Homework 12

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Due date : September 21, 2017, 12:00 pm

For the questions 1 to 4 refer to the simple Keynesian model of aggregate income (Y ) determination.

1. 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 with following behavioral equations:

C = c0 + c1 YD

T = t0 + t1 Y

YD = Y T

(a) Solve for equilibrium output.

(b) Solve for taxes in equilibrium.

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

(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? (Dont do the algebra.
Use your intuition and give the answer in words.)

2. Taxes and transfers

Recall that we define taxes, T , as net of transfers. In other words,

T = Taxes Transfer Payments

(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 increase in taxes. How does the increase in transfer payments affect equilib-
rium output in this case?
(c) Now suppose that the population includes two kinds of people: those with high propen-
sity to consume and those with low propensity to consume. Suppose the transfer policy
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You do not need to submit this homework. This deadline is the target you should set for yourself.

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 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?

3. The paradox of saving

You should be able to complete this question without doing any algebra, although you may
find making a diagram helpful for part (a). For this problem, you do not need to calculate
the magnitudes of changes in economic variablesonly the direction of change.

(a) Consider the economy described by following behavioral equations:

C = c0 + c1 YD

YD = Y T

I = b0 + b1 Y

Suppose that consumers decide to consume less (and therefore to save more) for any
given amount of disposable income. Specifically, assume that consumer 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 sav-
ing equals investment. Therefore, if the government could just convince households to
attempt to save more, then investment, and output, would increase.

4. The exit strategy problem

In fighting the recession associated with the 2008 crisis, taxes were cut and government
spending was increased. The result was a very large government deficit. To reduce that

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 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?
(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 busi-
ness confidence and thus reduce the decline in output that would otherwise occur with
deficit reduction. Is this argument valid? [Note: the c0 in C = c0 + c1 YD and the b0 in
I = b0 + b1 Y represent consumer confidence and business confidence respectively.]

The following questions are from the chapter on demand for money.

5. Consider a bond that promises to pay Rs. 100 in one year.

(a) What is the interest rate on the bond if its price today is Rs. 75? Rs. 85? Rs. 95?
(b) What is the relation between the price of the bond and the interest rate?
(c) If the interest rate is 8%, what is the price of the bond today?

6. Suppose that money demand is given by

M d = P Y (.25 i)

where P Y is Rs. 100. Also, suppose that the supply of money is Rs. 20.

(a) What is the equilibrium interest rate?

(b) If the Reserve Bank wants to increase i by 10 percentage points (e.g., from 2% to 12%),
at what level should it set the supply of money?

7. Suppose that a persons wealth is Rs. 50,000 and that her yearly income is Rs. 60,000. Also
suppose that her money demand function is given by

M d = P Y (.35 i)

(a) Derive the demand for bonds. Suppose the interest rate increases by 10 percentage
points. What is the effect on the demand for bonds?

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 (b) What are the effects of an increase in wealth on the demand for money and the demand
for bonds? Explain in words.
(c) What are the effects of an increase in income on the demand for money and the demand
for bonds? Explain in words.
(d) Consider the statement When people earn more money, they obviously will hold more
bonds. What is wrong with this statement?

8. ATMs and credit cards

This problem examines the effect of the introduction of ATMs and credit cards on money
demand. For simplicity, lets examine a persons demand for money over a period of four
days. Suppose that before ATMs and credit cards, this person goes to the bank once at the
beginning of each four-day period and withdraws from her savings account all the money she
needs for four days. Assume that she needs Rs. 4 per day.

(a) How much does this person withdraw each time she goes to the bank? Compute this
persons money holdings for days 1 through 4 (in the morning, before she needs any of
the money she withdraws).
(b) What is the amount of money this person holds, on average?
(c) Suppose now that with the advent of ATMs, this person withdraws money once every
two days. Recompute your answer to part (a).
(d) Recompute your answer to part (b).
(e) Finally, with the advent of credit cards, this person pays for all her purchases using
her card. She withdraws no money until the fourth day, when she withdraws the whole
amount necessary to pay for her credit card purchases over the previous four days.
Recompute your answer to part (a).
(f) Recompute your answer to part (b).
(g) Based on your previous answers, what do you think has been the effect of ATMs and
credit cards on money demand?

9. The money multiplier

Assume the following:

The public holds no currency.

The ratio of reserves to deposits is 0.1.
The demand for money is given by

M d = P Y (.8 4i)

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 Initially, the monetary base is Rs. 100 billion, and nominal income is Rs. 5 trillion.

(a) What is the demand for central bank money?

(b) Find the equilibrium interest rate by setting the demand for central bank money equal
to the supply of central bank money.
(c) What is the overall supply of money? Is it equal to the overall demand for money at the
interest rate you found in part (b)?
(d) What is the impact on the interest rate if central bank money is increased to Rs. 300
billion?
(e) If the overall money supply increases to Rs. 3,000 billion, what will be the impact on i?
[Hint: Use what you discovered in part (c).]

10. Bank runs and the money multiplier preferring to hold on to their cash.
During the Great Depression, the U.S. economy experienced many bank runs, to the point
where people became unwilling to keep their money in banks, preferring to hold on to their
cash cash.
How would you expect such a shift away from checkable deposits toward currency to affect
the size of the money multiplier?