Note: In the following problem, it is important to show all the steps used to get your answers.
Suppose an imaginary closed economy is characterized by the following:
C = c0 + c1 (Y − T)
T = 300 I = 400 G = 400
C is consumption, Y and YD are, respectively, income and disposable income, T is the level
of taxes, I and G, are, respectively, private investment, and government spending.
c0 and c1 are, respectively, autonomous consumption and the marginal propensity to con-
sume; their values are unknown. However, the expression for private saving, S, is as specified
below.
S = 0.5Y − 500
1. Find the equilibrium values of GDP, consumption, disposable income, and private saving.
(5 points)
2. Find the expression of the investment multiplier in terms of c0 and/or c1. (3 points)
3. Find the values of c0 and c1 and the value of the investment multiplier (Hint: you’ll prob-
ably find c0 is equal to an even number, which is multiple of 2). (5 points)
4. From this question on, you must use when needed the values of c0 and c1 found in the pre-
vious question. Suppose now that the government tax revenue, T, has both autonomous
and endogenous components, in the sense that the tax level depends on the level of in-
come.
T = t0 + t1Y
t0 is the autonomous tax level, and t1 is the marginal tax rate.
Given the values of private investment and government spending mentioned above, find
the expression for the equilibrium GDP in terms of c0, c1, t0 and t1. (4 points)
5. Assuming that t0 = 200 find the value of the marginal tax rate that will yield the same
level of equilibrium GDP as the one obtained (1). (4 points)
6. Find the expression for the investment multiplier in terms of c1and t1 and possibly c0, and
t0. (4 points)
7. Assume now that private investment, I, increases by 50. Find the change in GDP, ∆Y,
induced by the change in investment, ∆I = 50. (4 points)
8. The government does not like the change in GDP induced by the increase in private in-
vestment. It wants to bring it back to the level found in Question (1). For that purpose, it
has the options to change its spending or to change taxes.
(a) If the government changes its spending alone, find the level of ∆G required to coun-
teract the effect on GDP of the fall in investment. (4 points)
(b) If the government changes instead the level of its autonomous taxes alone, find the
level of ∆t0 required to counteract the effect on GDP of the fall in investment. Explain
what happened. (4 points)
(c) How does ∆G compare to ∆t0? Explain the difference, if there is any. (4 points)
(d) In which direction should the government change its marginal tax rate, t1 (increase
or decrease), if it uses it as the sole policy instrument to counteract the effect of the
change in investment? Explain intuitively your answer. (4 points)
Only need to answer 5-8 questions!!!!
