Question

1. In a closed economy, suppose GDP equals $21 trillion, consumption equals $13 trillion, the government spends $7 trillion and has a budget deficit of $800 billion.

a. Find government saving, taxes, private saving, national saving, and investment.

Please show clearly how you calculated your final answers, and box/circle your final answers (in trillions of dollars) with proper labels

No credit will be given to an answer in incorrect units, in notations that differ from what’s used in the lectures, without clear calculations, or without a box or circle around it.

b)Assume that GDP, initial consumption, and government spending are as specified in part a, but suppose now that the government cuts taxes by $200 billion. Determine what happens to public saving, private saving, national saving, and investment if consumers save the full proceeds of the tax cut.

Please show clearly how you calculated your final answers, and box/circle your final answers (in trillions of dollars) with proper labels

No credit will be given to an answer in incorrect units, in notations that differ from what’s used in the lectures, without clear calculations, or without a box or circle around it

c)Assume that GDP, initial consumption, and government spending are as specified in part a, but suppose now that the government cuts taxes by $200 billion. Determine what happens to public saving, private saving, national saving, and investment if consumers save 1/4 of the tax cut and spend the other 3/4

1. Consider your answers in parts b and c carefully. The amount of the tax cut is identical in both cases, but the impact on national saving and investment differ. This shows that the impact of a tax cut on national saving and investment depends very much on the behavior of consumers.

   • - Which scenario do you think is more realistic? (think about what your own

     behavior may be if you receive a tax cut)

   • - Why is this an important question for policymakers to consider when they are

     trying to decide on tax policy?

2. Now let’s use the model of the loanable funds market to analyze the situation presented in part c. Please graphically illustrate how the loanable funds market changes from the equilibrium shown in part a, to the new equilibrium shown in part c.

   You can draw the graph by hand, but please label all axes, curves, and intercepts carefully. The units for the horizontal axis should be in trillions of dollars. Label the initial equilibrium point as “a” and the new equilibrium point as “c.” Use an arrow to show how the curve/curves have shifted in response to the tax cut.

   Assume the initial equilibrium interest rate is ra% and the new equilibrium interest rate should be labeled as rc%. You should be able to figure out the equilibrium quantities of loanable funds for equilibrium points a and c using the answers you found in earlier parts of the question.

   No credit will be given to a graph with messy and squiggly lines that your TA cannot read, and without proper labels in correct units.

3. Is rc% higher or lower than ra%? Does the tax cut situation in part c show crowding out?

Answer 1