Question

7. Consider a closed economy where the marginal propensity to consume is 0.85. Technological progress increases GDP by 20 billion pesos. Expansionary fiscal policy results in a $10 billion decrease in tax revenue and a $12 billion increase in the government budget deficit. (a) Calculate the (dollar) change in government spending. (b) Calculate the approximate (dollar) changes in private, public, and na- tional saving (c) Will the equilibrium real interest rate increase, decrease, or stay the same? Use a supply-demand diagram for the loanable funds market to support! your answer.

Answer 1

is a sign,i.e, a neganne, (Nore. Since Tax Revenue decreases, there 7.) from the above information, we havie that: Marginal propensity to consume (mpc) = 085 Inerease în GDP (Y) : 2 y = $20 billion pesos Decrease in Tax Revenue (T) : ST = - $10 billion Further, siou preceding it's values), 'We know that: Budget Deficit = Government expenditure (6) - Tax Reverine (T) . or Budget Deftcit = G -Tin le so Increase in government budget deficit: 0(G-T), in since, . (a) we have AG – T) = 12. - AG - AT = 12 . . voi -) AG = 12 + AT -) AG = 12 - 10 (since', 4T=-10) : =) AG=2 Therefore, the government spending (or expenditure), increases by $2 billion (b) Marginal Propensity to consume is the change in ti consumption dire to 1 unit change in income (or, GDP). oo An increase in GDP by $20 billion and an MPC = 0.85 - would result in an : Increase in consumption (C): 40 = (0.85 x 20) - $ 17 billion.

AT= -10) D Private saving is given byr e n el Y- C-T. to the change in Private saving would be a D(Y-C-T) -44 - OC - OT = 20 - 17.-(-10) (since, 04=20; 40 = 17;. - 20 -17 + 10 = 13 :: Private Saving will increase by $13 billion. Public Saving is given by a n o T-G. in the change in public saving would be at man A (T-G) . - AT - 4G : -10 - 2 (sincé, OT=--10,; OG = '2). ==122 ir public saving decreases by $12 billion a é [Note: Public saving = T-G to Budget petist = G-TE-+G 3 -(1-6). i . Budget Deficit = - Public Saving so If Budget deficit increases by $12 billion, then public Saving decreases by $12 billion, ie, the same amount).. une în public saving in m

Moreover, we know, National Saving = Private Sawing + Public Saving , so change in National Saving = change in private saving & change in public saving = 13+ (-12) = 13-12 = 1. i. National saving increases by $1 billion (c) sime the National saving increases and we know that saving is the source of supply of loanable funds, we can say that the supply of coanable finds will increase. This increase in the supply would decrease the real interest rate. Heme, equilibrium real interest rate will decrease and investment will increase. 1. In the following diagram we have considered the market for loanable finds. Do' and ss' are the demand and supply cornes of loanable funds respectively. As the supply of coanable funds increases, the supply corne shifts to the right from 'ss' to S, sí, decreasing the equilibrium real interest rate and increasing the equilibrium amount of loanable funds transacted cive, investments. The demand corne remains unchanged at DD'.

(Real Juierest Rate; (r) -5,- I. 11 - Jovestment (1) MARKET FOR LOANABLE FUNDS. - In the above diagram, equilibrium interest rate decreases from rotor, and the equilibrium level of investment increases from Io to Inno