)]).)

8. The slope of the expenditure function is

a. .6

b. .64

c. .75

d. .8

9. The new equilibrium level of RGDP is

a. $7,750 billion

b. $7,600 billion

c. $7,640 billion

d. $7,890 billion

Y = 2.5 x C = 2.5 x 240 = 600. Thus, Y₂ = Y₁ + 600 = 7000 + 600 = 7600.

10. The tax multiplier is

a. 2.224

b. 2.000

c. 1.500

d. 1.875

Y /T = 600/300 = 2.0