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# Homework 1

1. Suppose that the government of Lumpland is enjoying a fat budget surplus with
fixed government expenditures of G = 150 and fixed taxes of T = 200. Assume
that consumers of Lumpland behave as described in the following consumption
function:
C = 150 + 0.75(Y - T)
Suppose further that investment spending is fixed at 100. Calculate the
equilibrium level of GDP in Lumpland. Solve for equilibrium levels of Y, C, and
S.
Next, assume that the Republican Congress in Lumpland succeeds in reducing
taxes by 20 to a new fixed level of 180. Recalculate the equilibrium level of GDP
using the tax multiplier. Solve for equilibrium levels of Y, C, and S after the tax
cut and check to ensure that the multiplier worked. What arguments are likely to
be used in support of such a tax cut? What arguments might be used to oppose
such a tax cut?
2. Assume that in 2011, the following prevails in the Republic of Nurd:
Y = \$200 G = \$0
C = \$160 T = \$0
S = \$40
I (planned) = \$30
Assume that households consume 80 percent of their income, they save 20
percent of their income,MPC = .8, and MPS = .2. That is, C = .8Yd and S = .2Yd.
a. Is the economy of Nurd in equilibrium? What is Nurd’s equilibrium level of
income? What is likely to happen in the coming months if the government
takes no action?
b. If \$200 is the “full-employment” level of Y, what fiscal policy might the
government follow if its goal is full employment?
c. If the full-employment level of Y is \$250, what fiscal policy might the
government follow?
d. Suppose Y = \$200, C = \$160, S = \$40, and I = \$40. Is Nurd’s economy in
equilibrium?
e. Starting with the situation in part d, suppose the government starts spending
\$30 each year with no taxation and continues to spend \$30 every period. If it
remains constant, what will happen to the equilibrium level of Nurd’s
domestic product (Y)? What will the new levels of C and S be?
f. Starting with the situation in part d, suppose the government starts taxing the
population \$30 each year without spending anything and continues to tax at
that rate every period. If it remains constant, what will happen to the
equilibrium level of Nurd’s domestic product (Y)? What will be the new
part e? Why?
3. In 2000, the federal debt was being paid down because the federal budget was in
surplus. Recall that surplus means that tax collections (T) exceed government
spending (G). The surplus (T - G) was used to buy back government bonds from
the public, reducing the federal debt. As we discussed in this chapter, the main
method by which the Fed increases the money supply is to buy government bonds
by using open market operations. What is the impact on the money supply of
using the fiscal surplus to buy back bonds? In terms of their impacts on the money
supply, what is the difference between Fed open market purchases of bonds and
Treasury purchases of bonds using tax revenues?
4. You are given this account for a bank:
ASSETS LIABILITIES

Loans 3,000

## The required reserve ratio is 10 percent.

a. How much is the bank required to hold as reserves given its deposits of
\$3,500?
b. How much are its excess reserves?
c. By how much can the bank increase its loans?
d. Suppose a depositor comes to the bank and withdraws \$200 in cash.
Show the bank’s new balance sheet, assuming the bank obtains the cash by
drawing down its reserves. Does the bank now hold excess reserves? Is it meeting
the required reserve ratio? If not, what can it do?
5. Illustrate the following situations using supply and demand curves for money:
a. The Fed buys bonds in the open market during a recession.
b. During a period of rapid inflation, the Fed increases the reserve requirement.
c. The Fed acts to hold interest rates constant during a period of high inflation.
d. During a period of no growth in GDP and zero inflation, the Fed lowers the
discount rate.
e. During a period of rapid real growth of GDP, the Fed acts to increase the
reserve requirement.
6. The demand for money in a country is given by Md = 10,000 - 10,000r + where
Md is money demand in dollars, r is the interest rate (a 10 percent interest rate
means r = 0.1), and is national income. Assume that is initially 5,000.
a. Graph the amount of money demanded (on the horizontal axis) against the interest
rate (on the vertical axis).
b. Suppose the money supply (Ms) is set by the central bank at \$10,000. On the
same graph you drew for part a., add the money supply curve. What is the
c. Suppose income rises from = 5,000 to = 7,500. What happens to the money
demand curve you drew in part a.? Draw the new curve if there is one. What
happens to the equilibrium interest rate if the central bank does not change the
supply of money?
d. If the central bank wants to keep the equilibrium interest rate at the same value as
it was in part b., by how much should it increase or decrease the supply of money
given the new level of national income?
e. Suppose the shift in part c. has occurred and the money supply remains at \$10,000
but there is no observed change in the interest rate. What might have happened
that could explain this?
1. Assume the following model of the economy:
C = 180 + 0.8(Y-T)
I = 190
G = 250
T = 150
a. What is the value of the MPC in this model?
b. Draw the planned expenditure curve and indicate its slope and y-intercept.
c. Compute the equilibrium level of income, that is, the level of income that
equates planned (E) and actual (Y) expenditure.
d. Calculate the level of unplanned inventory accumulation when Y = 3000.

## 2. Consider the same model as in Problem 1:

a. Compute the initial equilibrium level of income.
b. If government purchases were to increase by 10 to 260, what
would happen to each of the following?
i. the planned expenditure curve
ii. the equilibrium level of income
iii. the level of consumption
iv. the government budget deficit
c. Starting again at G = 250, suppose that taxes increased by 10 to
160. What would happen to each of the following?
i. the planned expenditure curve
ii. the equilibrium level of income
iii. the level of consumption
iv. the government budget deficit
d. Starting over one last time at G = 250 and T = 150, suppose that
government expenditures and taxes were both increased by 10 to
260 and 160, respectively. What would happen to each of the
following?
i. the planned expenditure curve
ii. the equilibrium level of income
iii. the level of consumption
iv. the government budget deficit
3. Suppose that the following equations describe an economy. (C, I, G, T, and Y
are measured in billions of dollars, and r is measured as a percent; for
example, r = 10 = 10%):
C = 170 + 0.6(Y-T)
T = 200
I = 100 - 4r
G = 350
(M/P)d = 0.75Y - 6r
(M/P)s = M/P = 735
a. Derive the equation for the IS curve. (Hint: It is easier to solve for Y here.)
b. Derive the equation for the LM curve. (Hint: Again, it is easier to solve
for Y.)
c. Now express both the IS and LM equations in terms of r. Graph both
curves and calculate their slopes.
d. Use the equations from parts a. and b. to calculate the equilibrium levels
of real output, the interest rate, planned investment, and consumption.
e. At the equilibrium level of real output, calculate the value of the
government budget surplus.

4. Suppose that there is a sudden increase in the demand for money—that is, at
the same levels of r and Y people want to hold more money. What would
happen to the money demand curve and thus the LM curve? Illustrate your

## 5. In 2003, the U.S. Congress enacted substantial increases in defense spending

to counter terrorism and significant reductions in taxes.
a. Illustrate graphically using the model of the Keynesian cross the
short-run effects on the planned expenditure curve and the
equilibrium level of GDP?
b. Illustrate graphically the effects of these policies on the IS and/or
LM curves? Be as precise as you can about the exact shifts.
c. What happens in the short run to the equilibrium levels of real
output and the interest rate? Explain how the outcome of this
policy in the IS-LM model differs from the outcome in the classical
model of the economy studied in chapter three.