Econ 98- Chiu
Spring 2005
Midterm 2 Review: Macroeconomics
Disclaimer: The review may help you prepare for the exam. The review is not
comprehensive and the selected topics may not be representative of the exam. In
fact, we do not know what will be on the exam. We try to make our answers
complete, but we cannot guarantee their correctness. Use at your own risk and
use good judgment.
SUGGESTED SOLUTIONS
Page 1 of 7
Econ 98- Chiu
Spring 2005
Midterm 2 Review: Macroeconomics
Problem 1. Fiscal Responsibility.
HELLA DIFFICULT QUESTION (too hard for even the midterm).
Congress runs a budget deficit of $200. Fiscal responsibility becomes the new hit-sensation for
politicians. Fiscal responsibility becomes almost as hot as William Hung. Congress wants to
close the budget deficit, but does not want to affect equilibrium output. How much should G and
T rise (by different amounts)?
PAE=C+I+G+NX
C=60+.8(Y-TA+TR)
I=50
NX=0
Assume a closed economy, fixed interest rates, and fixed prices.
Step 1. Translate the problem into equations. The prompt tells us lots of information.
Lets take those words and turn them into math.
Currently Congress faces a budget deficit of $200. Let the subscript “0” represent the
present. We know that Congress wants to balance the budget in the future. Let the
subscript “1” represent the future.
Equation 1:
Equation 2:
G0-T0=200
G1-T1=0
Take the difference between Equation 2 and Equation 1.
Minus
Equation 3:
G1-T1=0
G0-T0=200
(G1-G0)+(-T1+T0)= -200
Remember that the “change” in anything is the new value minus the old value. Hence
we can rewrite Equation 3 as follows:
Equation 4:
∆G - ∆T = -200
If we rewrite Equation 4 in terms of ∆T, then we get a very useful equation:
Equation 5:
∆T = 200 + ∆G
Excellent, we know how to balance the budget! But do not forget that Congress does
not want to change equilibrium output. Hence the effects on output from increasing net
taxes and increasing government spending must cancel each other out. Let ∆YT be the
Page 2 of 7
Econ 98- Chiu
Spring 2005
Midterm 2 Review: Macroeconomics
output change caused by a change in net taxes (∆T). Let ∆YG be the output change
caused by a change in government spending (∆G). Or in equation:
Equation 6:
∆YT + ∆YG = 0
Step 2. Solve for the tax and government spending multipliers.
Let ∆YT be the output change caused by a change in net taxes (∆T). We know that:
Equation 7:
∆YT = (-mpc)(1/(1-mpc)) * ∆T
Remember that mpc=.8. Hence,
Equation 8:
∆YT = -4∆T
Let ∆YG be the output change caused by a change in government spending (∆G). We
know that:
Equation 9:
∆YG = (1/(1-mpc)) * ∆G
Equation 10:
∆YG = 5∆G
Step 3. Substitute.
Combine Equation 5 and Equation 8:
∆T = 200 + ∆G
∆YT = -4∆T
∆YT = -4 (200 + ∆G)
Equation 11:
∆YT = -800 - 4∆G
Combine Equation 6, Equation 10, and Equation 11:
∆YT + ∆YG = 0
∆YG = 5∆G
∆YT = -800 - 4∆G
Equation 12:
[-800 - 4∆G] + [ 5∆G] = 0
Step 4: Solve for ∆G and ∆T.
ANSWER:
ANSWER:
∆G = 800
∆T = 200 + ∆G = 200 + 800 = 1000
Page 3 of 7
Econ 98- Chiu
Spring 2005
Midterm 2 Review: Macroeconomics
Problem 2. Expansionary Fiscal Policy and Money Markets.
a) The economy is in trouble. Congress engages in expansionary fiscal policy. Calculate the rise
in government spending necessary to get the economy back to full-employment output (Yf).
The economy is currently at Y1. Assume Congress does not want to mess with net taxes.
Assume Congress ignores the money market effects on output because they overlooked it.
C = 60 + .95Yd
Y1=1000
Yf=5000
∆Y = (1/(1-mpc)) * ∆G
∆Y = (1/(1-.95)) * ∆G
∆Y = 20∆G
∆Y = Yf – Y1 = 5000-1000 = 4000
4000 = 20∆G
ANSWER:
∆G = 200
Page 4 of 7
Econ 98- Chiu
Spring 2005
Midterm 2 Review: Macroeconomics
b) Show the effects of the expansionary fiscal policy on the Keynesian-cross diagram. Label the
economy’s recessionary output Y1 and the full-employment output Yf. Assume the
government ignores the money market effects on output.
PAE
Y=PAE
PAE2
PAE1
Y1
Page 5 of 7
Yf
Y
Econ 98- Chiu
Spring 2005
Midterm 2 Review: Macroeconomics
c) Congressional ignorance takes hold in the economy. Using the money market diagram show
the expansionary fiscal policy effects on interest rates. Label any new curves or interest rates
with the subscript 2.
ASSUME CONSTANT MONEY SUPPLY. REMEMBER THAT THE FED NO LONGER
HAS A MONEY SUPPLY TARGET. BUT LETS ASSUME THAT IT DOES MAINTAIN
THE MONEY SUPPLY FOR THE SAKE OF THIS QUESTION.
r
Ms
r2
r1
Md2
Md1
M
Page 6 of 7
Econ 98- Chiu
Spring 2005
Midterm 2 Review: Macroeconomics
d) Show the money market effects on the Keynesian-cross diagram. Why is the economy not at
full-employment as originally planned by Congress?
ASSUME CONSTANT MONEY SUPPLY. REMEMBER THAT THE FED NO LONGER
HAS A MONEY SUPPLY TARGET. BUT LETS ASSUME THAT IT DOES MAINTAIN
THE MONEY SUPPLY FOR THE SAKE OF THIS QUESTION.
G up  PAE up  Y up  Md up  r up  I down  PAE down  Y down via the
multiplier effect
PAE
Y=PAE
PAE2
PAE3
PAE1
Y1
Y3
Page 7 of 7
Yf
Y